Everyone except perhaps Democrat politicians were relieved when they saw how mild the 2001 recession ended up to be—in fact it might not even technically count as a recession, since we did not get two consecutive quarters of falling real GDP.
The Media did however try desperately to point out how lousy the labor market has been since then and that the succeeding expansion has been a lot slower than the official numbers would indicate. Still, given the bursting of the great stock market bubble as well as 9/11, the 2001 - 2002 recession was indeed surprisingly mild even if the official numbers may have underestimated its severity. Compared to Japan in the 1990s and even more so to America in the 1930s or to 1973-74 It seems that we have absorbed the bursting of a stock market bubble exceedingly well. Or have we simply postponed the inevitable?
There are some very bright spots in the American economy.
The Corporate Sector
#1 Corporations are looking much stronger than they looked in the late 1990s. For one thing, after-tax corporate profits are at record high levels.
#2 Corporate financial savings are back to near record highs.
#3 Corporate debt while still at historically high levels at 65% of GDP, the debt burden has fallen since its 2001 peak and is actually no higher than it was at the last cyclical peak in 1990. All in all, the corporate sector looks pretty healthy, similar to way it looked just before the peak in 1929.
With the cost of money being so low, reflecting low interest rate and high stock market valuations, business investment will most likely continue to rise. However, new investment is likely to be limited by the exceedingly low level of capacity utilization.
The government sector, on the other hand, is a completely different story. Its financial balance sheet is now at its worst levels in history. If we include state and local governments, total government deficits are at roughly 6% of GDP. When it comes to trade, the current account deficit increased, during a supposedly recessionary period, from 4.4% of GDP in 2000 to 5.7% by the second quarter of this year, with a projected deficit of well mover 6% by year end.
The private sector
Typically the private sector has a large financial surplus during recessions and roughly balanced savings during booms. This time around the private sector has weaker financial savings than its ever had, which will strongly limit its ability to increase spending. What is truly worrisome is the complete disappearance of household savings all together. Mean while the government which is borrowing all time record high amounts from abroad is masking their real overspending. In time there will have to be real spending cuts to curb the massive budget deficits. But the sector that poses the biggest threat to the economy is the household sector which is spending and borrowing at an unsustainable level. The household savings rate, which in the early 1980s ( the last time we had a surplus in our balance of trade) was more than 10% of disposable income, is now at a record low 1%. At the same time, household debt has risen steadily, from roughly 65% of total assets in t! he early 1980s to 80% in the early 1990s to 95% in 2000 to 114% in the second quarter of 2004. More importantly, mortgage debt relative to disposable income has gone from just over 40% in 1980 to 85% today. Record low savings and record high debt levels means that there is a substantial risk of a spending downturn in 2005. Alan Greenspan tries to downplay the risk of a collapse in the household sector by pointing out that household assets are also at historically high levels. While the rise in asset values until 2000 was mostly a result of stock prices, in recent years the stock market bubble has been replaced by what may be a new housing price bubble. There are, however, several problems with Greenspan's view. First of all, in most cases it is a different group of households that have huge assets than those that have high indebtedness. So for many households leverage is very high indeed, despite the seemingly reasonable debt to asset ratios.
Second, given the fact that leverage is at record high levels which in conjunction with nonexistent savings, households are much more vulnerable to a drop in asset prices than ever before. Therefore there is always the risk that asset values will decline, even as debt levels keep rising. Particularly worrisome is the high leverage in the housing market. With household real estate asset values rising from the (135% to 150%) range of disposable income, that it used to fluctuate within before 2000, to a record 184% of disposable income. means that the housing debt to income ratio has more than doubled from slightly above 40% in the early 1990s to 85% today. If housing prices were to fall back to their historical mean, at slightly above 140% of disposable income, requires a decline in house prices of only 20%, then one fourth of all home owners would have their home equity wiped out completely and in many cases would be forced go bankrupt.
Since this has been a credit driven price boom there is no evidence that the relative housing price increases really reflect an increase in the subjective value of housing for the general population. History tells us that there is a strong likelihood of a price correction back to the mean that existed for decades, until just a few years ago; With a savings rate near zero and a quarter of home owners leveraged to a level which would wipe out their entire housing equity, any financial crisis would be deeper than the one associated with the bursting of the 2000 stock market bubble. However, unlike after the stock market bubble, this time the Federal Reserve has very little room to reduce interest rates as interest rates are already negative in real terms and historically low in nominal terms. The Federal government also has very little room for any further fiscal stimulus because of its historically super high budget deficits.
Nor is any help likely to come from abroad. To be sure, a falling dollar which is almost certain to fall further, may help export industries and domestic companies which compete with imports, but that will weaken the Asian and European economies making strong U.S. export growth unlikely despite the weaker dollar.
The Mystery of Record Low Interest rates
One mystery surrounding the current situation is the near record low level of interest rates given the huge budget deficit, record low household savings, a housing bubble and an investment recovery (near bubble), one would expect high interest rates. Are the low interest rates due to low inflation? Not hardly, while inflation is far below the levels of the 1970s they are now above 3% and are rising quickly. Are they this low because of massive money supply increases that have pushed real interest rates below their natural level? No, the money supply is increasing at a far slower rate than it has been over the last ten years. The only logical reason seems to be the massive purchases of U.S. government bonds by Asian central banks, particularly the Bank of China and the Bank of Japan, in their effort to maintain their exchange rates and keep interest rates low. During the first half of this year foreign central banks bought more than $201 billion of U.S. asset! s, $180 billion of which was U.S. government bonds. This means that foreign central banks financed more than 60% of the U.S. current account deficit and nearly the entire increase in government debt. The reasons why they are doing this is because they want to avoid a sharp increase in the value of their currencies , which they fear would severely damage their export industries. But this is in itself an unsustainable situation. Their increasing purchases of U.S. treasuries make them increasingly vulnerable to heavy losses if the dollar falls and interest rates were to rise, as the ever increasing U.S. current account deficit forces them to purchase ever increasing amounts of treasury Securities. . The longer this unsustainable process is allowed to continue the heavier the losses will eventually be.
Conventional Wisdom states that only if Asian countries accept a sharp appreciation of their currencies and the U.S. adopts much tighter monetary and fiscal policies can the situation be prevented from getting worse. But that would most probably precipitate a world wide recession and its my opinion NO politicians in either Asia or the United States would be willing to face up to that.
The conclusion is that Alan Greenspan and George W. Bush did not prevent the stock market bubble of the late 1990s from turning into a crisis. They have only postponed it.
IS THERE ANY WAY OUT OF THIS DELIMA? Maybe? ONE IN A MILLION !
I know that its hard to believe but there is a one in a million chance that we can work our way out of this situation . That one in a million chance is If BUSH can get his whole agenda passed in one package. That’s the one and only way to do that, without nickel and dimeing each proposal so that none of them achieve their objectives, even if they were all passed separately which I doubt would be possible. It is necessary to put them all together in one neat package, in order `to achieve the prerequisite of # 1 Increased Savings #2 Government Budget deficit reduction and #3 Reduced Imports (legally) and # 4 Resolve the eminent bankruptcy of Medicare/medicade and Social security.
a) The US savings rate must be drastically increased, in order to reduce our trade deficit and re-liquefy our economy. this can only be accomplished by instituting a 15 - 18% federal sales tax as part of completely revamping the federal income tax. This would, for the first time in our history, eliminate the penalization of savers. In order to get bi-partisan support we could also institute a Flat 10% tax on all incomes over $200,000 and an additional 10% Tax on all income over $1,000,000. This should immediately raise the savings rate between 2 to 3%
b) As part of the same package, increase Social security payment by 2%. For anyone 44 years old or younger, the 2% would go to buy a 7% US savings bond that would go into an IRA type account, not to be touched for any reason until retirement. They would of course forfeit any claim to social security. This in conjunction with the federal sales tax would bring about a further 2% increase in savings, holding down both short and long term interest rates and reducing our dependence on Foreign central banks buying our Bonds, extending and increasing our economic growth to between 4 - 5% that could last 10 to 15 years. we could then easily grow ourselves out of our budget deficits. The 2% paid by people older than 44 would also go to supplant future increases while guarantying NO decreases in their benefits. In 40-50 years or so the government would be completely out of the social security business. Of even greater importance, poverty in the Us would be well! on its way to being eliminated, once you realize that the 2% would grow to well over $2million in 50 years and that money would be owned by the individual, not the state and thus be available to be passed on to their heirs. Please Note: Unlike passed increases that only served as a hidden income tax, which was quickly spent by the Government. (there is NO trust fund) The whole 2% is a forced savings that belongs 100% to the individual and can never be touched by the government.
c) Health care reform. In conjunction with the above, an increase of 2% for Medicare/Medicade that like the S/S would go into personal savings accounts in conjunction with a reformed medical insurance, based on medical saving accounts, and catastrophic coverage as a minimum available to everybody, with additional coverage being offered in a competitive environment by Pvt. Insurance Companies; which like the 2% Social security increase, would NOT be considered as a TAX because the individual would be keeping all this money from day one. Any monies not spent would be allowed to accumulate tax free and go towards their estate or retirement. It would be a forced saving with the Government unable to touch that money. In this way the 20 million 18 to 24 year olds, that are part of the 43 million uninsured but that choose not to buy insurance, even though it is available to them at a very low cost, would now become part of the total pool reducing the Pool’s ove! r all risks and costs. If all this is done in one package we could easily have corporations pay the entire 2% given their tremendous savings in health care and d)
d) Complete Tort reform must be part of the package. It would reduce the cost of doing business, especially health care costs, in the USA by between 10 to 20%. This would automatically make all Domestic companies ultra competitive in the new world economy. The elimination of ridiculous law suits, would also allow for our public sector , especially schools to be improved without one cent of additional money. (It would possible, if a comprehensive Tort reform package was passed to have the corporations pay the 2% social security payments.)
All of the above is just the bare bones of an idea and must be fleshed out but it’s the best I could do without doing extensive research and writing a book.
What are the chances of all this happening? No more than one in a million but at least there is a chance
Aubie Baltin CFA, CTA, CFP, Phd. (Retired)
Palm Beach Gardens FL
December, 2004
561-840--9767