The US Economy's Three Major Imbalances
by Bonddad, Thu Jul 06, 2006 at 04:23:00 AM EDT
The U.S. economy suffers from extreme economic imbalances that must be resolved. The longer they persist, the more difficult and painful their ultimate resolution will be. The imbalances result primarily from an excess of consumption and borrowing, and insufficient savings and production, and can only be resolved by less of the former and more of the latter. Recession is not the only way to reduce consumption, but since our economy is 70% consumption, any noticeable dip in consumption will lead to recession. The Fed should not prevent this from occurring any more than a clinician at a rehabilitation center should try to prevent a patient from suffering withdrawal by giving him with more heroin.
In one paragraph Peter Schiff of EuroPacific Capital has neatly summed up the basic problem of the US economy. Below I will explain why these imbalances are a big headache waiting to happen.
From Calculated Risk:
For the first nine months of the 2006 fiscal year (starts Oct 1st), the National Debt has increased $487.3 Billion. The record is $491.1 Billion for the first nine months of fiscal 2004.
The annual increase in the debt is running around 4.5% to 5.0% of GDP. This is a classic "structural budget deficit" or "high employment deficit" - something most economists believe should be avoided.
According to the Bureau of Public Debt, total federal debt outstanding has increased from 5.6 trillion in the 2001 to 8.3 trillion currently. The essential problem here is simple. Government revenues are lower than government expenditures. According to the Congressional Budget Office revenues from individual taxpayers were $994 billion in 2001 and $927 billion in 2005. Over the same time, the government has increased discretionary spending from $649 billion to $967 billion. To fund the difference, the government has increased total debt by 48%.
Eventually the US Treasury must either pay-off or refinance the debt. Paying off debt requires paying off the entire issue which will cost a great deal of money. If the government refinances the debt, it will have to charge a higher interest rate because currently rates are very low by historical standards. In addition as the US increases its total debt outstanding, lenders may start to demand a higher interest rate as additional compensation for higher risk associated with US debt. None of these scenarios is economically beneficial to the US. In fact, resolving them could be very painful.
Here are three very important inter-related facts:
2.) In 2001, the US savings rate (which is gross income less all expenditures) was 2.8%. It has declined since then and has been negative since the second quarter of 2005. This means consumers are spending everything they make on a monthly basis.
3.) According to the Bureau of Economic Analysis GDP reports, consumer spending has increased at a consumer expenditure deflator adjusted amount of 15.84% for this expansion.
Here's the problem these statistics present. Consumers were already spending most of their income when this expansion began. Their income has not increased after inflation the entire expansion. However, somehow they increased their spending 15.84%. Where is the money coming from?
Tons of debt. Total consumer debt as a percentage of GDP increased from 74.72% in the fourth quarter of 2001 to 90.78% in the first quarter of 2006. Over the same period total consumer debt outstanding grew at a compound annual growth rate of 11.65%.
The problem with all this debt is eventually it "breaks the bank". We are already seeing the negative impact of these actions:
* Even though tougher filing laws took effect Oct. 17, the number of monthly bankruptcy filings grew by more than 300 percent between November and March, from 13,758 to 49,977, according to a June report from the Administrative Office of the US Courts.
* Foreclosures on home mortgages were up 38 percent nationally in the first quarter of 2006, according to property tracker RealtyTrac Inc.
* The average American household owes more than $9,300 on credit cards, up from $2,966 in 1990, according to Cardweb.com.
The Trade Deficit
The trade deficit seems to be ephemeral with little impact on the man on the street (MOTS). However, it is a very real problem.
First, here is a simple explanation of the trade deficit. Supposed you and your neighbor buy products from each other every month. However, you always buy more from him than he sells to you. Where do you get this extra money to buy additional products from your neighbor? The first place to look is your savings. However, as pointed out above the US has no savings. If you have no savings you pay for your purchases with IOUs. As you continue to buy more from your neighbor than you sell to him, your neighbor will eventually start to wonder if you will ever pay off those damn IOUs.
Let's extrapolate this scenario to the international stage. According to the Bureau of Economic Analysis, the total balance of payments deficit increased from $341.8 billion in the fourth quarter of 2001 to $829.1 billion in the first quarter of 2006. To pay for this deficit, total foreign holdings of US debt has doubled since 2001, rising from $1.055 trillion to $2.065 trillion. China and Japan have purchased 55.78% of this increase.
However, Asian Central Banks have greatly slowed their purchase of US Treasuries over the last year. In fact, Japan has slightly decreased its holdings from $667.1 billion to $639.2 billion over the last year. China has increased its holdings slightly from $297.9 billion to $323.2 billion. In 2004, several Asian countries - China, Japan and South Korea - all announced they were going to move away from dollar investments. While all three quickly retracted these official statements within 24 hours, these country's subsequent actions indicate diversification away from dollar-based assets is indeed occurring. The point here is will the Asians continue to buy our debt to finance the deficit? While there is no way of knowing with certainty, their recent behavior casts doubt on that possibility.
Trade deficits place the home country's currency at risk. Currency traders look at the country and start to ask a fundamental question: "When will this country pay off its debt?" While the dollar has been lucky so far, the risk continues so long as the trade deficit persists. While it is possible the dollar could have an orderly devaluation, there is always the possibility of an ugly correction - a sharp sell-off of the magnitude of 20% or more. A devalued currency means the host country will start to import inflation, forcing the Fed to raise rates which will slow economic growth.
The common thread running through these three imbalances - federal, personal and international - is debt. Essentially, the US is living beyond its means. We are financing growth based on future expectations and assumptions. And if that pays off, great. However, it is important to ask this question: Given the US is the most important economy in the world (at least for now), is this the right way to manage its finances? Should the largest economy in the world use this much debt in this way?
No. All of this debt increases the US's risk exposure. While everything on the macro level (GDP, unemployment level) is fine now, what would happen if a random event happened that really hurt the economy? For example, suppose currency traders started selling the dollar because the US' fiscal house was not in order. In response, the Fed raises rates to defend the dollar. This slows the economy, increasing lay-offs. Heavily indebted consumers who have little to no savings start having trouble making their house payment and eventually the lender forecloses on their home. Then people start declaring bankruptcy. Eventually, this becomes a spiraling downhill cycle that leads to major problems.
At some point and in some manner these balances will correct. It could be gentle or hard - we simply don't know. But most importantly, it is the prospect of a hard correction that should concern policy makers.