Deleveraging
Although investor views of the economy have reversed in the last five months, the reality probably hasn't. The good life and rapid growth that started in the early 1980s was fueled by massive financial leveraging and excessive debt, first in the global financial sector, starting in the 1970s and in the early 1980s among U.S. consumers. That leverage propelled the dot com stock bubble in the late 1990s and then the housing bubble. But now those two sectors are being forced to delever and in the process are transferring their debts to governments and central banks.
This deleveraging will probably take a decade or more - and that's the good news. The ground to cover is so great that if it were traversed in a year or two, major economies would experience depressions worse than in the 1930s. This deleveraging and other forces will result in slow economic growth and probably deflation for many years. And as Japan has shown, these are difficult conditions to offset with monetary and fiscal policies.
The deleveragings of the global financial sector and U.S. consumer arena are substantial and ongoing. Household debt is down $374 billion since the second quarter of 2008. The credit card and other revolving components as well as the non-revolving piece that includes auto and student loans are both declining. Total business debt is down, as witnessed by falling commercial and industrial loans.
Meanwhile, federal debt has exploded from $5.8 trillion on Sept. 30, 2008 to $8.8 trillion in late August. Many worry about the inflationary implications of this surge, but the reality is that public debt has simply replaced private debt. The federal deficit has leaped as consumers and business retrenched, which curtailed federal tax revenues, while fiscal stimulus, aimed at replacing private sector weakness, has mushroomed.
Four Cylinders
As discussed in our May 2010 Insight, in the typical post-World War II economic recovery, four cylinders fire to push the economic vehicle out of the recessionary mud and back out on to the highway of economic growth. At present, only one - the ending of inventory liquidation - is generating significant power. The other three - employment gains, consumer spending growth and a revival in residential construction - are sputtering at best.
The Inventory Cycle
Historically, the liquidation of excess inventories accounts for major shares of the decline in economic activity in recessions. Around business cycle peaks, the sales of manufacturers, wholesalers and retailers begin to weaken but their managers can't tell whether that's the beginning of a major drop in business or just a minor dip in an upward trend. So they delay cutting production and orders until the downward trend is firmly established. Meanwhile, inventory-sales ratios leap as the numerators, inventories, rise and the denominators, sales, fall. That makes cuts in production and orders imperative and propels the economic downward trend in the process.
That was also the case in the Great Recession. In our view, it really started in early 2007 with the collapse in subprime residential mortgages, and then spread to Wall Street that summer with the implosion of the two Bear Stearns hedge funds in June. But these were financial declines, and recessions are measured by production, employment and spending, which are dominated by the goods and nonfinancial services segments of the economy. So the recession didn't officially start until December 2007.
Consumers Go On Strike
Furthermore, it wasn't until late 2008 that the collapse in home equity as house prices nosedived (Chart 2), rising layoffs (Chart 3) and the drying up of consumer lending drove consumers into retrenchment. But they suddenly went on a buyers strike in the last four months of 2008, and the results were leaps in inventory-sales ratios. Consequently, the cuts in inventories to get rid of unwanted stocks were far and away the biggest in the post-World War II era.
The reduction in inventory liquidation has been key to economic growth starting in the second half of 2009. In the third quarter of last year, it accounted for 66% of the 1.6% annual rate real GDP gain and 58% of the fourth quarter's 5.0% advance. The inventory-building in the first quarter of this year was responsible for 67% of the 3.7% annual rate rise in real GDP and 36% of the rise of 1.6% in the second quarter. In total, in the last four quarters, the inventory swing provided 58% of the 3.0% rise in real GDP.
