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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.