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The Virtuous Cycle Of The Economy

Written by Lance Roberts | Jan, 19, 2013

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Today we got three disparate economic reports all linking us back to the virtuous cycle of the economy, or lack therof.   As we have discussed previously the virtuous cycle of the economy is as follows:

The consumer spends their income on both non-discretionary and discretionary items.   When a paycheck rolls into the family household the mortgage, utilities, insurance, etc. all get paid.   Groceries are purchased and gasoline is put into the car(s). If there is some discretionary money left over at this point it is then used to purchase those items that are not absolute necessities to their daily living.   As consumers make purchases this draws down the inventory that businesses have available to sell.   As inventories are drawn down production must increase in order to fill current and future estimated demand.   As production reaches higher levels business must then decide on when to borrow money to expand, how much to expand, how many new employees to hire to meet production demands and how much to increase the inventory of component goods to meet production requirements.

As hiring increases due to rising demand the available pool of skilled and unskilled laborers diminishes and employees can then begin to demand higher wages. As wages increase consumers have more income with which to make purchases. Therein lies the virtuous economic cycle of life. 

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Therein Also Lies The Problem

As we have discussed in our previous posting on the NFIB Small Business Index there is no demand on businesses to increase production or hire more employees. With “Poor Sales” being near the highest levels in the history of the survey and the idea that “This Is A Good Time To Expand” at near the lowest levels of the index – there is no pressure for businesses to borrow or deploy capital to expand productive capacity which in turn would increase employment and ultimately wages.  This is why we are seeing the economy shifting into a slower gear.

Today’s economic news continues to belabor this point. Jobless claims remain above 400,000 which is where the economy is normally during a recession and, more importantly, the number of people The number of people on emergency unemployment benefitsincreased 53,398 to 3.47 million in the week ended April 30, the latest week for which data is available. A total of 7.94 million people were claiming unemployment benefits during that period under all programs.   This is just the people claiming benefits, of course, there are the masses than have gone to work part time for economic reasons and those that have just fallen off the roles completely as their benefits ran out into the realm of “having given up looking for work”. These uncounted and underemployed masses make up nearly 1 in 5 workers.   

Existing Home Sells “Unexpectedly” Drop

While the economists were shocked by the drop in existing home sales today – this is something that we have been speaking about for quite some time. “The recovery is very sluggish,” said the NAR’s senior economist, Lawrence Yun, adding that unnecessarily tight credit is continuing to restrain the market. It is interesting that he states the credit is “unnecessarily” tight considering that 1 in 5 home owners are delinquent, 1 in 4 homeowners are underwater in their mortgage and with 37% of the market consisting of distressed sales, which include both foreclosures and sales of homes where the bank agrees to take less than what is owed, it is not an environment that banks are willing to lend into.

Home starts have also been extremely weak and, being a huge multiplier of investment capital due to the multitude of jobs that are created by building a new home, this continued weakness both starts and existing sales does not bode well for longer term economic prosperity. There has never been an economic recovery in the history of the United States where housing was not leading the way and with the huge overhang in existing homes that can be sold at cheaper prices than building a new home – the continued drag on the economic cycle will continue without this important ingredient fueling some of the growth.

Philadelphia Fed Piles On The Disappointment

The trifecta of economic weakness out this morning is completed by the Philadelphia Federal Reserve report on manufacturing in that region. The business activity index slumped to 3.9 from 18.5 in April.  Economists had expected a reading of 20, just a slight miss, based on a continued disbelief that anything can actually decline in an economic cycle.   However, as we have been discussing as of late with several other manufacturing reports, most recently the Empire Manufacturing Index, it appears that virtually all of the indexes from the ISM to the Philly Fed have all turned down from cyclical peaks.  With GDP barely growing at 1.8% in the first quarter this does not bode well for a pick up in economic activity in the near future. 

Back To The Virtuous Economic Cycle

With this, and all of the other recent economic data all showing signs of accelerating weakness this creates the “chicken and egg” syndrome for the economy.  Consumers can’t spend more because their salaries and wages are being eaten up by rising food and fuel costs, they have a lack of mobility to move to where jobs might be because they are trapped in their homes and can’t sell.   Businesses are worried about poor sales and there is no sign that consumers are going to pick up spending at any point in the near future, particularly when according to a recent survey 70% believe that we are either in a recession or depression, so there is no reason to expand production or capacity.  The administration has done little to clear the uncertainty of the future economic environment and the threat of increased taxes and health care costs weigh on their spending and expansion decisions.  This is turn keeps the very large pool of unemployed persons begging for jobs, 6 applicants for every job opening, which gives businesses the ability to keep wages, a major cost to their bottom line, suppressed.  This is good for profit margins but a killer for the virtuous economic cycle because without a tight labor market where employees can demand higher wages this feeds the loop in keeping consumption depressed as costs increase but there is not a corresponding increase in wages to offset rising costs.

This is turn is why deflationary economic pressures are so bad for the economy and why a deflationary cycle is so hard to break. So, while our administration plays shell games in Washington at the expenses of taxpayers – the economy is bleeding a slow death back into recessionary territory.

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