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

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.”

As more and more facts and numbers about the current crisis in the US emerge, I find myself wondering just how deep this recession is and how long it is going to last. A number of people, among them Stiglitz, have indicated that it is deep and severe. But still the question remains: How severe?

This is what The Guardian (UK) writes:

America looks like it is already in recession, one that threatens rapidly to become the biggest slump since the 1920s. The collapse a week ago of the country’s fifth-largest investment bank, Bear Stearns, signalled that the crisis sweeping the world’s credit markets had taken a decisive turn for the worse.

Maybe it is a sign on the depth of the crisis that The Independent (UK) today brings an article entiteled:

USA 2008: The Great Depression

Food stamps are the symbol of poverty in the US. In the era of the credit crunch, a record 28 million Americans are now relying on them to survive – a sure sign the world’s richest country faces economic crisis

.. Forty states are reporting increases in applications for the stamps, actually electronic cards that are filled automatically once a month by the government and are swiped by shoppers at the till, in the 12 months from December 2006. At least six states, including Florida, Arizona and Maryland, have had a 10 per cent increase in the past year.

So, an inreasing number of American families have problems putting food on the table. Meanwhile, in Washington the republican government is concerned about proposing a plan for regulating the financial institutions, and launches a plan many commentators (Wall Street Journal) say is mostly “dead on arrival” (New York Times). And, one might add, a plan that will only, at best, be relevant to the next crisis - the current one is here and regulation is not going to make it disappear.

Wall Street regulation is not going to solve it. Not now.

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.

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.

Another popular, somewhat more refined way of explaining away the current crisis in the American economy is to refer to the crash of the sub-prime marked, and its leveraging by means of C.D.O’s (collateralized debt obligations), and perhaps throwing in some blame for Moody’s as well. That’s really blaming the instruments, not finding the cause.

Still, that’s the version presented to the American public today by New York Times. It has all the marks of a great story, and I’m willing to bet it’s going to sell well. While appealing, it doesn’t hold up as more than a partial explanation.

Because the huge mountain built by these three factors - sub-prime loans, CDO’s and high rankings by Moody’s - didn’t stumble upon itself. It wasn’t iself the reason it fell, that is to say.

It fell because the housing marked finally burnt itself out. As it has to. Because for a long time capital (in terms of the real interest rate) has been far too cheap in the US. The US used cheap capital to buy its way out of the last crisis (as indeed it has several times in the past), and it resulted in a far too high rate of construction in the housing sector. As it had to. When capital is cheap, it’s put to use for lots on non-productive purposes.

At the same time, of course, cheap capital means it’s also cheap to borrow for people wanting new homes or wanting to speculate in real estate. So there was supply, and there was demand. And for a long time, - and I am sure history will confirm this - too long a time actually, demand kept up with supply due to speculation using cheap capital.

But even under these circumstances, when the discrepancy between supply and need for capital goods such as housing grow too big, the fun is over, as the demand for these goods are more limited (bounded) than for some other types of goods.

This is one part of the real explanation for the current recession, I think. Not the instruments (C.D.O.’s, subprime loans, or Moody), but the structure on which they rested.

More to come!

Following the coverage of the current crisis in the US, I strongly feel the news media in the US attribute far too big a role to the current prices of oil as a factor causing or contributing to the recession.

For instance, New York Times a few days ago published a graph showing the inflation adjusted price of oil, and pointed out that oil now was more costly than in 1980, and at its highest ever price (after the most recent price adjustments) (illustration from New York Times):

While this is obviously true, it is also only true when viewed from an American point of view. If the declining value of the dollar in international currency markets it factored in, oil is actually still 30-40% less expensive now than it was in 1980.

So to my mind, Americans, and most certainly American media, are looking in the wrong direction when explaining the crisis to the American public. To the extent that their explanations are believed, this may slow down the appropriate and necessary adjustments to the current challenges facing the American economy. It is necessary to look elsewhere.

More to come!