SERIOUS MONEY:THE SUMMER that never was for both investors and sun worshippers is in its final days but the former will be happy to know that stock price weakness earlier in the week failed to breach the lows registered earlier in the month, suggesting a temporary reprieve may be at hand. Not surprisingly, the overpaid permabulls have returned from their trenches with confident declarations that a new bull market is not far away.
Unfortunately, their recent commentaries verge on the ludicrous in some cases, with higher food and oil prices being pinpointed as the reason for US consumers' current travails. How the demise of the most feeble and debt-driven expansion in modern history can be traced to increased energy and food bills alone beggars belief. The fact of the matter is that it's all about debt.
The economic expansion that accompanied Alan Greenspan's later years at the helm of the US Federal Reserve was characterised by debt-fuelled household consumption centred on perhaps the most unproductive asset of all - housing. The folly of Greenspan's easy money is all too apparent from the decline in credit elasticity.
The output created by an additional dollar of non-financial debt dropped by more than a third during the current expansion compared with the 1990s, falling to the lowest level since record keeping began in the 1950s. This is hardly surprising given that the typical family had no option but to turn to debt to maintain consumption in the face of declining real income while the hollowing out of manufacturing industry meant that the multiplier effect of credit creation passed to emerging economies in Asia and elsewhere.
The perilous state of US household finances has been widely ignored due to the staggering increase in asset prices since the "great moderation" began in the 1980s.
Unfortunately, such arguments almost always focus on aggregate numbers and not on the middle classes, who are the driving force of the US economy.
The Federal Reserve's survey of consumer finances in 2004 provides a more enlightening picture.
The middle classes accounted for just 15 per cent of total household wealth in the US and an even smaller percentage of the cumulative increase in net worth since the early 1980s.
Furthermore, the typical family saw no increase in wealth from 2001 to 2004 despite the surge in home prices as debt to net worth rose by more than 15 percentage points to 62 per cent, and debt to income increased by more than 40 percentage points to 141 per cent. The increase in consumers' indebtedness is staggering, with more than 60 per cent of the increase since the early 1980s occurring from 2001 to 2004.
It is clear that US households viewed asset price gains as permanent and stepped up their rate of borrowing to smooth consumption, which was made all the easier by a steady stream of financial innovations.
Unfortunately, the asset-based economy has now moved into reverse. The secular bull market in stocks ended eight years ago and the house-price boom, fuelled by extraordinarily naive monetary policies, imploded two years ago.
Household balance sheets that appeared so healthy are becoming less so by the day with the cumulative loss of wealth already approaching $4 trillion (€2.57 trillion), with a further $2 trillion to come. Almost one in four homeowners could find themselves with negative equity before the housing market hits bottom and more than 40 per cent of all families with net worth of less than $10,000.
The demise of the asset-based economy is not a fiction and stems from the economic fact that wealth cannot grow faster than gross domestic product (GDP) in the long run. Economic growth theory illustrates that a market economy always requires three to four units of capital to produce one unit of output.
Indeed, the US's wealth-to-GDP ratio ranged from 3.2 to 3.8 until the 1990s, when it soared to almost five. However, mean reversion is now in full swing as asset prices return to more justifiable levels vis-a-vis corporate earnings and personal income. This means that wealth gains are likely to fall below nominal GDP growth for an extended period and US middle classes will have no option but to save the old-fashioned way.
Careful analysis of household balance sheets reveals that, even when the financial system's current malaise is resolved, investors should expect no more than subpar growth from the US economy. The debt-fuelled binge of recent years centred on unproductive assets and saw households lever up their balance sheets on asset price gains that proved illusory. The secular bear market has further to run.
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