Weak consumer spending will last for years

It has been my thesis for some time that we are seeing a secular change in consumption patterns in the United States. This will have grave implications for a world economy used to seeing the American consumer as an economic growth engine and consumer of first choice. Retail sales in the United States have fallen 10% since peaking in November 2007. Much of this decline represents a permanent fall in consumption by overly indebted American consumers.

 

Having finally had a chance to dissect the retail sales data from last week, I wanted to show you a few graphs which indicate how much consumption has fallen in the present downturn and what the implication is for the future global economy. But, first, I want to start with a broader discussion as to why the fall in US consumption is a longer-term change and not a cyclical one.

 

The Balance Sheet Recession

 

Numerous economies seem on there way to recovery: Germany and France, Singapore, and Hong Kong, to name a few, have all posted positive economic growth. China looks likely to hit its 2009 growth target of 8%. But, the U.S., generally assumed to be a leader in recovery, is looking like a laggard. Mind you, there are other laggards like Spain and Ireland too. Why are these countries lagging? The Balance Sheet Recession.

 

Nomura’s Chief Economist Richard Koo wrote a book last year called “The Holy Grail of Macroeconomics” which introduced the concept of a balance sheet recession, which explains economic behaviour in the United States during the Great Depression and Japan during its Lost Decade. He explains the factor connecting those two episodes was a consistent desire of economic agents (in this case, businesses) to reduce debt even in the face of massive monetary accommodation.

 

When debt levels are enormous, as they are right now in the United States, an economic downturn becomes existential for a great many forcing people to reduce debt. Recession lowers asset prices (think houses and shares) while the debt used to buy those assets remains. Because the debt levels are so high, suddenly everyone is over-indebted. Many are technically insolvent, their assets now worth less than their debts. And the three D’s come into play: a downturn leads to debt deflation, deleveraging, and ultimately depression. The D-Process is what truly separates depression from recession and why I have said we are living through a depression with a small ‘d’ right now.

 

Secular inflation will be non-existent

 

Therefore, the problem is a lack of demand for loans not a lack of supply. The Federal Reserve can print all the money it wants. But, if there is little demand for more indebtedness, it is not going to have the desired effect of permanently reflating the economy – although it can create bubbles.

 

The corollary of this is that inflation will be non-existent on a secular basis. For the increase in liquidity to feed into consumer price inflation, people have to actually buy more stuff. And that’s not what happens in a balance sheet recession because people are concentrated on reducing debt and increasing savings.

 

Moreover, there is a huge glut of excess capacity globally now that we have had a major fall in consumption. Producers are waiting for demand to catch up with supply – not exactly the sort of situation that makes for inflation. I should point out that capacity is not fixed – it grows obsolete if unused. So, much of the investment in manufacturing capacity in China and property in America is going to have to be liquidated eventually.

 

But, the economy doesn’t move in a straight line. It courses through cycles. Just as we could be entering a cyclical recovery in the middle of a depression, it is altogether possible that the Federal Reserve can produce high cyclical levels of inflation despite the secular trend toward disinflation. A lot of this is likely to come through commodity prices or destruction of the currency.

 

For example, while the change in consumer prices has gone negative in the United States since the downturn began…

 

when one strips out food and energy, it has declined much less than during the last deflation scare of 2001-2003, which caused Alan Greenspan to panic and reduce interest rates to 1%.

 

 

The discrepancy above is due wholly to changes in commodity prices. So, if commodity prices re-assert themselves going forward, we could see a major uptick in inflation. Moreover, a fall in the value of the dollar could precipitate inflation as well. And, finally, there is asset prices. It is clear the Federal Reserve and the Obama Administration are targeting asset prices in order to reflate the economy. All of that stimulus can and will create cyclical inflationary forces which could be large. Nevertheless, the underlying level of demand is slack and that means secular inflation levels will remain subdued. See my post “Central banks will face a Scylla and Charybdis flation challenge for years” for more on this concept.

 

This means the consumer will be under pressure

 

High debt and low inflation mean lower consumption growth. It’s hard to spend more when you have a mountain of debt staring you in the face and its not getting reduced in real terms through inflation.

 

Look at the charts to the left. They come from a story in Barron’s this weekend called They Shopped 'Til They Dropped. They depict a tsunami of debt in the U.S. economy that has been building for four decades. Even debt service levels have been inching inexorably higher since the 1980s. Clearly, the U.S. consumer is tapped out. And they are cutting consumption and reducing debt as a result.

 

So, for America, it is not business but consumers which are going to suffer a balance sheet recession. In looking for evidence on Koo’s thesis, we need to look at consumption and retail sales.

 

Michael Shedlock recently reported on the horrible back to school sales numbers. And Patty Edwards, a well-known Seattle-based retail analyst, was recently on Bloomberg radio with sobering anecdotal detail regarding the retail sector. She sees no sign of an impending uptick in US retail sales and is very worried about the Christmas selling season. The audio of her conversation with Tom Keene is below (not available in the RSS feed). It is very much in line with the balance sheet recession argument.

http://www.nakedcapitalism.com/2009/08/weak-consumer-spending-will-last-for.html