Downsizing and Consolidation

The American household continues the path of downsizing and consolidation. Electricity usage, which hardly ever declines, has fallen 2.3% in the US since August 2008, reflecting mostly the decrease in industrial output.

Rents have been dropping, as vacancy rates rise. This is perhaps an odd finding: shouldn’t the tightening of credit mean fewer people can buy homes, channeling more demand into the rental market? Similarly, shouldn’t rising foreclosures push more people into the rental market? It seems that these forces were overwhelmed by the drop in household income caused by the recession, and the resultant tendency to live more frugally.

Some condo developers expected the baby boomer generation to consolidate and move to smaller spaces in urban centers as they retired, but because home prices fell, they haven’t really done so. They can’t sell their homes at the price they think the homes are worth. There hasn’t been a movement away from suburbs en masse (in fact, there isn’t much moving at all: moving rates are the lowest they’ve been since 1948, when the Census Bureau began tracking them) though the preference for smaller homes seems to be increasing over the last 2 years. But that is probably a counter-reaction to the excesses of enormous McMansions, with their costly heating and electricity bills.

One hot trend is the tiny home. Several home builders are bucking the trend and moving toward very small homes. Often modular or mounted on trailers, tiny homes are less than 300 sq ft. People are going small for financial reasons, but also because of concerns over the environment and the impact of consumption. Large homes seem to engender large collections of things.

How does all this saving and decreased consumption affect the economy?

Keynes called it ‘the paradox of thrift’. Though saving is good for individuals, it can be bad for society, because it moves society to an equilibrium of lower spending, which Keynes considered the driver of economic growth. Here is where I part ways with Mr Keynes. Investment is the driver of economic growth, not spending, and higher rates of savings allow us to achieve higher rates of investment. But that won’t happen until businesses clean up their balance sheets and eliminate debt. That process will require some inefficient and overleveraged firms to enter bankruptcy. The sooner they do so, the quicker they can emerge and the sooner the economy can recover.

Individuals are curtailing their spending because that seems the smart thing to do, given the circumstances. My guess is that we’ll find a silver lining in this, for even though consumption is likely to grow more slowly in the coming years, we may be taking a path that is more sustainable.

The 'Soft Budget Constraint' Hardens

The fate of the US empire depends on access to debt and the ability to service the existing debt burden at low rates. We could’ve chosen a different path. During the 2000 election, Al Gore spoke of paying down the entire public debt. Perhaps things may have gone a different way in the absence of the Bush/Cheney bloodless coup of 2000.

But now we seem to be committed to sky-high deficits, despite recent talk of health care being ‘deficit neutral’ and plans for reducing the deficit. Even the tough talk hints at the reality: we speak of reducing the deficit, not eliminating it, not running a surplus, not reducing the total debt outstanding. The only thing that qualifies as a plan is to increase the debt at a slightly slower rate than the economy expands, so that the debt burden becomes smaller in relative terms, while growing in absolute terms. The economist James K. Galbraith calls it a ‘soft budget constraint’. But how long can it remain soft?

The Fed has poured money into the US Treasury market, a practice called ‘monetizing debt’; this has made Treasury yields fall across the board. That makes the debt easier to service, but if taken too far, it makes US Treasurys unattractive relative to other investment-grade debt.

Fed chair Ben Bernanke criticizes China for having a ‘savings glut’. While they have been spending more, he warns them, don’t save too much! America, with the exception of government, is not following his advice. Americans have gone from being like the fabled grasshopper who fiddles all day long to the ant who works and saves. (If only finding steady work was that easy. There are now six job seekers for every available job.) A new culture of frugality is spreading to every corner of American society. Americans are planting vegetable gardens, learning to preserve food by home canning, even raising chickens. (Not that the average American is doing all this, but things spread from the leading edge to the center) Fashion designers are bringing out new looks inspired by the 1930s, as designers and artists embrace the new ‘rough luxe’ aesthetic, elevating old, vintage, weathered, used objects.

There is a lot of talk about recovery, but state unemployment figures for September indicate that payroll unemployment declined in 43 states. Pressure is beginning to mount on the Fed to raise rates. A recent Barron’s cover story argues that the Fed should raise the interbank lending rate from 0% to 2%. If the Fed does raise rates, we’ll see how strong the recovery truly is. If that rate increase takes place while states continue to trim spending, residential foreclosures continue to escalate, followed by increases in commercial foreclosures, that looks like the making of the return of the credit crunch of 2008, and the double-dip recession of 2010.

War and Peace

Obama’s surprise Nobel peace prize has caused a reality rift in the US; On the right, Peggy Noonan writes that the Nobel peace prize has always been “an award by liberals for liberals”. She can’t believe Reagan didn’t get one. Yeah, Reagan. The guy who called the Soviet Union “the evil empire” and pushed for the star wars program to militarize space. Bret Stephens wants to give one to Harry Truman. You know, the guy who killed 300,000 civilians by dropping the bomb on Hiroshima and Nagasaki. No serious historian puts forth the claim that this barbarous act was necessary to get Japan to surrender. On the left, Howard Zinn asks, how can you give a Nobel peace prize to a man who’s continued two disastrous wars?

Meanwhile, Australia’s central bank has reversed the course of slashing rates to raise their overnight loan rate by a quarter point. Glenn Stevens, Australia’s chief central banker, warns of the danger of being ‘too timid’ in raising rates. Australia, it seems, wants to avoid the pitfall of being the world’s carry trade sop. Could that award be coming the US? If so, the strategy of borrowing in dollars, then dumping them to buy stocks or bonds in other currencies will weigh on the dollar’s value. The dollar hit a 14-month low recently.

US Fed chief Bernanke and Treasury Secretary Geithner talk of wanting to maintain a ‘strong dollar’ but actions speak louder than words. It seems more plausible that what is wanted is a steadily weakening dollar, which will make the government’s large and escalating debt easier to pay.

The average worker is likely to see continued pain from such a strategy, as wages continue to fall. Colorado has decreased its minimum wage, as their standard is tied to the CPI, and deflation slightly reduced the CPI last year, mostly due to falling oil prices. However, the weaker dollar places pressure on import prices, such as the prices of goods at Wal-mart and other low-cost retailers relied upon by the lowest-paid workers in the US. During a recession, prices and wages tend to fall, but not necessarily by the same amount. However, certain prices are rising again. Oil is now at $75, and gold is over $1060. We could easily see the worst of both worlds, stagnating economy combined with inflation.

The Fed has injected trillions of dollars of money into the economy, in a bid to prevent deflation. But all that money has to go somewhere; so far it seems to have gone into the stock market, and commodities like copper, oil, and gold. It’s hard to believe that the Fed could reverse course anytime soon and start raising rates like Australia. Imagine what a rate increase would do to the still-weak economy. Without one, the dollar will continue to slide.

Maybe the Nobel peace prize should be given to the economy. As the dollar loses value, the US will find it difficult to finance the imperial adventures in Iraq and Afghanistan; at least, that is my hope, though it hasn’t happened yet.

Greed vs Fear

Treasuries and gold are fear investments. Investors have bid up the price of 10-year Treasury bonds, driving down the yield to 3.178%. Fear. Gold has just hit a new high, $1038. More fear. Stocks are a greed investment, and stocks are looking tired, moving sideways after a 7 month rally. As the rally has continued, volume has seen a mild but steady decline.

If Wall Street is torn between greed and fear, what about Main Street? Unemployment continues to rise, hitting 9.8% as of last month. The economy seems to be continuing to shed jobs, albeit at a slower pace. Incomes are falling, as is the average workweek. More are working part-time when they’d like to have full time jobs. The housing market continues to decline, offering a benefit for some Americans: falling rents. Thousands of condos that cannot be sold, and thousands of homes that were bought by speculators who don’t want to sell at current prices but need cash to pay the mortgage hit the rental market, have pushed rents steadily downward. In addition, people are consolidating, doing with less.

People are even borrowing less. Total consumer credit has declined by 3.6% during this recession. Comparable declines haven’t been seen since 1991. Even with those declines, the consumer remains heavily mired in debt, so it seems reasonable to expect it will take consumers some time to lower their debt levels, as seems to be their preference. Many consumers are saying now that they wouldn’t return to their ‘spend now, pay later’ ways.

Corporations are facing the shock of billions of dollars of worthless assets clogging their balance sheets, or, even worse, these toxic assets are not on the balance sheet, because they are not being valued honestly. New accounting rules have allowed corporations more flexibility in their amortization of gains and losses, i.e., less transparency for investors, meaning more risk. Corporations have been hollowed out by two decades of mergers, acquisitions, restructurings, layoffs, and re-brandings. The CEO and upper management—facing little opposition from the Board of Directors, shareholders, workers, or other stakeholders—have looted the corporation. New models of leadership will be needed for corporations to move forward. I expect the wild executive compensation of the boom years will swiftly fade away.

Meanwhile the various levels of government struggle with massive revenue shortfalls and budget deficits. Most states are cutting spending and raising taxes. The former is good during a recession, the latter, disastrous. Many are following California’s example, turning toward debt to put off their budget problems. In the face of all this, the Federal government considers a health plan that will fine people who don’t have health insurance, and we debate over whether to call this a new tax or not.

In the battle between greed and fear, there is no contest. Indeed, I’ll believe in the recovery when I see some genuine signs that greed has returned.

Price Levels

Everyone’s attention seems to be focused on whether we’ll see deflation or inflation in the US economy (and in the global economy) as we move forward.

On the deflation side, we have the moribund housing market, falling or stagnant consumer spending, along with falling incomes and rising unemployment, and on the inflation side we have truly massive money creation led by the Fed, followed by the Treasury, and finally by the Federal government in the form of federal stimulus packages, all on borrowed money.

Which of these two forces will prove to be more powerful?

I live in San Francisco, one of the more expensive urban centers in the country. In my neighborhood, I see flyers posted that say “One Hour Massage, $40”. It caught my attention because I think that price is half to a third the price you would have paid two years ago. Basic economics: if goods and services won’t sell at a given price, then the price will fall.

The bond market may provide us with a clue, as bond investors are highly concerned about inflation. The yield on the bellwether 10-yr US Treasury bond has been dropping rapidly. Since mid August, the yield has fallen from 3.8% to close below 3.2%. This may mean that bond investors are taking a stand on deflation, but it may also mean that investors see the rally in the stock market ending soon, and they’re getting back into Treasuries for a safe haven. The surge in gold prices to close above $1,000 for six days seems to lend support to the safe haven thesis, but it also could support the inflation thesis.

Oil and copper are also important signals to the strength of the global economy. Both seem indecisive after strong gains this year. The same can be said for the CRB commodities index, which is up 25% from its low this year, recorded back in March.

Given all this indecision, we may see a bifurcation, with certain commodities and services rising while others fall. We await, with bated breath, the next round of economic developments. The latest labor market data indicate that the US economy shed 263,000 jobs last month, for a total of about 7.2 million jobs lost so far during this recession. That is a truly stunning number, made all the more serious when one considers that the economy must create 150,000 jobs or so each month in order to simply keep pace with population growth.