Economic Bottom Calls: Willful Ignorance

For my weekend missive I would like to present some charts that should make clear exactly what sort of storm we’re facing in this country, and why the mess cannot be over.

We will start with the most basic of known facts: Consumption is 70% of the economy, the government is the other 30%.

This is the chart that everyone should be focused on as their "first level" analysis; updated yesterday, it is The Federal Reserve’s G.19 data on consumer credit, presented in year-over-year percentage change.

Note a few things about this data:

In most cases during recessions consumer credit growth has not gone negative.  Notable exceptions are the 1991/92 recession, the immediate post-war "hangover" and, of course, this one.  The 1991/92 recession is particularly interesting in that revolving credit did not stop growing, but non-revolving (specifically, automobiles and other "durable credit-financed purchases") did, as is shown in the detail chart here: 

The Fed did not track revolving and non-revolving credit (mostly because there was no material revolving credit) prior to 1968.

I want to focus on the detail chart, and then re-state it a bit.  See, our population is growing about 1% annually, but this chart states rate-of-change in gross dollars.  That of course ignores the true state of the world in a "per-capita" view, which isn’t accurate. Subtract 1% off the current rates to get there.

The more-frightening aspect of this, however, is the fact that the rate of positive growth is clearly constrained – that is, each bounce has been weaker, and it appears that we have now "hit the wall" for the consumer.

The Stock Market has responded mightily, but to what?  That answer is simple – the source, historically, is right here:

With the breakdown it becomes more clear: it is the turn in revolving – that is, credit-card – debt that has led the market up in the modern era.  In 80-81 it was nearly two full years before the market turned.  In 1987 the turn-up in revolving debt led the market upward.  In the early 90s we never really had a meaningful pullback in the market, but again, the turn was not led by non-revolving (primarily durable) debt, but rather by revolving, and when it turned it sparked the 1990s market boom.  In 2000-03, again, revolving credit turned upward in the early part of 2002, and a year later the final market bottom was reached.

This is particularly ominous because where we are now looks a lot like 2000-03 in this chart.  In particular, "cash for clunkers" will spike non-revolving debt, just like "Drive America" did in 2001, but that did not mark the bottom.  Indeed, consumer credit spiked upward in the early part of the 00-03 downturn just like it did this time, as consumers desperately tried to hold onto their standard of living via credit cards.

In 2000-03, it "worked" – we avoided the meltdown, even though the stock market posted a 30% decline. 

But in 2008/09 the attempt to shift consumption to credit has failed – credit demand has now gone negative in the consumer sector for both durable and consumptive purposes.

History says you must watch revolving credit y/o/y change, and expect the turn in that demand to lead the stock market bottom by up to a year or even more. 

Note that in 00/03 when we hit the bottom on consumer revolving credit (mid 2001) we still had another, confirmatory, move down.  The first big rally in 2001 off the 9/11 lows in fact occurred into a declining consumer credit environment – just as it is now.  As the violence of the first move downward was greater in this case, thus the reaction rally should be expected to be greater, and it has been.

But CAN we spur people to borrow?  The data says no, and you better believe that both Bernanke and The Federal Government know it.  Thus, charts that look like this:

Notice some important facts from the past, most-specifically that the market did not begin a durable rise until we had plateaued and were about to decline in government debt growth, with consumer debt growth taking the baton back from the government’s "stimulus."

You can clearly see where in early 2001 the policy response began with government "printing" of credit (Fed-sponsored, of course), but the recovery occurred when that ceased.  It ceased because private activity took over and credit once again expanded in the private sector, leaving government free to draw back.

But the policy response this time was much more massive than previous and in fact during the last "recovery" we never managed to get below a 5% annualized rate.  Now we’re at four times that and current projections are that we will continue next fiscal year to run a deficit of about $2 trillion dollars – close to today’s rate.  Historically, until this rate of change begins to subside and the consumer is able to once again pick up borrowing activity there is no recovery.

The Federal Government is in effect trying to paper over these problems:

Civilian participation in the economy – that is, the number of people working as a percentage of the population, is back to where it was in the late 1980s, and in fact has declined since the beginning of the 00-03 downturn.  Despite the claims of a "booming economy" during the 03-07 time frame labor participation did not rise; we instead borrowed the money to "create" that boom, we did not earn it!

Note that since 1970, when you lose your job you tend to lose it for greater and greater periods of time.  This of course depresses consumer earnings which in turn has driven the reliance on credit.  Worse, duration of unemployment continues to rise dramatically until well after the recession is over – in fact, this has NEVER, EVER FAILED TO BE THE CASE. 

This chart alone should make your blood run cold if you are a banker – or trading on the belief that the banking system has hit bottom and credit-related losses are anywhere near "complete."  Job loss and unemployment are the most-reliable trend indicators for the direction of credit losses, both via foreclosure and consumer credit defaults.

In all recessions since WWII up until this one the recession itself was not triggered by defaults – that is, excessive credit in the system.  It was instead triggered by excess production capacity.  As such we entered the recession with a good-sized "cushion" between credit defaults and unemployment.

This recession was entered because of the overhang of credit.  The cushion was in fact zero, which is why we are now continuing to see ramping foreclosure rates.  In fact, according to RealtyTrac:

According to the report, Las Vegas has the country’s highest foreclosure rate for cities with a population of more than 200,000; the city saw 7.45% of its housing units, or one in every 13 homes foreclosed upon in the first six months of 2009. That’s a 22% increase from the previous 6 month period, according to RealtyTrac.

The Cape Coral-Fort Myers metro area in Florida had the second-highest foreclosure rate, with 7.2% of its homes foreclosed upon in the first half of this year.

Some cities saw foreclosure rates decline during the first six months of 2009, including Stockton, Calif., which saw its rate fall nearly 4% from the previous six-month period. Detroit’s foreclosure rate also fell 8% when compared to the rate during the last six months of 2008. Foreclosures in Cleveland also declined by 11%, compared to the previous 6 months, according to the report.

Stockton and Detroit are seeing a decrease because virtually all of the housing stock that CAN be foreclosed HAS BEEN ALREADY!

Of course the numerical rate has gone down – the better question is "of those homes LEFT that can be foreclosed upon, what’s the rate?"  Don’t ask that question.

Bernanke and The Federal Government have in fact "bet the farm" on the idea that they can "stimulate" the economy with federal borrowing.  You’ve heard it yourself – stimulus programs and TARP’d money to "make more loans available to consumers."

Yet in fact consumer credit is still contracting, not expanding, despite $700 billion of raw cash – the fuel for seven trillion in new borrowing – being injected into the banks.  We are now almost a full year into the massive policy response from The Fed and Government and yet borrowing among consumers continues to decline!

The gambit from last fall in fact has failed to turn around consumer credit – not because there is no credit supply, but because there is no demand from credit-worthy borrowers – the pool of Americans able and willing to take on new financial term obligations continues to contract.  The issue is not willingness – it is ability.

When this was detected this spring The Federal Government engaged in one last pumping effort – it cranked up its own printing press and threw – literally – $630 billion dollars into the economy between the first and second quarters.  That cranked up the y/o/y Federal Debt growth numbers dramatically and produced a rocket ride in the stock market as a good part of that went directly from the big banks into speculation in that market, along with a short-term move in GDP.

The intent was to produce a dramatic increase in consumer confidence and thus restart the "consumption engine" that drives our economy.

We now have the results on that: it produced only a fleeting change in confidence that is now (again) rolling over, and worse, it has done nothing to change the present situation and most importantly the labor indices:

Says Lynn Franco, Director of The Conference Board Consumer Research Center: "Consumer confidence, which had rebounded strongly in late spring, has faded in the last two months. The decline in the Present Situation Index was caused primarily by a worsening job market, as the percent of consumers claiming jobs are hard to get rose sharply. The decline in the Expectations Index was more the result of an increase in the proportion of consumers expecting no change in business and labor market conditions, as opposed to an increase in the percent of consumers expecting conditions to deteriorate further. However, more consumers are pessimistic about their income expectations, which does not bode well for spending in the months ahead."

Consumers continued to rate current conditions unfavorably in July. Those saying business conditions are "bad" increased to 46.3 percent from 45.3 percent, however, those saying conditions are "good" increased to 9.1 percent from 8.1 percent. Consumers’ assessment of the labor market deteriorated further. Those claiming jobs are "hard to get" increased to 48.1 percent from 44.8 percent, while those claiming jobs are "plentiful" decreased to 3.6 percent from 4.5 percent.

In short, the response "to date" from government has been the same response it has (with success) employed in previous recessions:

Pump government spending in an attempt to get consumers to once again take on more debt, thereby pulling forward yet more demand and lifting the economy.

The problem is that we are in this recession because of excessive consumer debt in the first place.

The reservoir of available-but-untapped credit is dry among consumers as a whole; we have, over the previous 20 years, drained the labor participation rate, we have drained equity in homes, we have drained savings and instead consumed far beyond our means.  Since there is no cushion upon which the consumer may draw, and in fact credit lines are being slashed at a furious rate to comport with diminished earnings power among the consumer, the government’s attempt to "prime the pump" was doomed to failure from the outset.

There is only one way to produce a durable economic recovery that does not involve massive contraction in GDP – we must find a way to boost actual personal incomes dramatically so as to free up additional spending power.  This means dramatically expanding the labor participation rate, which in turn means bringing jobs home rather than offshoring them.  In short, we must increase PRODUCTION, not paper-pushing.

That, unfortunately, would require protectionist measures last seen in the 1930s, and have a dramatic and horrifying short-term impact around the world.

Absent that the only durable solution available is to accept that our economy must contract to a level we can sustain via personal earnings, not credit, and to either pay down or default the excess credit in the system.  This in turn will significantly "reset" our standard of living to a lower level, as we will be paying more in cash and less in credit for what we consume.

Attempts to further shift consumption to the government balance sheet will be short-lived – eventually you have to pay that debt, and this sort of "solution" means dramatically higher taxes (which ALSO kills consumption.

The math simply prohibits further "pulling forward" on a durable basis; short-term stimulus measures intended to turn confidence will in fact prove fleeting, as the consumer, at this point, has barely de-leveraged his or her balance sheet at all – in fact, we are only back to where we were, in terms of outstanding credit, in the middle of 2007:

We have a long way to go folks, and further attempts out of the government to "pump" the economy and markets, while certainly making the stock market feel good in the short term, are unlikely to be able to turn around the credit demand picture, which is in fact the backbone of our economic engine.

Absent that turn-around the only paths forward are to either dramatically increase taxes (which will hammer consumption and thus stocks) or force repatriation of labor so we produce more (which will lead to nasty tariff wars ala The Great Depression.)  Attempting more and more fiscal stimulus to prop up a consumer with no more true borrowing or production capacity is a path that will produce "feel good" response only for the duration of the spending, the ability of the government to continue down that path is not indefinite in duration.