Few will argue against the fact that the U.S. economy is sputtering. For several years now I have been arguing that the government misdiagnosed our problems and subsequently applied the incorrect cure. If we take a look under the hood at the growth drivers of our economy we can reveal convincing evidence showing that this was in fact the case.
The following chart shows 30 years of US GDP along with potential output. The blue line represents actual GDP while the red line shows potential GDP. This represents what economists call the output gap.
At the current levels we are running an output gap of just over $1.2T. This merely means that the U.S. economy would be producing $1.2T more in total GDP if we did not have so much idle capacity.
The maths behind the U.S. economic growth of the last 100 years is fairly straight forward. Economists describe GDP in mathematical format as follows:
Y = GDP
C = Personal Consumption Expenditures
I = Fixed Private Investment
E = Net Exports/Imports
G = Government Consumption Expenditures
While all four components matter to the economy the C component (at roughly 71%) is the coaching staff, offence and defence of this football team. Let’s just call the other three components “special teams” – important, but far less so in the grand scheme of things. What’s happened to this crucial component of the U.S. economy in the last three years has been remarkable to say the least. There has been a dramatic stagnation in personal consumption expenditures (PCE). If we take a look at the historical data it’s truly incredible. PCE grew at an average rate of 7.5% for almost 50 straight years. Even more incredible is that this growth has been almost entirely uninterrupted.
When the Nasdaq bubble imploded, American balance sheets were cracked, but not shattered. Slowly, they began to come back. But as we all know now a far more nefarious bubble was brewing. One based on pure debt and speculation. When the housing bubble imploded in 2008, it shattered consumer balance sheets. Make no mistake – this is not a government debt crisis in the United States (as the hyperinflationists and defaultistas have tried to convince us). It is not a banking crisis (as Ben Bernanke has told us). It is a private sector debt crisis – primarily a household debt crisis.
If we look at the recent PCE data we see some signs of stability, but even this is nowhere near enough to sustain economic growth. By my estimates we would need to see 5.5%+ annual growth in PCE to fill the output gap in the coming 3 years. In the last 3 years we have seen a grand total of 5% growth in PCE. That is an astonishingly low rate compared to the average annual rate. Even if we cherry pick the absolute bottom in December of 2009 the annualized growth rate is just 2.9% – still well below trend growth and that includes an incredible equity market wealth effect and stable housing. This is the primary reason why we are seeing such an anemic recovery and tepid hiring. The balance sheet recession is strangling the household sector.
As I’ve previously mentioned, this current environment is easier to comprehend than most would like to admit. What is basically occurring here is a massive decline in consumer spending power which subsequently weakened corporate revenues. The lack of revenue strength leads to tepid hiring because visibility is poor. Margin expansion has helped companies maintain their balance sheets in recent years, but margin expansion alone can only sustain bottom line growth for so long before the market realises that there is no organic growth. At some point, the household must heal to the extent that they contribute to corporate revenues and sustain recovery. So what we’re seeing now is this frustrating positive feedback loop where corporations are waiting for revenues to rebound so they can expand their operations and hire, but the problem is that consumers are more focused on paying down debt as opposed to spending and accumulating debt. The problems are now being compounded by the fact that the government is no longer aiding growth.
Although I’ve believed this issue has been clear for the past two years, it has not been so obvious to those making decisions. Ben Bernanke misdiagnosed this as a banking crisis. Timothy Geithner agreed with him. Hank Paulson certainly agreed with him. So they went on their bank rescue mission while almost entirely ignoring the root cause of the problem. Meanwhile, the defaultistas and inflationistas have been on an austerity campaign attempting to convince everyone that the USA is bankrupt and on the cusp of becoming the next Greece – they have been and will continue to be wrong, yet their fear mongering campaigns continue to this day. This has not only exacerbated the level of fear and uncertainly and has largely contributed to the political gridlock we are beginning to see. So now we find ourselves in quite a bind.
As I expected, the initial stimulus plan helped give the appearance of recovery, but it did not solve the actual problem. It merely papered over the problems and injected some short-term relief. The problem of debt was still (and still is) brewing under the surface. Now as the stimulus effect wears off we are realising that the household sector remains incredibly weak, but there is no political will to attempt to solve the problems at hand. Ultimately, these problems will persist until the problem of debt has been reduced to a point that can sustain higher levels of expenditures. By my estimates, the current trajectory of debt repayment and economic growth leads me to believe this cannot occur until 2012 at the earliest.
What this all likely means is that growth will remain well below trend as the consumer continues to de-leverage. This creates a particularly uncertain environment for corporations and leaves the economy highly susceptible to exogenous risks (China, European debt crisis, housing double dip, etc). Political gridlock and continued misdiagnosis in government will certainly not help. Welcome to the balance sheet recession boys and girls. Enjoy your stay.
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