I have been reading a lot about the sustainability of economic recovery on the back of American consumer resorting to consumption again. Although the current economic data seems to support this view I have my reservation which I will try to analyze and present in the following write up.
American consumers are dependent not only on the revenue income they earn but they also use their asset to support their consumption by monetizing the increase in value of assets through debt market. Let us look at both the component in detail.
The consumption supported by revenue income is more stable than that generated by asset price inflation. The current income is a factor of employment and wage rate per hour. Current unemployment rate in US is around 10% while U4 unemployment rate which includes people have stopped searching for jobs is around 16%. More over the wage rate has been declining since 2008.
Which means that the consumption supported by this stable component should decrease as the revenue income is decreasing. But contrary to this consumption is again on the rise in America as 18% of an average American income is transfer from US government.
How long will the US government be able to sustain this transfer of income? Current US deficit is around 10% of GDP and the total debt to GDP ratio is around 60% this component will be withdraw sooner or later.
American consumers were dependent solely on their revenue income this Keynesian theory would have worked just fine. But the case is that American consumer also depends on asset price inflation to fund his consumption. Therefore even with this transfer of income continuing the consumption can not increase to the previous level.
The second leg which supports consumption is asset price inflation. The US consumer is typically dependent on rise in asset prices (Real estate, Equity, etc) to support its consumption. They monetize the equity (which is created by inflation) in the asset price through debt and use it for consumption. In 2007 when Real estate market had crumbled, it created shock waves across globe as American consumer started to save as jobs were being lost and they became less confident of their future.
To counter this US government started a massive program for re-inflating the asset prices. The topmost priority was given to boosting the prices of real estate and debt securities held in the pension account of millions of Americans. The US government assumes that if the prices of assets rise the American consumer will once again start consuming the equity generated by the inflated asset price
How long will the US government be able to sustain this transfer of income? Current US deficit is around 10% of GDP and the total debt to GDP ratio is around 60% this component will be withdraw sooner or later.
What the US government is trying to do is to stop the vicious circle of unemployment and drop in aggregate demand feeding each other. By transferring the money to the citizen it enables the citizen to consume and create employment.
The government believes that it will able to oil the consumption machinery long enough to reduce unemployment. The reduction in unemployment will enable the state to stop transfer of revenue to citizen and still the American consumer will consume as usual. If this transfer of income continues for next two three years it will create very high deficits which will result into higher interest rates and a week currency.
American consumers were dependent solely on their revenue income this Keynesian theory would have worked just fine. But the case is that American consumer also depends on asset price inflation to fund his consumption. Therefore even with this transfer of income continuing the consumption can not increase to the previous level.
To counter this US government started a massive program for re-inflating the asset prices. The topmost priority was given to boosting the prices of real estate and debt securities held in the pension account of millions of Americans. The US government assumes that if the prices of assets rise the American consumer will once again start consuming the equity generated by the inflated asset price
The American consumer who is monetizing the equity in their assets by taking on debt and using it for consumption, won’t be able to continue it for long. Following are the five reasons supporting my view.
- Their debt to income ratio is already above 120% which means that they have already over consumed.
- The cost of debt which has been decreasing since last 30 years is now on the rise. 10 year treasury yield will go above 6% in next two years which will increase the price of debt for every consumer. Which also means that more of government tax revenues and individual income will go towards supporting debt. and under no case the individual would be able to increase debt to accelerate consumption.
- Six million baby boomers (around 1/4th of population) are retiring over next eight years and they are retiring with inadequate savings to finance or continue their current life style. They will substantially reduce their consumption.
- Americans have run out with assets to inflate.
- Consumption in America creates jobs in China instead of America.
The cost of debt will increase and the consumer will focus on repaying debt and boosting their savings by sacrificing consumption. Even after all the spending the US government is doing it won’t be able to support consumption on sustainable basis unless they improve their productivity or move up higher on value chain through technological innovations.
The government which is already reeling under massive deficits will not be able to use fiscal deficit as a policy tool. The cost of debt will increase for the government and the value of US dollar will decrease in long term.
No nation can inflate its economy out of depression by spending more and taking more debt. What the US government is doing might help in short term but there is no way that US economy can have a sustainable growth without eradicating the problem of over consumption.
Unless this is done the present policies of US government are disastrous in the long term. Instead of eradicating the problem from its root the US government is only delaying the pain by few years. The impact of these polices will be seen in next two three years. I firmly believe that this stock market rally is not sustainbale. It will end sooner than latter. All investors be aware. The coming tsunami will not only pierce this stock market bubble, but will create massive debt deflation across the global and in all asset classes. Position your portfolio and in next two three years you will see the biggest financial depression in our life time. The entire monetary system on which the current financial world is running will crumble.
