from the hip

American newspapers, most notably New York Times, have now started to wonder why American consumers aren’t spending. And in the financial sector, stock brokers and real estate agents seem to expect that it will happen next week or so, judging from the advise they are giving. That really doesn’t seem very likely at this point.

Why do American consumers spend less?

Well. The financial system in the US is still not completely shored up. AIG just reported a loss of 25 billion dollars for the third quarter and will be receiving a 150 billion aid package. Fannie Mae lost 29 billion dollars. Circuit City is going down. Airlines are in trouble. GM and the whole American car industry is in deep trouble.

As for the overseas markets, most indicators are down there as well. Every time the numbers are revised, they get worse. Right now, according to Wall Street Journal, they indicate a deep recession in Europe as well. IMF (see figure) now assumes that 2009 will be worse than 2008 for the world as a whole.  For 2009   IMF predicts a decline in GDP in the advanced economies of 0.3 percent. If this happens, it will be the first time during the periode following the Second World War.  For the US IMF predicts a decline of  0.8 percent, and for the Euro-area 0.7 percent for 2009. So there will be little pull from overseas markets for American businesses.

Now, add to this that the banking system isn’t working, loans are hard to get, unemployment is on the rise and millions of jobs are threatened.  Consumer confidence is at the lowest ever.

Also, factor in a negative wealth effect. The positive wealth effects, the effect of people getting richer on paper when housing prices were rising, were key to the growth the last 5-7 years. Now this operates exactly in the opposite direction, and serves to limit peoples spending up and above the effects of other factors.

So, what does it mean?

So how likely is it that consumers will start spending in the near future? Not very. Let’s assume for a moment that consumer spending will continue as today for a while.

Consumer spending is down 30 percent on cars, and 3 percent on the average across all sectors. Consumer spending appears likely to fall next year for the first time since 1980. Perhaps by the largest amount since 1942.

If it stays the way it has been for the last three months for a full year, that means demand for goods and services from consumers in America will be down about 1200 billions. And, spending is still dropping. As well, demand from businesses is dropping. And, as I wrote above, demand from abroad is falling as well. And right now, American businesses have just barely started to adjust to these new numbers and levels. And this adjustment will mean more lay offs and more negative earnings reports. That is simply how it works. And it is hard to see any “quick fixes” that can act as a miracle cure and lift us out of this situation in the short term. Rather, the adjustments will have to work their way through the system.

As far as American consumers are concerned, I notice people using words like “lacking trust” or “fear” as reasons for the decline in consumption. These words suggest that consumers are driven by psychological factors, emotions, beliefs and sentiments. Such words, I think, are the wrong ones in this case. Right now, I think American consumers act very rational - markets are turbulent, times are getting harder, uncertainty is high, so the rational response is to buckle down, sit still and wait for the fog to clear up.

So, for the moment, and for a while, it is just going down, I think. We are nowhere near the bottom. I don’t think we will see new growth for at least 18 months.

That’s what I think.

See also:

• Yahoo Finance: Home values drop for 7th straight quarter
• New York Times: Best Buy Lowers Its Outlook for 2009
• Washington Post: Why GM Stalled
• Washington Post: Obama Asks Bush to Back Rescue of Automakers
• New York Times: A Town Drowns in Debt as Home Values Plunge
• Wall Street Journal: Indicators Across Europe Point to Deeper Recession
• New York Times: Jobless Rate at 14-Year High After Big October Losses
• Times:First full-year slump since 1940s, says IMF

It goes on and on - the financial crisis. Now Bank of England slashes interest rates to a 53-year low. The Independent writes:

Interest rates were today slashed to a 53-year low to fight off recession - but fears were growing that hard-pressed homeowners would fail to reap the benefit.

The shock 1.5 per cent cut by the Bank of England’s Monetary Policy Committee (MPC) is the biggest move since March 1981 and brings rates to 3 per cent - last seen in 1955.

Stock markets were stunned by the size of the cut and experts predicted rates could reach an all-time low of 1.5 per cent by mid-2009 as the Bank desperately bids to ward off a prolonged slump.

Also, the European Central Bank cut interest rates by 50 basis points today and signaled another reduction was possible later this year. In Germany the no. 2 bank has decided to tap into the government rescue plan, and the government will propose tax breaks on car purchases to stimulate spending!

The bottom still seems distant.

See also:

• New York Times: European Banks Reduce Rates, Some Sharply
• Guardian: Shock as Bank of England slashes rates to 3%
• New York Times: Bleak Reports Keep Markets in Free Fall
• Guardian: Wall Street and London shares plunge

I started writing about the credit crisis in the US and the possible international consequences of that crisis a long time ago. But writing about it gave me a strange feeling. Obviously I was writing about something that interested just a very few. And, equally clear was the feeling that I was writing about something nobody really wanted to hear about. Also, I strongly felt back then, something which major actors in the financial world as well as governments and central banks were more or less in denial about.

I am not happy to have been right. I am not happy that this crisis so far has turned out to be every bit as serious as I and a relatively small number of other people wrote back then. On the contrary, it is sad. Of course.

Today I feel that perhaps it is that unwillingness to see, to listen, to take the right measures at the right time, that has turned what was once a credit crisis in the US, originating in flawed valuation of the so called sub-prime mortgages, into the wild international beast we today speak of as the international financial crisis. Today governments all over the world fight against this crisis. And we have seen, I should think, that the crisis is not due to the price of oil, and that it cannot be solved by interest rate cuts. And a large number of financial institutions, from Lehmann to the Royal Bank of Scotland, have fallen victim to the crisis. At first there was no response. Then there was too little too late, as the Dainish Bank, for instance, noted. And now it is pure panic.

But now the fight is very much an uphill battle. Much time has been lost. And in this case lost time translates into lost confidence. That confidence must, of course, be restored. But it will take time. And even when the confidence in the international financial system has been restored, the battle will not have been won. There will also be serious shake outs in many sectors of the economy, will large companies failing and new winners emerging. And the global recession we are facing will not be over until consumers start increasing their spending again.

I fear they will not do so for quite some time.

See also:

• Financial Times: The week that panic stalked the markets
• Wall Street Journal: EU Writes Menu of Options
• Financial Times: UK to inject £39bn into banks
• Politiken: IMF frygter finansiel nedsmeltning
• Politiken: Eurolande klar med finansiel redningsplan
• Times: Royal Bank of Scotland under state control
• Guardian: Europe follows Brown plan for survival as EU bank bail-out plan is agreed
• Dagbladet: Europeiske land vil samkjøre krisepakker

While the economic downswing is still making itself felt in the US, it is now also hitting several European countries hard. And inflation is soaring, and hit a record high of 4.1 percent last month.

“There’s no obvious trigger for strong economic growth in Europe until the end of 2009,” says David Owen, chief European economist at Dresdner Kleinwort in London. “Massive [financial] imbalances need to be worked out, and the corporate sectors in many countries remain in a substantial deficit.”

Consumer confidence for the euro area has fallen to negative 29.7, the lowest it has been since 1993. And the news about the plunge in factory orders in Germany, led to the following comment, reported in the New York Times:

“It now looks likely that the euro zone will be the first major economy to fall into recession,” Jonathan Loynes, the chief European economist for Capital Economics, wrote after the report of sagging orders in Germany.

Great Britain

Royal Bank of Scotland, Britain’s second-largest bank, recently posted its first loss in 40 years after taking a £5.9bn hit from the credit crunch. And Barclays, the third-biggest bank, took a fresh £2.8bn write-down. Also, the price of houses are dropping rapidly, according to Guardian

the Halifax said house prices last month were 11% down on a year earlier - the first double-digit decline since its monthly healthcheck of the market was first published 25 years ago.

House prices back to 2006 and still falling, says Times. And new housing orders are down 33%. And, of course, home repossessions surge.

Business groups and City analysts warned that deep and rapid cuts in the cost of borrowing would be needed next year to pull Britain out of its first recession in more than 15 years. House prices are falling more rapidly than they were in the property crash of the late 1980s and early 1990s

It would seem a possible recovery in Britain will not be aided by increased consumer spending in the short term!

Recession in Germany?

Spiegel online writes that the German economy may have shrunk in the second quarter, according to early reports, and that the outlook for industrial production isn’t lively. Germany could slide into recession, and the German economy may have shrunk by around one percent. They also note that:

German factory orders were down by 2.9 percent in June from May, and orders from abroad for German goods plunged by 5.1 percent. Production at German factories rose by 0.2 percent in June — less than expected

Spain in deep trouble

Portugal, Italy, Greece, and Spain all face severe challenges. In Spain, the imploding domestic housing market has pushed the unemployment rate to 10.7 percent. The number of bankruptcies in the building sector is exploding, and one third of the job losses stems from the construction sector. As well, the housing market is stalling. The inflation is about 5 per cent.

The US

The credit cruch is still being felt, and so is the reversal of the wealth effect and high oil prices. In addition to bad news from the banking sector, Fannie Mae, Freddie Mac, Indy Mac, and so, in the latest sign of the deepening troubles, G.M. recently reported a second-quarter loss of $15.5 billionfollowing a loss of $8.7 billion reported earlier by Ford. Car sales are dropping, especially sales of American cars.

Guardian notes that:

The US mortgage finance empire Freddie Mac yesterday predicted the worst housing slump since the Great Depression as it set aside $2.5bn (£1.28bn) to cover credit liabilities caused by delinquent loans and foreclosures.

And in New York Times, Peter S. Goodman recently wrote (August 1) that “More Arrows Seen Pointing to a Recession”.

Overall

Pretty gloomy still. The most positive piece of news is the slight drop in oil prices. But still serious signals of a slowdown of growth and possibly recession both in Europe and the US.

The Bureau of Labor Statistics today reported that 80.000 jobs had been cut in the US in March. While officials and even newspapers in the US seem reluctant to use the word “recession”, more and more indicators show that the US is in a recession, or extremely close to being in one.

In an article in the New York Times, Andrew Stettner called for an increased focus on the job market in the US:

“People have been focused on the housing crisis, and rightly so,” said Andrew Stettner, a policy analyst at the National Employment Law Project, “but now the deterioration in the job market should be demanding much more attention from policy makers.”

The job cuts so far in the US seem to be fairly consistent with the early stages of a period with a reversal of the wealth effect. According to Washington Post the distribution of job cuts was:

The numbers are far worse than economists were forecasting, and they solidify the case that a serious economic downturn is underway.
….

The report shows clearly how the problems in the housing and financial markets are rippling through different sectors, showing the deep interconnections between seemingly separate parts of the economy.

The number of construction jobs, which has been falling steadily for 18 months, continued its rout. That sector shed 51,000 positions, as fewer residences are being built.

Fewer houses mean less construction and building materials; the number of manufacturing jobs fell by 48,000, with some of the steepest losses among makers of lumber, drywall and other materials. Automakers also shed jobs. With their homes less valuable, Americans seem to be holding off on big-ticket purchases.

Consumers pulling back means stores need fewer workers; the number of retail jobs fell by 12,400. The steepest losses were in sellers of building materials and appliances, both of which are highly tied to the housing business.

The branches of the economy, of course, are not seemingly separate. They are visibly interconnected. Job cuts are most severe in construction and associated industries. Then there are wealth effect consequences in the auto industry and consumer retailing. Its logical and as expected.

As to the depth and duration of this crisis, this is what Ian Shepherdson had to say in NYT today:

Many forecasters argue that the economy will rebound by the fourth quarter, a view rejected by Ian Shepherdson, chief domestic economist for High Frequency Economics.

“We are in for a much longer recession than Wall Street thinks,” he said. “This particular downturn is driven by a rare contraction in consumer spending, and that is starting to hurt a broader range of people than those hurt by the mortgage crisis.”

The real interest rate in the US after the last rate cuts by the Fed - the interest rate adjusted for inflation - is negative. Is that good or bad? Seems to me, reading about this in New York Times, that both Obama and Clinton hold much to narrow views on the crisis, and think it is mostly a financial crisis that can be solved by stimulating the economy and regulating the credit market.

Every time the rate has been cut in the last six months, the stock market has reacted positively. And the Fed has been looked upon as an institution that actually does something to reverse the current crisis in the American economy. The rate cuts have been said to stimulate the economy, and so on.

And, yeah, guess what, lower interest rates are great for the stock market. Always have been, always will be. Simply because lower rates means that on the average, and everything being equal (ceteris paribus, it’s often called), and all of that, stocks become more attractive as investment instruments compared to other instruments.

So, if the crisis facing the US had been a financial crisis, that would have shored up things neatly. But the current crisis is not financial - it only has some financial aspects. The crisis in 2008 is structural (I’ve discussed this a bit in previous post, and will get back to it as well in later posts).

Structurally, for the real economy, negative interest rates may be bad news, even if they are good for the stock market and for financial institutions in trouble.

If you think about if, you will quickly realize that negative interest rates simply mean that almost any investment that have a yield equal to the rate of inflation becomes a profitable investment. So, the lower the interest rate, the stupider the investments, so to speak.

And low interest rates were one of the main causes of the current housing crisis (quote from Bonfire of the Builders, Business Week):

A diverse cast of characters combined to launch the once-in-a-lifetime housing boom of the past five years. Traditional mortgage companies and banks unleashed a barrage of loans, many to borrowers with iffy credit histories who didn’t bother to read the fine print about upwardly mobile interest rates. Wall Street egged on the often-reckless underwriting by buying vast quantities of home loans for repackaging as securities. Now that the boom has fizzled and foreclosure rates are rising, the important role of large homebuilders as lenders is also coming into sharper focus.

In addition to spitting out subdivisions, many of which now stand half-empty, builders jumped into the mortgage business to a degree they never had. Wall Street provided the same encouragement it offered other lenders. Even as the housing supply began to exceed demand last year, builders kept sales brisk by pushing adjustable-rate, interest-only, and other risky loans. In some cases they attracted clientele who couldn’t afford conventional mortgages.

So now, with low interest rates, there is the risk of fueling the same speculative building spree again. And also, to make investors spend precious capital on low-yield projects that look good today, but will surely be bad once interest rates come up again.

In my opinion, and I’ll say more about this later, the American economy currently need high interest rates (something like a real interest rate of +3-4%) to ascertain that capital is spent on smart projects and to reduce non-productive speculative investments.

There is a good, in-depth article about “The Foreclosure Machine” in the US in New York Times today. For readers interested in the housing crisis in the US, it is highly recommended.

The price fall in the US continues and accelerates. According to The Independent:

The price of the average home was 11 per cent lower than a year ago, the S&P Case-Shiller index showed yesterday, as repossessed homes flood the market – and economists predict that the price adjustment may belittle more than half over.

…. “It does not look like early 2008 is marking any turnaround in the housing market,,” said David Blitzer, S&P index committee chairman. “Home prices continue to fall, decelerate and reach record lows across the nation. No markets seem to be immune from the housing crisis.”

Other indexes point in the same direction. But actually all these indexes most likely underestimate the problems in the housing market for the moment. The reason for this is that a large number of sellers are holding back. So at the same time the market has slowed down (New York Times):

Sales of new U.S. single-family homes fell to the slowest pace in 13 years

On the other hand, real interest rates are now negative. And the Fed is pumping liquidity into the market. So it’s easy to think that the housing market will pick up relatively soon.

However, I don’t think that’s the case. Given the huge structural imbalance in the housing market and the time it will take to achieve balance, on one hand, and the need the Fed has to also look at factors in the much bigger recession picture on the other hand, they can’t and shouldn’t maintain negative real interest rates for an extended period of time. And smart buyers, I think, know this.

Because the bigger picture is a federal budget out of control, a foreign trade deficit that is monumental, a continued weakening of the dollar as a result of low interest rates, low productivity (see NYT, Feb. 7) growth in the economy (see also OECD), cautious lending by the banks (reacting to the current uncertain situation), and the danger of a substantial imported inflation.

Then add to all this that a negative real interest rate most likely is exactly the opposite of what the American economy needs over the slightly longer term, as cheap capital will lead to decline in productivity.

Taken together, these factors should imply that a negative interest rate - which just is plain stupid but may momentarily be necessary - will and should only be maintained until the financial institutions are over the worst.

More to come!

Every day in American news media there are several commenter saying that the crisis will soon be over. And among the most positive are the real estate agents and real estate firms.

No wonder. They make most of their income when the housing market is bullish. But is it going to be up this year? Is it over? Is it really only a crisis in the sub-prime loan market and some associated financial instruments, so that all it takes is a few write downs, a reduction in the interest rates, and a little time, and then it will all be over?

Well. It depends a little on what you mean by a few write downs then.

An article in the Financial Times, entitled America’s economy risks mother of all meltdowns, refers to Prof Roubini, who states:

Step one is the worst housing recession in US history. House prices will, he says, fall by 20 to 30 per cent from their peak, which would wipe out between $4,000bn and $6,000bn in household wealth. Ten million households will end up with negative equity and so with a huge incentive to put the house keys in the post and depart for greener fields. Many more home-builders will be bankrupted.

So, yeah, if 4.000 to 6.000 bn, or something even near that, is a little. Or, compare that to the following from Wall Street Journal:

Merrill Lynch economist David Rosenberg, one of the most bearish Wall Street economists, says to look past the 1990-91 recession as a guide to the current downturn. The key difference: the depth of home-price declines.Mr. Rosenberg says in a note to clients that the current downturn is hitting more broadly than the credit crunch and real estate meltdown in the 1990-91 recession, which lasted eight months (as did the mild 2001 contraction). Home prices today are falling in 85% of the country vs. 40% during that period, he notes. When prices hit bottom in 1992, the inventory of new and existing homes for sale was at 7 months of supply. Now it’s at 10 months’ supply “with no improvement in sight,” says Mr. Rosenberg, who was among the first economists to forecast a 2008 recession. He sees average prices nationwide dropping 20% to 30% more, on top of the 11% decline since the 2006 peak.

And this, of course, is really the start of it all. Both talk about 20-30% drop in housing prices. That’s pretty substantial. And, this is when the negative wealth effect kicks in, because people that have lost 3.000, 4.000 or 6.000 bn dollar are not going to be spending quite as much as they did before they lost their money.

I think 2008 will not see any improvements at all. Rather I think we have only just begun to see the bad news of 2008.

In my previous post about the American recession I wrote about the structural causes of the current crisis. I stated that the housing market fell because it finally burnt itself out, after having been too hot for too long due to low interest rates in the US.

The fall in the housing market, which is likely to last for quite a while - I think well into 2009 - has another disturbing effect. It reduces the value of property in America. Thus, the wealth effect - everybody getting “richer” because the value of their houses and apartments have increased, and spending some of that newfound wealth on consumption - is reversed. Now there is a negative wealth effect.

A negative wealth effect means that this time increased spending will not be fuelling the economy and lifting it out of recession.

The effects of the reversal of the wealth effect are now slowly becoming visible in the US. Automakers are adjusting their sales expectations down:

Dismal Year Is Forecast for Car Sales

writes New York Times. And it doesn’t stop there:

Slump Moves From Wall St. to Main St.

In Seattle, sales at a long-established hardware store, Pacific Supply, are suddenly dipping. In Oklahoma City, couples planning their weddings are demonstrating uncustomary thrift, forgoing Dungeness crab and special linens. And in many cities, the registers at department stores like Nordstrom on the higher end and J. C. Penney in the middle are ringing less often.

… Many economists forecast that overall consumer spending will slip 1 percent for the first three months of the year.

“That’s a wow,” said Robert Barbera, chief economist for the trading and research firm ITG. “Outright declines for real consumer purchases are unusual.”

What is shaping up as the second recession of the 2000s is the product of declines in home values, which play a far bigger role in most Americans’ personal finances than the stock market. Households have borrowed against the increased value of their property to buy cars, send their children to college and add home theater systems.

What all the stories of declining demand point back to, is of course the wealth effect. And in months to come, it will increasingly be reinforced by imported inflation, making the crunch on the dollar increasingly felt by the consumers as well.

Indeed - all the charts for the US look bad for the moment: Jobless claims up, consumer sentiment down, housing starts down, retail sales down, industrial production down, dollar down. Meanwhile, the stock market will continue to be turbulent.

To me, it seems a rough ride is ahead!

More to come.