This past Monday, Stanley Fischer, the official who took over as Vice Chairman of the Federal Reserve in June, commented that the weak economic recovery might simply be continued fallout from the financial crisis and subsequent recession. However, “it is also possible that the underperformance reflects a more structural, longer-term shift in the global economy.”
The idea of a “structural shift” is a key point that I repeatedly addressed over the past several years as the economy has continued to “struggle through.” To wit:
“Post WWII, the U.S. was the epicenter of production and manufacturing for the majority of the world as war torn Europe, and Japan was rebuilt. However, post-1980; the collision of a structural shift in manufacturing, the rise in financial engineering and the age of ‘consumerism’ changed that dynamic. As can be more clearly seen in the chart below, the surge in consumer debt was used to bridge the gap between declining wage growth and an arguably unrealistic high standard of living.”
The rise of the consumer society is a crucial point that continues to be missed in the ongoing arguments that try to explain the inability of the economy to achieve lift off. Let me explain.
In any economy, there is a crucial link between production and consumption. In order for consumption to occur, production must come first. Simply, an individual has to go to work and produce something, which can be consumed by others, in order to receive wages that allows for personal consumption. In turn, economic activity can be directly traced by personal consumption expenditures as shown in the chart below.
This is not surprising in an economy that is nearly 70% (68.25% to be exact) driven by personal consumption expenditures.
What is important to notice is that while real PCE as a percentage of GDP has risen sharply since 1980, it has been a function of increasing debt levels and weaker economic growth rates as shown in the first chart above. However, let’s look at this a bit differently.
From 1980 through 2000 total inflation adjusted household debt grew from $3.8 Trillion to $8.95 Trillion. At the same time, PCE as a percentage of real GDP grew from 62% to 65.17%. In other words, it took $5.054 Trillion in debt to generate 3.17% increase in the PCE/GDP ratio.
However, from 2000 through 2007, the PCE/GDP ratio expanded from 65.17% to 67.84%. This 2.67% increase required an expansion of $6.46 Trillion in debt. Not surprisingly, the diminishing rate of return on debt growth is clearly shown.
We can look at this a little differently by looking at comparing how many dollars of real (inflation adjusted) debt is required to create one dollar of real GDP. This is shown in the chart below.
From 1950 through 1980, real GDP growth trended higher on an annualized basis. This is because, as stated above, following the end of WWII, American’s returned to buying homes, raising families, and producing the core goods consumed by an industrialized economy. From 1960-1980 in particular, it required a fairly stagnant $0.60 in debt to create $1.00 of economic growth. This left another $0.40 in savings that was used for productive investments.
However, beginning in 1980, that dynamic changed as the economy shifted from production to services and financial engineering. As interest rates fell, and banking became deregulated, the extension of credit allowed American’s to begin living beyond their normal means. From 1980 to the peak in 2007, the dollars of debt required to create economic growth grew from $0.60 to $1.05. The majority of that surge came post 2000 as individuals turned to their homes as a source of cheap credit to fuel consumption expenditures.
Currently, the ratio of debt required to create economic growth has declined to $0.83. However, this is still an unsustainably high level of debt that drags on the ability of households to consume at rates to boost economic growth higher.
The problem is quite clear. With interest rates already at historic lows, the consumer already heavily leveraged and economic growth running at sub-par rates – there is not likely a capability to increase consumption as a percent of the economy to levels that would foster higher rates of economic growth.
While the ongoing interventions by the Federal Reserve have certainly boosted asset prices higher, the only real accomplishment has been a widening of the wealth gap between the top 10% of individuals that have dollars invested in the financial markets and everyone else. What monetary interventions have failed to accomplish is an increase in production to foster higher levels of economic activity.
Corporate profitability, which has primarily been a function of cost cutting, increased productivity, stock buybacks, and accounting gimmicks can certainly maintain the illusion of economic prosperity on the surface, however, the real economy remains very subject to actual economic activity. It is here that the inability to re-leverage balance sheets, to any great degree, to support consumption provides an inherent long-term headwind to economic prosperity.
With the average American still living well beyond their means, the reality is that economic growth will remain mired at lower levels as savings continue to be diverted from productive investment into debt service. The issue, of course, is not just a central theme to the U.S. but to the global economy as well. After five years of excessive monetary interventions, global debt levels have yet to be resolved.
Mr. Fischer is correct. The “structural shift” is quite apparent as burdensome debt levels prohibit the productive investment necessary to fuel higher rates of production, employment, wage growth and consumption. Many will look back at this point in the future and wonder why governments failed to use such artificially low interest rates and excessive liquidity to support the deleveraging process, fund productive investments, refinance government debts, and restructure unfunded social welfare systems.
Until the deleveraging cycle is allowed to occur, and household balance sheets return to more sustainable levels, the attainment of stronger, and more importantly, self-sustaining economic growth could be far more elusive than currently imagined.
Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter, and Linked-In