An amateur hitchhikers guide to the past
by Ravi Verma, Tue Nov 24, 2009 at 09:48:01 AM EST
There has been a lot of (justifiable) angst over the economy, and the recession. Some have called for the firing of Tim Geithner, and/or Ben Bernanke and/or Larry Summers in order to correct the course. The justifications are as follows:
(a) Geithner bungled up the AIG rescue, by unnecessarily giving away 100 cents on the dollar; instead of forcing AIG's counterparties to take a haircut.
(b) Ben Bernanke (and Alan Greenspan before him) grossly underestimated the magnitude of the downturn, even when every available indicator was smoking out the ears.
(c) Larry Summers...well, he is just Larry Summers. And furthermore, Larry Summers went out of the way to mock and ridicule Raghuram Rajan, the most notable Cassandra of the current economic downturn. back in 2005
There are other reasons of course (most notably in my mind ~ would you trust your $13T economy to a man who would shave $42k from his taxes ), but the bottomline is that between the three of them, not one of them got it right. So why are they running the show ?
I would not have picked either one of them (well, except for Bernanke; but I would have stripped the Fed chair of most of his powers ~ as the Congress is now mulling).
But I would not replace them either. Why is that ?
The President picked them. And they are responsible for implementing the President's political agenda. So what is the President's agenda ?
In order to understand that, we have to first understand what happened. I am sure you have heard many different viewpoints on what happened. Here is mine:
Here is a historic chart of US savings rate going as far back (thanks to my favorite blog for this, and I am going to quote them here ).
Notice that the saving rate went negative during the Depression as household used savings to supplement income. And the saving rate rose to over 25% during WWII.
There is a long period of a rising saving rate (from after WWII to about 1974) and a long period of a declining saving rate (from the early '80s to 2008). (corrected text)
Some of the change in saving rate was related to demographics. As the large baby boom cohort entered the work force in the mid '70s, the saving rate declined (younger families usually save less). But, as I noted above, I expected the saving rate to start to increase in the last '90s.
What CR does not mention, but which you can see from the chart is that, absent an extraordinary event, the US consumer likes to have a savings rate of around 5 to 10%. You can almost call this a 5-10 rule, somehow grounded in human psychology ~ we would like to save 5 to 10% of every dollar that we make.
As noted by CR, the savings rate started to decline in the early 1980s, until it reached almost 0 back in 2008. How does this jive with the 5-10 rule ?
The answer is simple: MEW. Or mortgate equity withdrawal. This is the moneys borrowed by US homeowners against rising equity in their homes. It is a sizeable fraction of the overall economy, and the Federal Reserve closely tracks this number (pdf link: Finance and Economics Discussion Series
Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, D.C. Estimates of Home Mortgage Originations, Repayments, and
Debt On One-to-Four-Family Residences Alan Greenspan and James Kennedy 2005-41) . Here is a chart of US MEW over time
Note: a better chart to use would have been active MEW (this would be MEW + changes in HELOC); but they show the same trends except active MEW does not go negative in 2008-2009.
As an aside, note the size of the MEW as a percentage of disposable personal income: 8% in 2004-2006. About 1 in 10 dollars of our perceived disposable income was borrowed money. This was the one indicator that was screaming bubble. Given that the Fed was closely tracking this number (the data above is from a paper by Alan Greenspan and Jim Kennedy), I am shocked that they missed it (and I hope a journalist can dig this story and find an explanation).
I am not going to go into why MEW increased to the levels it did ~ the explanations are long and detailed, and have been made elsewhere. Furthermore, the explanation for that is irrelevant to the point I wish to make.
Instead, I would like you to focus on the MEW and savings charts. Add up the MEW as a percent of disposable income (red line above) with the savings rate since 1980. The chart is depicted below:
The sum is about within the 5-10 rule.
Thus, US consumers were lulled by rising home values into thinking that they were saving enough, when in fact the real savings rate was dipping down to zero. Quoting an earlier President, there truly was "morning in America". As an aside, I have often wondered if this "morning in America" sensation was deliberately created by the powers that be (Clinton/Rubin/Bush/Greenspan), and I have concluded that they were probably not capable of doing so. Or at least, I like to think that they were not capable enough of doing so ~ the idea of someone (anyone) having that kind power is truly frightening.
In any case, the bubble had to pop. And it popped when the MEW ATM was turned off ~ the net MEW as a function of personal disposable income decreased to 0 in 2008 (it had to!).
This resulted in a savings shock. We are used to saving 5-10%, we thought we had been saving 5-10%, but had been saving close to 0. So we decide to save more money.
So what happens when we decide to save more money ? They have to cut back on personal consumption expenditures. What is the degree of the cutback. One, rule of thumb answer (one given to me by my brother way back when) is that if we cut back expenses by 5% (in order to save 5%), then the US GDP must shrink by 5%, or 4 quarterly Year over Year (Y-o-Y) declines of 5%. A 10% cutback would require about 4 quarterly declines of 10%. This is about what we have experienced, but reality is more complicated (thankfully, or else I would be in agreement with my brother).
Because of rising incomes, our PCE continues to rise, even as our savings rate remains the same. Here is chart of Annual change in PCE vs change in Personal Savings Rate (1955 through Q1 2009).
Note that we have a positive change in PCE, even at no change in Savings rate, and that our PCE remains unchanged only when we increase savings by around 5% or so ~ this can be attributed largely to rising incomes. (We continue to increase our PCE when we earn more). Also note the huge scatter in the data. This can be attributed to fluctuations in incomes, changes in demographics, and to confidence in the political system. My brother's rule of thumb is represented by the solid line, but there is considerable leeway around that.
Also note that we have never had a "savings shock" of this magnitude before (at least not since WWII). Today, we are in the realm of a savings shock of 5-10%. Noone knows how to model this, and what PCE changes to expect (and yeah, I suspect that includes the likes of Krugman, and Roubini and Volcker). I suspect the answer has a lot to do with human psychology and very little with actual economics. If we believe that things will eventually right itself, then the change in PCE will be minor (or a small negative), and things will right itself rapidly. If we lose confidence, we will have a large negative change in annual PCE, and things will take a long time to right itself.
The answer is mostly psychological (and thus political), and very little economic. If we can pretend hard enough that we will be okay, then we will be okay.
Speaking for myself, I started hoarding cash back in 2006. I walked away from the stock market in 2007 ~ I had no confidence in Greenspan, or Bush, or any of his cronies. I have more confidence in Obama, and in Geithner and in Summers and in Bernanke ~ even though I disagree with what they are doing (more on that in a second). Thus, I bought a new house about 3 months back; and have been steadily buying new appliances. I am still not in the stock market, but that is only because I used up all my cash to buy a house. I believe things will get better.
But how ? And what is the President's agenda on that front ??
I am about diaried out for today, so I will have to take that up some other time. But the bottomline is that a rapid recovery hinges on confidence in the political system. Today, we are blessed with a 2-party political system wherein a substantial fraction of one party is batshit insane. So how does one have confidence in a 2-party system function in the absence of a responsible opposition ? Therein lies the President's agenda... I think !!