Brother, Can You Spare a Trillion?

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The (in)famous Credit Default Swap (CDS) market provides the market’s best guess that an issuer will default on its debt. A low spread is good. A high spread is bad.

Check this out.

Campbell Soups’ (no relation!) CDS is less than the U.S. government CDS. This means that the market believes there is a greater chance of the U.S. government defaulting than Campbell Soup.

The 5-year CDS for U.S. government is 70 basis points. Campbell Soups’ is 65 basis points!

This portrays a very pessimistic outlook for the consumer. There will be a high demand for soup – perhaps from the soup kitchens?

Given this grim assessment, it is naïve to think that the consumer will lead us out of this recession.

Here are the reasons why.

The Setting

The 533,000 jobs lost last month are evidence of a deep recession. Job losses directly hit consumer spending.

In the 2001 recession, consumers led the charge that took us to recovery. In contrast to previous recoveries, the recovery (beginning in 2002) generated relatively few jobs.

However, the 2001 recession was mild and short (only 3 quarters in length).

This recession is shaping up to worse than any economic episode since the Great Depression

Consumer Spending and GDP

Consumer spending comprises close to 70% of GDP. However, in contrast to other GDP components, consumer spending is less volatile. For example, investment has wild swings during recessions and recovery. Consumers prefer to smooth their consumption. Nevertheless, all eyes are on the consumer.

Indeed, some of the latest policy moves are designed to operate at the consumer level.

The Fed has moved aggressively to purchase $500 billion in mortgages from government sponsored enterprises and $100 billion of debt from the GSEs. The direct effect of this will be lower mortgage rates for consumers.

The Fed and Treasury have set their recent focus on the securitization market which includes credit cards, student loans and small business loans. They will provide financing for investors purchasing these assets up to $200 billion. The Treasury will kick in $20 billion from TARP to cover losses up to $20 billion. Needless to say, the failure of the credit card market would have devastating effects on both consumer confidence and spending.

These are helpful but not sufficient.

A lower mortgage rate for someone with a house below water is useless – they have no ability to refi their house and to get the lower rate.

Reasons that consumer will not lead

1. No MEWs

Mortgage equity withdrawals were the driving force behind the last recovery. In the 2002-2007 period, a huge amount of equity was withdrawn from houses and made its way into consumer spending. Roughly 75% of real GDP growth in this period can be directly related to the MEWs.

It is naïve to think that some new round of MEWs will spur consumer spending. If your house is under water, you cannot refi and you certainly can’t withdraw equity – because the equity is negative. Hence, the most important engine of recent GDP growth has been stripped out.

2. High unemployment

As I mentioned, the period following the 2001 recession was called the “jobless recovery.” Though there were few new jobs created, this did not phase the consumer’s spending plans. However, this time is different. The size of the job losses is much higher and we are facing unemployment rates of up to 9%. Consumers like to smooth which means the fear of losing your job will curtail spending plans.

3. Savings rate

In the bubble times, consumers drove their savings to negligible levels. Interestingly, this is in sharp contrast to corporations who spend the recovery years (in many but not all cases and non-financials) strengthening their balance sheets. Now faced with the specter of the worst recession in the post WWII period, it is time to save. Ironically, the easy money policy of the Federal Reserve during the recovery, incented people to spend — not to save. We pay for that now with increased savings (and lower consumption growth).

4. No help from our friends abroad

In usual circumstances, there is a diversification effect from globalization. When one country is in recession another country is not – and the country in recession can benefit from strong exports. This is not the case today. The recession is deep and global. We can expect some limited help from a handful of emerging markets. All of this spells longer recession and little reason for the consumer to take the lead.

5. Wealth effect

Consumers respond to permanent rather than temporary fluctuations in wealth. For example, consumers do not necessarily cut back consumption if there is a correction in the stock market or if there are regular fluctuations in the value of the housing stock. Again, the situation is different today. We have seen a massive revaluation of the housing stock (the consumer’s main asset) – and we have not seen the corner turned. In addition, we have seen a very substantial bear equity market. While most consumers don’t trade stocks, many have 401K plans that have been punished by the stock market revaluation. The wealth effect serves to dampen spending growth.

6. Fear and lack of confidence

Fear drives consumers into crisis mode (which means maximum savings). Consumers see wild volatility in markets. They see policy makers seemingly trying everything – with little immediate effect that they can see. They also see policy makers shifting course which induces lack of confidence. Finally, we are in six weeks of limbo – the transition of the old leaders to the new. These factors make it unlikely that the consumer will take the lead.

7. No good news

Looking at the economic data, there is not one single indicator that would suggest that we have reached the trough. This causes a lack of hope and it is an unlikely time for the consumer to gamble and take the lead on spending.

A shorter list of positive factors for the consumer

A. Energy prices

Gasoline is back to pre-2007 levels. From the peak, the decrease in energy prices is analogous to a $200 billion tax cut. However, we know from previous experience that the relation between consumption expenditures and gasoline prices is not that sharp. Much of the $200 billion will be saved.

B. Fiscal stimulus

The new administration is looking for a $500 billion fiscal stimulus to be ready in January. This could be helpful. However, it is not clear whether this will simply stop the downdraft or whether it will lead to a recovery. One glaring issue is that the government deficit is exploding. Finally, the $500 billion plan will likely be a multiyear program. It is not clear how much of this will get into the hands of consumers in 2009.

C. Monetary actions

As mentioned above, the Fed’s new policy initiative should reduce mortgage rates (for those that are able to refinance). The Fed and Treasury action on the securitization market should also be helpful. However, neither of these moves will lead to a boom for consumer spending. Both banks and policy makers are also working on ways to restructure mortgages.

D. No inflation

Inflation is like a sales tax. Currently, we are in a period of deflation driven by energy prices. Deflation is a mixed bag. It is good for the consumer because the consumer can wait for prices to become cheaper. However, it is bad for the economy because people wait rather than spending.

E. New leadership

We should expect some new ideas from both government and Treasury. While this is probably in the positive factor, the government track record (lax oversight, slow to respond to crisis, inconsistent policies) will likely cause the consumer to adopt the wait and see approach.

Final thoughts

The jobs number today confirms that the economy is a freefall. Indeed, it is hard to point to one substantial piece of information that could be used to make the case that the trough is near.

2 Responses to Brother, Can You Spare a Trillion?

  1. Tom Humes says:

    Nice Site layout for your blog. I am looking forward to reading more from you.

    Tom Humes

  2. Richard Boltuck says:

    Your article nicely catalogs some of the factors bearing on the path out of the global recession. In the end, the bursting of the mortgage and housing bubbles signaled imbalances during at least the last six years of world growth — characterized by, among other features, too little savings in the U.S.; exchange rates that validated export-led growth in Asia, especially China, and resulted in the accumulation of massive reserves that were recycled into the U.S. (and elsehwere), suppressing medium term interest rates; and a resulting boom in U.S. investment in McMansions rather than productive commercial capital (which an overvalued dollar assured would not be competitive in world markets). A resumption of U.S. consumer spending leading restoring the status quo ante hardly seems like a sensible path out of the recession. Instead, we plainly need a restructuring of investment, a restoration of a lost balance. Which means, concretely, less construction of over-sized housing and a smaller financial sector (which has survived on side-bet derivatives which failed to account for systemic risk, and now, as we see, even Ponzi schemes preying on the gullible rich). But it also means an expansion in productive capital in North America that supports more balanced trade with the ROW, particularly Asia and the GCC/OPEC countries. Trade imbalances are not per se “bad” of course, but isn’t it odd that emerging economies have been lending to developed industrial economies rather than the other way around, hardly what Solow-style growth convergence would predict? Which is all a long way of saying the path out of this recession involves consumer spending, to be sure, but more so in China then the U.S., together with commercial investment spending. Of course, getting from here to there does involve breaking some ongoing vicious circles of negative feedbacks that result in excess productive capacity, which is, of course, a strong deterrent to the investments needed in the longer run. But markets do end and correct these negative feedback loops quite efficiently given some patience. Do we have that patience — or will we adopt policies that respond to political demands and actually slow down the painful adjustments that are inescapably needed (as I would argue occurred in the 1930s)?

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