Why So Depressed?

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Phil Gramm, economic advisor to Presidential candidate John McCain, said last month that the U.S. consumer was in a mental recession and that the economy’s fundamentals didn’t warrant the low consumer confidence numbers. Mr. Gramm made the following comments in a Washington Times interview: McCain adviser talks of ‘mental recession’ (07/09/2008)

why so depressed

We have sort of become a nation of whiners.
You just hear this constant whining, complaining about a loss of competitiveness, America in decline.
We've never been more dominant; we've never had more natural advantages than we have today. We have benefited greatly (from the globalization of the economy in the last 30 years).

WE have benefited greatly,” Mr. Gramm? In case you hadn’t heard, real wages for the average consumer have DECLINED this decade unlike Wall Street heads who have been showered with multi million dollar bonuses. They have received these bonuses as a reward for helping expand the financial economy’s largess to produce a generational credit bubble and for selling our asset-backed slime all over the world, damaging our financial institution’s credibility in foreigners’ eyes. Those same Wall Street CEOs have been punished for their crimes by getting the boot with outlandish bonuses and severance packages as the small list below highlights.

  • Lloyd Blankfein: Goldman Sachs Group Inc. $67.9 million bonus received in 2007.
  • Charles Prince: Citigroup Inc. – Retires with a $42 million package in 2007
  • Stanley O’Neal: Merrill Lynch & Co. Inc. – Retires with $161.5 million in 2007
  • Angelo Mozilo: Countrywide Financial Corp – Retirement package of $23.8 million, while refusing to accept $37.5 million severance package in 2007
  • Martin J. Sullivan: AIG - $47 million severance package received in 2008

Main Street has not been as fortunate as their Wall Street brethren in terms of income nor received as many handouts, backstops, and bailouts from the Fed and Treasury. Indeed, Main Street has much to be concerned about. Both corporate America and the consumer do not see the same sanguine environment that Mr. Gramm does. Here’s a small list of confidence indicators and charts, with many at all-time lows.

  • ABC News/ WA Post Consumer Confidence Index: Hit 16-year low in May
  • Conference Board
    • Present Situation Index: 5-year Low
    • Expectations Index: 30-year, all-time low
  • CEO Confidence Index: Six year low
    • CEO Investment Confidence Index: All-time low
  • NFIB Small Business Optimism Index: 22 year, all-time low
  • NRA Restaurant Performance Index: All-time low
  • NAHB Housing Market Index: 23-year, all-time low

consumer and business confidence
Source: NFIB/ABC News/Washington Post

nahb housing market index
Source: National Association of Home Builders

national restaurant association
Source: National Restaurant Association

What is the cause of all this pessimism? The U.S. is entering into a period of economic weakness and the U.S. consumer has never been more under prepared to navigate the waters ahead with a record low savings rate and all-time high debt obligation ratio. Moreover, the U.S. consumer has likely come to terms with the realization that it’s spent up, that after nearly three decades of a debt binge, consumer balance sheets are in dire need of some healing. Moreover, businesses likely see a protracted consumer retrenchment ahead and know what that will mean to their bottom line. But why did the U.S. consumer go on a debt binge over the last three decades, and what were the fundamental shifts that led to this? I would suggest there are two primary causes of the consumer’s debt binge, both rooted in the consumer’s struggle to maintain its standard of living.

A Shifting Economy

One of the biggest undercurrents in the U.S. economy over the last four decades has been a shift from a manufacturing economy to a service economy. Manufacturing employment as a percent of total employment has fallen from 26% in 1970 to 9.8% currently, while service employment has risen from 68% to 84.4% over the same period.

manufacturing and service employment percent total employment
Source: U.S. Bureau of Labor Statistics (BLS)

This shift has come with some benefits, primarily of which is an improvement in employment stability. The greatest swings in employment resulting from business cycles have always been in manufacturing as seen when looking at the year-over-year (YOY) rate of change in manufacturing versus service employment below. Thus, the shift towards a service economy has led to smaller swings, both positive and negative, in employment growth. Greater stability in employment growth has translated into greater overall economic stability, as the growth rate swings in GDP have also been reduced.

Source: U.S. Bureau of Labor Statistics (BLS)

Source: U.S. Bureau of Labor Statistics (BLS)

real gdp
Source: Bureau of Economic Analysis (BEA)

While our economy has benefited from improved employment and overall economic stability, this stability has come at a price. One of these costs is an overall reduction in the average income as manufacturing jobs pay higher wages than servicing jobs. Thus, shifting more of the U.S. economy’s workforce towards lower paying jobs has led to a decline in the standard of living in terms of average income generation. Compounding the income affect of shifting towards lower paying service jobs is a greater disparity in earnings between manufacturing and service workers.

real average weekly earnings
Source: U.S. Bureau of Labor Statistics (BLS)

real average weekly earnings
Source: U.S. Bureau of Labor Statistics (BLS)

With declining income levels, the U.S. consumer turned towards debt as a means to maintain its standard of living. This can be seen when looking at manufacturing employment's share of total employment and household debt as a percent of GDP over the last four decades. During the 2001 recession our manufacturing base was utterly decimated and did not recover as manufacturing jobs were exported overseas to Asia. Manufacturing employment fell from 17.5 million in 2000 to 13.5 million currently. Coincident with the 4 million loss in manufacturing jobs was a surge in household debt as a percent of GDP which rose from 71% to 99% over the same time period. While shifting from a manufacturing economy to a service economy (which led to a decline in average income levels) contributed to Americans turning towards debt to maintain their standard of living, a loss in the purchasing power of the dollar likely played a greater role.

household debt and manufacturing employment

No Nation Has Ever Devalued Its Way into Prosperity

Americans determination to maintain their standard of living in the face of a major debasement of the U.S. currency is likely the greatest culprit for why consumer debt has soared to mind numbing levels. Since President Nixon took the U.S. off the gold standard in 1971 the Federal Reserve has expanded the monetary base from $69.89 billion to $870.54 billion currently, an increase of 1146%, or at a 7.05% compound annual growth rate (CAGR). The CAGR of monetary expansion in the 37 years after the removal of the gold standard increased by 20% relative to the 37 years prior to the removal, which saw the monetary supply grow at a 5.92% CAGR. Monetary expansion was even worse when measured on a per capita basis in the 37 years post the removal of the gold standard relative to the prior 37 years. The CAGR on a per capita basis of the monetary base was 4.50% in the 37 years prior to the removal of the gold standard and 5.90% in the following 37 year period, an increase of 31% in the CAGR. The result of this accelerated monetary expansion is explained below in a speech by Fed Chairman Bernanke given in 2002.

st louis adjusted monetary base
Source: Federal Reserve Bank of St. Louis

st louis adjusted monetary base per capita
Source: Federal Reserve Bank of St. Louis/ Census Bureau

Deflation: Making Sure “It” Doesn’t Happen Here
Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of dollars in circulation, or even credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is the equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Bernanke, Ben S.
November 21, 2002.

The U.S. dollar has lost over 82% of its value since the gold standard was removed. The average standard of living has fallen as a result of higher prices where $1 doesn’t go as far as it once did. In order to compensate for this loss in purchasing power and in order to maintain the same standard of living, there was a major shift in the economy and American household. Families increased their income levels by living on two incomes instead of one, and women entered the workforce in droves. As a result, the percentage of male workers as a percent of total employment shrank and the link between shifting towards two income families and a decline in the dollar is seen below, with the two series showing a 98% correlation.

employment trends and purchasing power of the dollar
Source: BLS

Keeping Up With the Joneses

As shown above, the last three decades have witnessed a major debasement of the U.S. dollar. Assets have been the primary beneficiary of the increased money supply as the stock market and housing each saw a bubble as money chased both to unsustainable levels. While many Americans saw their net worth accelerating, using this appreciated wealth to finance a larger lifestyle, not everyone went along for the ride. Those who rented or did not have enough discretionary income to pour into the stock market did not benefit from the spectacular asset inflation seen by their neighbors.

This can be shown by looking at the share of national income that the top 5% represented. The top 5% earners had income levels that were large enough to be able to afford a home and invest in the market during the great asset inflation of the last 30 years. The top 5% earned 16.4% of total national income in 1980 and 22.3% in 2006. For those who could not maintain or improve their standard of living by using inflated assets, they turned to the other side of the accounting equation, debt. The increase in household debt as a share of GDP rose in tandem with the rising national income disparity as those who could not benefit from asset inflation turned to debt to keep up with the Joneses.

total household debt as percent of gdp and income disparity
Source: BLS/BEA

Not only did debt levels rise, but the savings rate plunged from roughly 12% in 1982 to a low of negative 0.5% in 2005. Which takes us to today’s consumer who is spent up, debt laden, and has very little cushion to weather the coming economic storm, hence record low consumer confidence levels. The ability to accumulate enormous amounts of debt created the illusion of prosperity, a development described below by Mark Twain.

Beautiful credit! The foundation of modern society. Who shall say that this is not the golden age of mutual trust, of unlimited reliance upon human promises? That is a peculiar condition of society which enables a whole nation to instantly recognize point and meaning in the familiar newspaper anecdote, which puts into the mouth of a distinguished speculator in lands and mines this remark: -- I wasn't worth a cent two years ago, and now I owe two millions of dollars.

Mark Twain
The Gilded Age (1873)

Make no mistake; the debt-financed prosperity has been an illusion. Initially everyone seemed to benefit from rising assets and/or declining interest rates which made debt more affordable. Our lifestyle’s largess increased as we purchased bigger homes, bigger cars and more toys. Now, consumers are scared about keeping their jobs, worried about high energy and food prices, falling home prices, falling stock markets, rising inflation, greater government deficits, government bailouts, and the threat of higher taxes. It seems we have come full circle in the inflation cycle described in the book by Jens O. Parrson, Dying of Money: Lessons of the Great German and American Inflations, with an excerpt given below.

dying of money

Everyone loves an early inflation. The effects at the beginning of inflation are all good. There is steepened money expansion, rising government spending, increased government budget deficits, booming stock markets, and spectacular general prosperity, all in the midst of temporarily stable prices. Everyone benefits, and no one pays. That is the early part of the cycle. In the later inflation, on the other hand, the effects are all bad. The government may steadily increase the money inflation in order to stave off the latter effects, but the latter effects patiently wait. In the terminal inflation, there is faltering prosperity, tightness of money, falling stock markets, rising taxes, still larger government deficits, and still roaring money expansion, now accompanied by soaring prices and ineffectiveness of all traditional remedies. Everyone pays and no one benefits. That is the full cycle of every inflation.

The Courage to Chose

We as American’s will have the ability to learn from the mistakes of the last few decades and return to monetary restraint. Our savings rate will have to increase in concert with a decline in our consumption levels. Changes will have to be made and our standard of living will come down to reality as our prior standard was based on debt, not true financial soundness. We are beginning to see signs of the necessary changes being made as consumers shy away from the big and bulky SUVs and switch towards more fuel efficient cars to save on gas, or switching from name brand foods towards store brands. Other, more drastic changes are also occurring. Last week I spoke with my sister-in-law who manages an apartment complex in southern California. She told me she was getting notices left and right from her tenants. Three-bedroom occupants were moving into two-bedroom units, two-bedroom occupants were moving into one-bedroom units, and one-bedroom units were moving back in with their families. These changes are the necessary requirement for irresponsible borrowing by both the consumer and government. We have financed our lifestyles with debt, the government has financed its lifestyle through higher income taxes and the inflation tax (money printing), the other way the government taxes its citizens. Both the government and U.S. consumer are going to have to start making choices, sound financial ones as Minyan Peter points out in his article below.

The Courage To Choose

I believe that in time, historians will define the last twenty years in America as the “Age of Aspiration” where, thanks to unprecedented levels of credit, Americans could become anything they wanted. Where, thanks to 0% down debt and a seemingly robust economy, we could own bigger homes, fancier cars, and more lavish vacations – where our bounty was limited only by the boldness of our wants.

Well, I, for one, believe that our Age of Aspiration is ending. And, with its conclusion, we must, for the first time in almost a generation, begin to reconcile our wants with our means. We must choose what to do without, rather than what more to do with.

But I would suggest that few of us are prepared for this challenge. Why? Because abundance relieves each of us from having to prioritize what is important. When anything is possible, everything is possible. Few of us have really had to choose.
As I look ahead to 2008, though, I believe that each of us, the communities we live in, and the organizations and companies we serve, are going to have to make choices. We are going to have to separate what is most important from least, and act accordingly. Where life was once limitless, it will now be constrained. And, like it or not, all of us will need to return to our vocabulary a simple phrase that I believe has been lost over the past 20 years: “I can’t afford that.”

Today’s WrapUp has focused on macro developments over the last few decades and the WrapUp next week will look at what the future is likely to hold as the consequences of the past debt cycle come home to roost.

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About Chris Puplava