Nov02

Debtwatch No. 40 November 2009: Have we dodged the Iceberg?

by Cassander on November 2nd, 2009 at 8:47 pm
Posted In: Debtwatch

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Part 1: The USA

The most recent “unexpectedly good” growth figures for the USA appear to indicate that what will still be the worst downturn since the Great Depression is finally over.

However this is not your usual downturn. Not only is it acknowledged as the most severe since the Great Depression, it has also evoked the most remarkable government economic stimulus ever seen. It would be bizarre if this had not had an effect on the data.

Whether a recovery is truly underway in the private sector therefore depends on how the economy is likely to perform after the stimulus is withdrawn.

The “recession is over” reaction could be valid under two circumstances. Either:

  1. The figures are very high even when the government stimulus is taken into account; or
  2. If the economy could be expected to continue growing endogenously after the stimulus were withdrawn, even if the aggregate numbers for this quarter were good only because the government stimulus was so large.

Let’s consider the first option. The growth rate on an annualised basis for the last quarter was 3.5%. The BEA’s decomposition of this notes that 1.66% of the growth was due to increased motor vehicle output, which was primarily driven by  the government’s “Cash for Clunkers” program. Another 0.48% was due to the growth in government expenditure.

There are also some elements of the figures that simply seem, in the original sense of the word, incredible. For example, rising investment levels—up 11.5%—were a major reason for the positive reading. But all components of this measure were either tepid or negative—except for residential investment, which was up a whopping 23.4%.

That just doesn’t tally with the most depressed real estate market in history; possibly this huge contribution to aggregate investment could be the result of a large movement from a very small base, whereas the sector’s weight in the overall calculations of investment hasn’t been revised downwards to reflect its true contribution today. Or it could be a problem with the data sample that will be revised substantially downwards in later estimates of GDP.

Either way, the prospect that a serious recession, which was caused by the bursting of a housing bubble, which left an unprecedented stock of unsold existing houses on the market, and which has led to an unprecedented unsold over-supply of existing housing stock, has been ended by a revival in housing investment… is simply incredible.

That leaves the second option—that even though the positive figure was the product of the government stimulus, when this is withdrawn the economy can be expected to continue growing on its own.

Here trends in consumer income and non-residential investment are the important issues. These would both need to be positive (or at least turning from lows) for the private sector to resume growth in the next quarter without the need for stimulus.

Consumer disposable income fell at a substantial 3.4% annualised rate in the quarter, while fixed investment expenditure rose by an anaemic 2.3% and investment in structures fell by 2.5%.

It is thus likely that if the government stimulus were withdrawn, both these private sector areas would show even more negative figures over this quarter.

However, another way of looking at whether this is the end of the recession is to look at the timing of turning points in the data and economic recoveries (this requires attempting to deduce the cyclical components in the data from the trend). On this and the conventional set of indicators, it looks like the “avoided the iceberg” call could be right. Firstly as the next graph indicates, during the recession all factors save government spending were below trend, and the two biggest factors in the turnaround are a revival in investment (driving almost exclusively by the “23.4% rise” in residential investment!) and net exports.

The role of net exports is unusual (though unremarkable), but the turnaround in investment is a sign of recovery that has occurred in all previous recessions—as the next chart indicates.

However there is another factor that hasn’t yet been considered—the role of credit. During post-War recession, credit growth has dropped well below trend, and the recovery has involved rising debt levels. This is not the sign of a healthy economy—far from it—but this is how the US economy has “recovered” from every previous post-WWII recession.

Not this time it appears: if this is a recovery, then it’s a highly unusual one because credit growth is still well below trend—and, in fact, negative: America is deleveraging.

We therefore have the strange combination that one accepted “leading indicator” of recovery—a turnaround in investment—appears to have occurred, while another less favoured indicator—the trend in credit growth—is still pointing at recession.

I apologise for getting somewhat geeky here, but this is one issue that a simple check of charts can’t decide—we have to delve deeper to work out which of these two contradictory indicators to take more seriously. So the next two tables get slightly more technical and look at the correlations over time between changes in the components of GDP and credit and changes in real GDP.

Here the data favours debt growth as the leading indicator to watch. Investment is strongly correlated with GDP, but that’s hardly surprising since it constitutes a major and volatile component of GDP. Just as with consumption—the larger but less volatile major component—its correlation is highest when coincident with GDP. It is not a leading indicator.

The two best leading indicators are debt, and government spending—with the former stronger than the latter. Government spending a year ahead of GDP is a good indicator of which way GDP will go—something which supports the Chartalist approach to macroeconomics and undermines conventional “neoclassical” economic thinking. But changes in debt are a stronger indicator still, and have a stronger effect closer to the actual movements in GDP.

The previous correlations covered the whole post-WWII period (from 1952 till now), but there has clearly been structural change in the US economy over that time—especially the relocation of production to offshore low-wage countries, the growth of the FIRE sector with the economy’s increasing dependence on debt, and the shift in economic policy from a “Keynesian” orientation to a “Neoclassical” one (prior to this crisis) in the mid-1970s. So the next two tables repeat the above correlations, but just with data from 1990.

These reinforce the argument that movements in debt matter as an indicator of whether we’re out of the recession or not—and the answer is no. It also appears that the influence of government spending on economic performance weakened while neoclassicals were in charge (and behaving as neoclassicals—rather than “Born Again Keynesians” as they are now).

So I don’t believe that this quarter of growth for the USA implies it has dodged the iceberg. Instead a patch-up job has been done on the damage, but the USS is still taking on water as the private sector deleverages.

Part 2: Australia

The Australian result of only one negative quarter of growth, followed by a return to positive growth is the best in the OECD. This was driven by:

  1. The dramatic positive impact on household budgets from the cut in interest rates by 4%, which reduced debt service from 15.4% to 10.3% of disposable income;
  2. A stimulus package that was equivalent to 2.5% of GDP, the largest such package in the OECD;
  3. Australia’s unusual position as a commodity producer—so that we benefited from China’s huge stimulus package and recent stockpiling of commodities; and
  4. The enticement to households to take on additional mortgage debt that goes by the name of the First Home Buyers Boost.

The first two factors alone resulted in a 9% increase in houshold disposable income over the year from June 2008 to 2009—an unheard of development in boom times, let alone during an economic crisis. As Gerard Minack put it in his Downunder Daily on October 9th, “If that’s recession, bring it on!”

As a result of this policy-driven paradox—rising disposable income in a recession—Australia will not record a fall in real output on an annual basis in 2009, a result that is in stark contrast to outcomes in the rest of the OECD.

So fast and massive government action—by both its Treasury and Central Bank wings—averted a recession in the face of an unprecedented financial crisis.

This is a welcome outcome—and one that contradicts one of the latest fads that dominated economics prior to the GFC, “rational expectations macroeconomics”, which argued that the government couldn’t affect real output. As I noted in an earlier post, though neoclassically-trained economists drove the policy response, they did so as “Born Again Keynesians”, and if their rescue does work, then it contradicts neoclassical economics just as much as the GFC’s very existence did in the first place.

Also as noted in that post, the only school of economic thought that could be vindicated by this outcome is the Post Keynesian “Chartalist” group, which argues that any macroeconomic downturn can be averted by sufficiently strong government action.

The question for the future is what the economy is likely to do after the special factors that turned it into a comparative boom for Australian households and exporters are unwound.

Already the RBA has started to reverse the first factor above, by raising interest rates by 0.25% at its October meeting, flagging that it will do as much or more on Melbourne Cup day, and implying that the reserve rate could be as high as 5-6% by the end of 2010. If the RBA followed that plan of action, then the debt servicing costs for households would rise to over 15 percent of household disposable income. This would reverse more than half of the improvement to disposable incomes engineered by government policy during the GFC.

Moreover, this increase in debt servicing costs would come on top of the removal of the First Home Buyers Boost (FHBB)—which I prefer to call the First Home Vendors Boost.

Prior to that foolish policy, Australian households were deleveraging—reducing their debt levels. Thanks to it, they increased their debt levels so that the ratio of mortgage debt to GDP in Australia is now at an all-time record, and exceeds the level in the USA (though not the UK). in mid-2008, the mortgage debt to GDP ratio peaked at 84.9%, and it then fell to 84.2% by the end of 2008. Under the influence of the FHOB, that ratio stopped falling and is now 88.4%—an all-time record, and five times the level that applied in 1989.

This government-induced $50 billion increase in mortgage debt has been a major factor in driving the economy upward, despite the GFC. The takeup of the boost is truly staggering—from a nationwide total of 121 in October 2008, to 5,385 the next month, and a peak of 20,389 in June 2009. The total enticed into taking out a mortgage will surely exceed 200,000 by the end of December—and represent more than one percent of the Australian population.

How did the Government get such a fabulous “multiplier” out of its Boost—put in $1.5 billion, get $50 billion additional spending on housing (at $7000 per recipient, times roughly 200,000 recipients by the time the Boost ends—there were 171,000 recipients as of the end of September 2009)? Because the recipients of the grants used the $7,000 to get an additional $40,000-$50,000 in finance from their mortgage lender, and then handed this over to the First Home Vendor (FHV) in a grossly inflated sale price.

The FHV then took this additional cash and leveraged it into an additional $200,000 or so for their next house purchase. So the FHVB caused a bubble, not merely in the sub-$500,000 price range that most First Home Buyers inhabit, but right up to the $1 million range that accounts for more than 90% of Australian housing. The leverage on the FHBB was not merely seven to one, but closer to 50:1 given this flow-on effect.

With this government-engineered mortgage debt spree, it’s no wonder that the Australian house price bubble, which had begun to deflate in late 2008, has taken off once more. It’s rather apt that my walk to Kosciuszko (as a result of Rory Robertson’s bet with me) will start from Parliament House, since there’s no doubt about Parliament’s role in keeping this Ponzi Scheme alive.

The impact on Australia’s financial position was dramatic and will, in the long run, be very, very bad. It has encouraged us to go back to the same unsustainable trend of rising debt to income levels that caused the GFC in the first place. It has also engineered an unnaturally fast return to rising debt levels: in the 1990s recession, it took 29 months to go from “peak debt” (85.34% of GDP in February 1991) to “trough debt” (79.14% in July 1993). This time it has taken just 14 months (from 164.8%in March 2008 to 158.84% in May 2009).

After the 1990s recession, debt levels took off in the Great Aussie Mortgage Bubble, rising from 85% to almost 165% of GDP in just 15 years. If we are to get out of this crisis the same way we escaped from “The Recession We Had To Have”, then debt levels would need to continue rising relative to GDP. Which raises the question, “Who Are You Going To Lend To?” Both households and businesses are carrying more debt than in any previous recession, and the business sector is still deleveraging—only households are taking on more debt.

All these factors lead me to expect that 2010 will be a bad year for the Australian economy:

  • The combination of the RBA’s rate rises and the ending of the First Home Buyers Boost will in all likelihood prick the house price bubble inspired by the Boost in the first place—and lead as many as 175,000 households to be very angry that they were enticed into this speculative bubble in the first place. If this happens, there is little prospect of making the House Price Souffle rise twice by yet another foolish enticement into debt.
  • The political pressure on the government may lead it to unwind its stimulus, which will remove a key prop from the economy; and
  • Deleveraging, which has been the looming problem that government policy (especially the First Home Vendors Grant) has simply delayed, will kick in as it has in the USA. The most likely manifestation would be a decline in discretionary consumption and non-mining investment.

I therefore expect that the RBA won’t get to complete its intended program of raising interest rates, but will be forced to go into reverse in 2010 as it was in 2008. It shouldn’t be forgotten that the RBA was still raising rates in mid-2008 to fight inflation. They didn’t see the GFC coming, and I believe that they’re making a similar mistake this time—believing that it’s all behind us when the special factors that minimised the impact are terminating.

So no I don’t believe we have dodged the iceberg—we’ve merely pushed it below the surface, from where it will rise again to dent out economic hull once more. And all the while the neoclassical economists who didn’t realise they were in an ice field in the first place are busily rearranging the deckchairs on the Titanic.

Table One

Table Two