Saturday, November 22, 2014

America’s False Dawn

NEW HAVEN – Financial markets and the so-called Davos consensus are in broad agreement that something close to a classic cyclical revival may finally be at hand for the US. But is it?

At first blush, the celebration seems warranted. Growth in real GDP appears to have averaged close to 4% in the second half of 2013, nearly double the 2.2% pace of the preceding four years. The unemployment rate has finally fallen below the 7% threshold. And the Federal Reserve has validated this seemingly uplifting scenario by starting to taper its purchases of long-term assets.

But my advice is to keep the champagne on ice. Two quarters of strengthening GDP growth hardly indicates a breakout from an anemic recovery. The same thing has happened twice since the end of the Great Recession in mid-2009 – a 3.4% average annualized gain in the second and third quarters of 2010 and a 4.3% average increase in the fourth quarter of 2011 and the first quarter of 2012. In both cases, the uptick proved to be short-lived.

A similar outcome this time would not be surprising. Indeed, much of the acceleration in GDP growth has been bloated by an unsustainable surge of restocking. Over the first three quarters of 2013, rising inventory investment accounted for fully 38% of the 2.6% increase in total GDP. Excluding this inventory swing, annualized growth in “final sales” to consumers, businesses, and the government averaged a tepid 1.6%. With inventory investment unlikely to keep accelerating at anything close to its recent rate, overall GDP growth can be expected to converge on this more subdued pace of final demand.

That gets to the toughest issue of all – the ongoing balance-sheet recession that continues to stifle the American consumer. Accounting for 69% of the economy, consumer demand holds the key to America’s post-crisis malaise. In the 17 quarters since “recovery” began, annualized growth in real personal consumption expenditures has averaged just 2.2%, compared to a pre-crisis trend of 3.6% from 1996 to 2007.

To be sure, there were indications of a temporary pick-up in annual consumption growth to nearly 4% in the fourth quarter of 2013. Yet that is reminiscent of a comparable 4.3% spurt in the fourth quarter of 2010, an upturn that quickly faded.

The lackluster trend in consumption is all the more pronounced when judged against the unprecedented decline that occurred in the depths of the Great Recession. From the first quarter of 2008 through the second quarter of 2009, real consumer spending plunged at a 1.8% average annual rate. In the past, when discretionary spending on items such as motor vehicles, furniture, appliances, and travel was deferred, a surge of “pent-up demand” quickly followed.

Not this time. The record plunge in consumer demand during the Great Recession has been followed by persistently subpar consumption growth.

This should not be surprising. The American consumer was, in effect, ground zero in this horrific crisis. Far too many US households made enormous bets on the property bubble, believing that their paper gains were permanent substitutes for stagnant labor income. They then used these gains to support a record consumption binge. Compounding the problem, they drew freely on a monstrous credit bubble to finance the gap between spending and income-based saving.

When both bubbles burst – first housing, and then credit – asset-dependent US consumers were exposed to the American strain of the Japanese disease first diagnosed by Nomura economist Richard Koo.

Koo has stressed the lingering perils of a balance-sheet recession centered on the corporate sector of the Japanese economy; but the analysis is equally applicable to bubble-dependent US consumers. When the collateral that underpins excess leverage comes under severe pressure – as was the case for Japanese businesses in the early 1990’s and American consumers in the mid 2000’s – what Koo calls the “debt rejection” motive of deleveraging takes precedence over discretionary spending.

The Japanese parallels do not stop there. As research by the economists Richard Caballero, Takeo Hoshi, and Anil Kashyap has shown, Japan’s corporate “zombies” – rendered essentially lifeless by their balance-sheet problems – ended up damaging the healthier parts of the economy. Until balance sheets are repaired, such “zombie congestion” restrains aggregate demand. Japan’s lost decades are an outgrowth of this phenomenon; the US is now halfway through the first lost decade of its own.

Indicators of US balance-sheet repair hardly signal the onset of the more vigorous cyclical revival that many believe is at hand. The debt/income ratio for American households is now down to 109% – well below the peak of 135% reached in late 2007, but still 35 percentage points above the average over the final three decades of the twentieth century.

Similarly, the personal saving rate stood at 4.9% in late 2013, up sharply from the low of 2.3% in the third quarter of 2005; but it remains 4.4 percentage points below the average recorded from 1970 to 1999. By these measures, American consumers’ balance-sheet repair is, at best, only about half-finished.

Optimists see it differently. Encouraged by sharp reductions in households’ debt-service costs and a surprisingly steep fall in unemployment, they argue that the long nightmare has finally ended.

That may be wishful thinking. Plunging debt service is largely an outgrowth of the Fed’s unprecedented zero-interest-rate policy. As long as the stock of debt remains excessive, consumers will dismiss the reduction in interest expenses as nothing more than a temporary subsidy from the Fed.

Moreover, the decline in unemployment largely reflects persistently grim labor-market conditions, which have discouraged many workers from remaining in the labor force. If the labor-force participation rate was 66%, as it was in early 2008, rather than 62.8%, as it was in December 2013, the unemployment rate would be just over 11%, not 6.7%.

Yes, there has been some progress on the road to recovery. But, as Carmen Reinhart and Ken Rogoff have long documented, post-crisis healing is typically slow and painful. Notwithstanding the Fed’s claims that its unconventional policies have been the elixir of economic renewal in the US, the healing process still has years to go.

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    1. CommentedBen Smtih

      "As long as the stock of debt remains excessive, consumers will dismiss the reduction in interest expenses as nothing more than a temporary subsidy from the Fed."

      It's an enormous error to assume that a majority of American's are economically literate enough to understand the effect the federal reserve has on their personal finances.

    2. CommentedCraig Stevenson

      Mr Roach cites these numbers, while previously dercying the over-consumption of the american consumer, firmly in the America produces nothing camp, even while he waas saying this the US was the largest producer of Manufactures in the World, and the largest provider of services to the world, while the American consumer, despite the rise of the Global Middle class provides 50% of all final user demand, and has acted as a demand provider to the global economy for decades (justifying investment in manufactures and infrastructure elsewhere insofar as they are financiallly viable. I am not sure what he teaches at Yale but have long thought that is perwpecitve, as has been shown otherwise via his predictions, as false, irrelevant, based in a false economic philosophy and irreal related to conditions around the globe.

      While I applaud the QE enabled deleveraging of the US Fianncials, to the tune of 3.6 trillion over the last 4 years, the surge in pension assets, the lessening of state and federal debt (lower as a percentage of the economy than in many of the years of the 1980's; especially the middle of the decade), it seems that the financial narrative wanes. mr Roach, ought to get with the picture. Although the US has provided demand, and while the likes of Roach would admire the "lending" of funds to the US by Asian economies in the 2000's (MArty Feldsteins brilliant idea that Asia could insure against financail volatility by structuring surpluses that require the American taxpayer via treasury purchases to crowd out spending in the IS budget) it should be noted however that much of these funds which were lent to the US economy, because it needed have just been which has been just deleveraged and pushed onto Government balance sheets. Starve the beast, where these idealogues fail to realize that what the desire is had only by failed states, has never been existent in the history of the US economy, and doesn't work in the case of modern economies. I am not sure who would attend his classes, but I teach rather more substanitve issues in mine.

    3. CommentedProcyon Mukherjee

      It is unsurprising that questions around the current recovery is directed across a range of leading indicators, which is a riposte that intrinsic structural change is yet to happen. But apart from the foreboding signs on display, there is not much on offer, as in this article as well.

      But I am more attracted to the title of this essay, “America’s false dawn”, which portends a deeper issue that when the S&P 500 or the Dow reaches the glories of wealth creation, how could it be that doubt around recovery makes a headline? Does this mean that our penchant for paper or transitory wealth allures us to a maddening search for yield, which in itself is an escapade from the realities of economy that subsumes any creation? Could we stay rich selling each other paper for long?

    4. CommentedM1ro Br@da

      Today economics is not sufficiently sophisticated (in terms of logic) to describe reality. It is actually pseudo-sophisticated just to make impression of the competence...
      Clearly, the problem is a power structure - not allowing a change. It does not seem to be like a 'trembling hand equilibrium'... Nobody (can) knows what will follow - that's only sure thing...
      Maybe good time to revive the idea of Discontinuity (instead of growth):