In my mind, the easiest way to understand the over-leverage of the U.S. household is to look at the ratio of consumption to GDP. This number is essentially the amount of U.S. income devoted to consumption as opposed to investment or exports. The higher this number grows the more households have borrowed to support their consumption.
The share of income allocated to consumption in the United States has risen from 62 percent in 1980 to over 70 percent in 2008. Over 40 percent of the rise has occurred since 2000. This level of consumption is way too high. It is high by historical post-war U.S. standards and it is high by contemporary international standards.
Take a look at the inset box. Of the major industrial economies, the United Kingdom has the highest ratio. At 64 percent of GDP, however, the United Kingdom has only reached levels of consumption similar to that of the early 1980s United States.
To make a stronger link with leverage, one can glean similar insights from the current account deficit of the United States. Over exactly the same period that consumption as a share of GDP has been rising, the current account deficit of the United States has been falling. The match is close even to the point of matching the three percentage point jump since 2000. The current account deficit represents real indebtedness to foreign economies. It does not matter whether this debt is incurred because oil prices have risen or because we buy a lot of TV’s.
The share of consumption to GDP in the United States must fall and it seems that we are, finally, at the turning point. There are only two ways for this adjustment to occur: either consumption must fall or the other components of GDP must rise.How far does consumption have to fall? It depends on how far the ratio of consumption to GDP must move. I believe the ratio is likely to return to 1980 levels but a strong case can be made that the ratio need only fall back to the level of the late 1990s.
Assuming no growth in other components of GDP, consumption would have to fall 3.2 percent per year to bring the ratio back to its 2000 level within five years. For the ratio of consumption to GDP to fall back to its 1980’s level within five years, consumption would have to fall 7.4 percent per year. If we allow 10 years for the ratio to return to its 1980’s level, consumption only needs to fall 3.2 percent per year.
These falls are huge and well beyond anything in the modern historical record for industrial economies with the possible exception of the Great Depression. Only Argentina (and perhaps some of the Asians during the Asian Financial Crisis, though I have not checked) suffered falls of this magnitude. In 2001 and 2001, Argentina experienced repeated double-digit falls in consumption.
Of course the consumption numbers are all relative to the other components of GDP. Consumption does not have to fall as much if other parts of the NIPA accounts are growing. However, because consumption has such a large share of output, the other components would have to grow very fast indeed to keep consumption from having to fall at all. In addition, I have trouble imagining components like investment expanding when consumption is falling at these rates (see the next section).
These numbers are scary.
Implications for House Prices? By the way, the large fall in consumption has significant implications for house prices. Assuming that there is no downward adjustment in the housing stock, a back of the envelope calculation indicates that house prices have to fall 38% along this (1980) adjustment path, with the first 19% occurring in the first five years.
(Technical note: The back of the envelope calculation is derived from a Gordon-Growth decomposition, assuming log utility and constant interest rates. With log utility, the level of the interest rate does not matter. I also ignore changes in population size. This is essentially a poor man’s version of the techniques used in this Fed paper. )
Again, these numbers seem quite large. But, perhaps by coincidence, these are exactly the numbers experienced in Japan during its economic collapse in the 1990s. Between the peak in house prices in 1992 and 1997 Japanese land prices fell 19.4 percent. Between 1992 and 2002, land prices fell 37.7 percent. The numbers are not rigged or preplanned, nor are the dates carefully chosen. They just turned out exactly that way.
Another 20 to 30 percent fall in house prices from where we are now is not beyond the realm of possibility.
Implications for Other Asset Prices? MSmith’s original question was on the implications for investment. Here I am on shakier ground but the Gordon Growth model was originally intended to analyze equity prices. The same analysis should then essentially apply. Stock prices are in for a rough ride.
Let’s stick with the theme of comparing the current U.S. situation to the Japanese situation in the 1990s. Japanese equity markets peaked in 1989 and following the peak, the fell, on balance, for the next 15 years.
Below I have plotted Japanese stock prices against the Dow and indexed them both to 100 in their peak year. For the Dow, the chart starts in 1985 and runs through year end 2008. The Nikkei line starts in 1967 and also runs through year end 2008. In other words, the two time series are shifted such that their peak dates match.
With consumption likely to fall and the demographic situation continuing to worsen, U.S. equity markets are going to have a hard time outperforming Japanese equity markets of the 1990s.
I hope I am wrong, but we shall see.
Assuming no growth in other components of GDP, consumption would have to fall 3.2 percent per year to bring the ratio back to its 2000 level within five years. For the ratio of consumption to GDP to fall back to its 1980’s level within five years, consumption would have to fall 7.4 percent per year. If we allow 10 years for the ratio to return to its 1980’s level, consumption only needs to fall 3.2 percent per year.
These falls are huge and well beyond anything in the modern historical record for industrial economies with the possible exception of the Great Depression. Only Argentina (and perhaps some of the Asians during the Asian Financial Crisis, though I have not checked) suffered falls of this magnitude. In 2001 and 2001, Argentina experienced repeated double-digit falls in consumption.
Of course the consumption numbers are all relative to the other components of GDP. Consumption does not have to fall as much if other parts of the NIPA accounts are growing. However, because consumption has such a large share of output, the other components would have to grow very fast indeed to keep consumption from having to fall at all. In addition, I have trouble imagining components like investment expanding when consumption is falling at these rates (see the next section).
These numbers are scary.
Implications for House Prices? By the way, the large fall in consumption has significant implications for house prices. Assuming that there is no downward adjustment in the housing stock, a back of the envelope calculation indicates that house prices have to fall 38% along this (1980) adjustment path, with the first 19% occurring in the first five years.
(Technical note: The back of the envelope calculation is derived from a Gordon-Growth decomposition, assuming log utility and constant interest rates. With log utility, the level of the interest rate does not matter. I also ignore changes in population size. This is essentially a poor man’s version of the techniques used in this Fed paper. )
Again, these numbers seem quite large. But, perhaps by coincidence, these are exactly the numbers experienced in Japan during its economic collapse in the 1990s. Between the peak in house prices in 1992 and 1997 Japanese land prices fell 19.4 percent. Between 1992 and 2002, land prices fell 37.7 percent. The numbers are not rigged or preplanned, nor are the dates carefully chosen. They just turned out exactly that way.
Another 20 to 30 percent fall in house prices from where we are now is not beyond the realm of possibility.
Implications for Other Asset Prices? MSmith’s original question was on the implications for investment. Here I am on shakier ground but the Gordon Growth model was originally intended to analyze equity prices. The same analysis should then essentially apply. Stock prices are in for a rough ride.
Let’s stick with the theme of comparing the current U.S. situation to the Japanese situation in the 1990s. Japanese equity markets peaked in 1989 and following the peak, the fell, on balance, for the next 15 years.
Below I have plotted Japanese stock prices against the Dow and indexed them both to 100 in their peak year. For the Dow, the chart starts in 1985 and runs through year end 2008. The Nikkei line starts in 1967 and also runs through year end 2008. In other words, the two time series are shifted such that their peak dates match.
With consumption likely to fall and the demographic situation continuing to worsen, U.S. equity markets are going to have a hard time outperforming Japanese equity markets of the 1990s.I hope I am wrong, but we shall see.
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2 comments:
Once again market forces should be allowed to find clearing prices. As you note, the US trade account is going to improve, my view its secular and will be dramatic in 2009. By H2 of 2009, it should be greater than -20 billion per month.
The global implications are profound. Deflation needs to be embraced as the economic organization now, policy needs to enhance the markets finding clearing prices as quickly as possible.
How to enhance the deflationary search for new a equilibrium? First, negative sovereign rates to incentivize reallocation into private sector assets. Secondly, large scale debt for equity swaps, particularly in the financial sector. With so many institutions becoming banks holding co's fierce competition is set for deposits, CD yields are going to rise. Even with the swap of debt to equity, much consolidation must occur within the US financial sector.
Debt for equity can be done relatively quickly and reduce cash flow requirements of the underlying economic entity.
Allow the USD to rise as private sector assets prices are found at market levels. Collapsing inflation will benefit the consumer, there is no end to the supply of cheap labor globally. With manufactured deflation set to be very intense in 2009, a strong USD will improve cash flow of the household sector further improving the credit quality of the sector.
Fourth, do not blow out explicit government liabilities. The US tax base is likely shrinking given tax loss carry forwards in the non household sector, and the poor demographic trend. Also existing government entitlement programs will see significant increases in spending outside of any stimulus package enacted.
Its important to recongize the delevering in the US as being secular and the resultant squeeze on domestic cash flow, even with the decline you outline, the consumer will be far and away the biggest portion of the economy and its cash flow.
A high usd and deflationary manufacturing environment will maximize private sector cash flow and is indeed what the market wants to do. Printing money is unimaginative and the US can end up being like Argentina.
Hello! A link to your site appeared in Google Ads on my Gmail page and brought me to your most recent post.
In your 8 May 09 post you write: "The global economy cannot return to health until households have worked off at least part of their excess debt. So far they have made little progress." I think this is exactly right. I think it tells us what U.S. economic policy must do.
In your post of 31 December 08 you write: "The share of consumption to GDP in the United States must fall and it seems that we are, finally, at the turning point. There are only two ways for this adjustment to occur: either consumption must fall or the other components of GDP must rise." You write: "In addition, I have trouble imagining components like investment expanding when consumption is falling at these rates...."
Okay, so... consumption must fall *relative* to the rest of GDP... and you don't see investment picking up the slack... Obviously the federal government is doing what it can... But I think you omitted an important point: Since the 1970s or so, U.S. economic growth has been below par.
If GDP growth has been too slow, then GDP today is too small. And if that is true, then one cannot hope to find a solution in a *further* reduction of GDP or the rate of GDP growth. One cannot hope to find a solution in the reduced growth of consumer spending. I understand and agree fully with much of what you say, but to call for a decline of the U.S. economy is Fall-of-Rome.
The solution *must* lie elsewhere. I refer you back to your statement of 8 May 09, above. The solution to the economic problem is to reduce outstanding debt.. If you like, change the word "is" to "includes."
The first comment to this post says, "Printing money is unimaginative and the US can end up being like Argentina." Nonetheless, the Fed has been printing money like it's going out of style.
Essentially, the Fed is printing money and using it to support the existing modus operandi. Therein lies the problem, for the existing m.o. is what got us into this mess. My method would be to print some money (you decide how much) and use it to pay off existing consumer debt. Or existing debt, your choice. My method: 1. Reduces debt. 2. Takes the new money out of circulation immediately. 3. Makes banks more liquid. 4. Creates a consumer more willing and able to take on more debt and help the economy grow.
If I have said anything interesting, you can google Arthurian Economics.
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