Consumer spending trends

We all know that there are many Americans suffering economic hardship right now because they are out of work, lost a lot of their retirement funds, or have lost value in their houses. All of these factors create a reduction is spending for two reasons, lost of immediate income and loss of credit.

Now, the opposite is true as well. When an unemployed person gets a job, they suddenly have much greater access to credit. Rightly or wrongly, a newly employed person often starts to spend future income in order to get items that were put off because of their financial situation and because they simply feel better.

This trend also exists in homeowners who refinance and of course if retirees get increased retirement income. However, the new job impact is normally the greatest. This is a much faster increase than the opposite, since when you lose your job you don't immediately lose your access to credit and usually for a few months, consumption drops slowly.

What does this mean for the economy? Well, right now we are still losing jobs on a net basis. However, we are seeing signs of a bump up in the economy from the stimulus programs as well as the fact that industry needs to restock inventories that were burned off in the first half of this year. Now in any given month, a certain number of people are hired and a different number are let go. So, even in periods with net job loss, we often see increases in consumer spending, since those getting jobs start spending faster than those losing jobs stop spending. There is therefore a tipping point where consumer spending increases enough in this economy to have demand exceed supply, requiring an increase in production.

When that happens the economy is in recovery. Recovery's feed upon themselves. More demand creates more economic activity creating more jobs. Other factors of course are related to imports and exports and whether the jobs created are in this country or elsewhere.

I believe we have passed that tipping point and are creating enough jobs to increase spending over the decreased spending from job losses. So with increased spending and inventory replenishment we may have a very good fourth quarter, better than many expect.

Economic revival

There is a quote by B.C Forbes that goes, "The victors of the battles of tomorrow will be those who can best harness thought to action."

Yesterday I watched a speech given by President Obama in Indiana where he announced a grant to the local factory to build electric vehicles or a component thereof. The actual grant was one of many from the stimulus and similar announcements were apparently being made by the Vice President and other members of the cabinet.

What I found significant was that he talked about the need for American to take leadership in the renewable energy field.

I couldn't agree with him more, and the question is can we?

The Government stimulus and the bank bailouts have been widely criticized. However, they shouldn't be in fact they serve as real investments in America. As far as the bank bailouts, if the banks generally recover, as many of them seem to be, and they repay the Tarp money with interest computed at the Treasury rate, they are simply investments that transfer money borrowed by the Government to a future period. Since they provided needed reserves and allowed the financial system to recover they are in fact not a debt being handed to the next generation. Further, our stock positions in C and AIG may end up being profitable as well as the amounts we get for the warrants the financial institutions gave us.

Similarly, while it may take a while longer, the amounts provided to the Auto industry have similar potential. When I hear analysts arguing against them, they immediately assume we will never get paid back. I don't really know, but I do see some signs of recovery in the Auto industry, helped in part by Cash for Clunkers. So maybe that money will return to the treasury and not add to the debt down the road.

I would also like to address a comment I hear about cash for clunkers that sort of is inane yet often repeated. It is arguing that it is stealing sales from the future. There is no proof of this and further, what about all those sales that didn't happen between the middle of 2008 and now? I know that I have been thinking about replacing my wife's car and when I heard about Cash for Clunkers coming, decided to wait. Turns out her car doesn't qualify but I don't think I was the only one thinking that way. Further, cars wear out. There is some normal turnover cycle for cars and it is greater than the rate that we have seen recently. The cars being sold in this program are not just cars that would have been sold anyways. They are in many cases cars that should have been sold over the last six months. Another factor is that it is stirring other economic activity. There has been an uptick in used cars recently. Ever occur to anyone that it might be well worthwhile to buy a clunker if you don't already own one? Finally, every car turned in generates jobs, sales tax and improves gas mileage reducing the need for foreign oil and improving air quality. I challenge anyone to find a more productive Government use for the $3 Billion dollars.

Considering the need to reduce foreign oil dependence and increase jobs in this country, the investment in renewable energy has the potential to do both of these things. We need to be the ones to win the battles of tomorrow by harnessing thought to action. Every person working generates taxes, every product that gets built in this country creates jobs. A lot of the analysts who pooh pooh the stimulus, are in the financial sector and they don't care if the work is performed in this country or somewhere else as long as they can profit from it. I have no problem with them betting against America, and I also think the rest of the world has some wonderful investment opportunities that don't conflict with American prosperity. But if you are betting that America is down and not getting back up, I think you are going to lose that one.

Unemployment impact

How much will a high rate of unemployment impact the overall economy? The answer to that depends on two factors. First, assuming that the unemployed will have some sort of income, whether from Government, benefits, retirement funds or perhaps "off the books" work, that will offset the loss of employment income to some degree. Of course, the amount of Government aid they get impacts taxes. The second factor is the ability of businesses to be profitable if you subtract the loss in disposable income, the first factor, from the economy.

I haven't seen very much information on the actual reduction in income suffered by an unemployed individual, and anything I come up with here is clearly speculative, but lets assume they lose 2/3rds of their income. I actually think that between retirement funds, Government aid, part time work both on and off the books, they will actually do better than this but I need to use some number. Well, if we were to have a long term unemployment rate of 10%, and nothing else was to change, we would see a 6.6% decrease in disposable income from unemployment. Now of course, you have to subtract the unemployment rate that we had prior to the downturn and lets use 4%. So instead of 6.6% we have a net decrease of 4%. Clearly, a factor and there are other factors that may very well mitigate that impact but lets use that.

So if high unemployment led to a reduction in consumer spending of 4% what does that mean for the economy? I guess it depends on you view of what a recovery is going to look like. Considering other factors in the economy, such as loss in housing and equity wealth and increase in savings it would potentially lead to a smaller economy of about 15%.

Now if the economy was about to contract by 15%, this would be quite scary. However, the economy has already contracted by more than that and is now in fact starting to recover a bit. What we are seeing is company after company reporting earnings that support a contraction to a lower need for revenue in order to maintain profitability.

A number of analysts or bloggers seem to think that cost reduction is a one time event and try to discount it. However, when a company reduces cost by laying off workers or closing plants, this is an ongoing reduction. The savings keep on helping profitability. So if a company has adjusted its operations to be profitable at a certain reduction in revenue and revenue then grows, the improved profitability actually may lead to greatly increased profits.

So, as we watch what may very well be, at least initially, a jobless recovery, how bad is it for the economy? On an ongoing basis, I think it will lead to about a 4% reduction in economic activity and consumer spending. Without ignoring the individual devastation that losing a job can cause, from a purely economic impact it becomes a fairly minor overall factor in economic recovery.

Whither the middle class?

One of the trends that is hidden when you look at employment/unemployment numbers is the fact that for many Americans, the traditional path to the middle class is disappearing. This is because of the transitioning of America from a manufacturing country to a service industry country.

Starting in the late 19th century and continuing through much of the 20th, we saw tremendous growth in American manufacturing. Industries, such as the Auto Industry, Steel, Aircraft, heavy machinery and many many others needed workers. It coincided with a migration of many rural workers to cities and suburbs. It also provided good wages and benefits and enabled American workers, often starting with few skills and maybe a high school education, to own homes, cars, send their children to college and generally have a standard of living that exceeded that of most of the world.

In the latter stages of the 20th century, the cost of labor in the United States began to become a significant drain on profitability for American industry. Foreign competition started to seriously challenge many of these industries. What we saw happen then and what is still continuing is that these jobs started to disappear, or perhaps more accurately, migrate from high cost areas to lower cost areas. Initially, a lot of this migration was from the Rust Belt to the Sun Belt, but of course ultimately, it is now going overseas to even lower cost areas.

If you consider the garment industry, once a major employer in New York, and then a major employer in some Southern States and now almost universally moved offshore. The International Ladies Garment Workers Union has lost a tremendous number of members and has merged despite that catchy jingle.

There are many examples of other industries, many of them better paying than garment workers where the jobs have left, look at Michigan, and are not coming back. So what happens? Well eventually, other jobs, mostly service industry jobs, get created.

Now there are two types of service industry jobs. One is relatively high paying and generally requires at least a college degree for entry. At the top of this pyramid you have financiers, lawyers, doctors, and other professionals who make very nice salaries when there is work. The other type of service job is best typified by the phrase "do you want fries with that?". Now of course there are only so many fast food jobs, but there are many service jobs that require few skills for entry but also don't pay very well.

So workers who used to get high paying jobs in manufacturing are now lucky if they make half as much in some service industry. Of course many of these folks work multiple jobs and both spouses are now required to work in order to maintain the lifestyle they have come to expect. The problem is that ultimately, on a permanent basis that is not sustainable. First, even many of these jobs are disappearing as we go to self service in service industry after service industry and replace brick and mortar stores with on-line retail. We need fewer and fewer tellers, grocery check out clerks, gas attendants, sales clerks at stores, etc. etc.

So if we have lost the high paying manufacturing jobs and are starting to lose the lower paying service jobs, what is next? Well, one thing you hear discussed is retraining. However, there are clearly limits to that. First, the jobs you retrain people for have to exist, and if you train too many you will create a glut.

Now one area that helped absorb this workforce had been construction. However, with the glut in housing, many, many jobs were lost in that sector and while some will come back it is unlikely they will get back to the bubble numbers. There is money in the stimulus program for public works projects, repairing and replacing infrastructure, but while that is necessary work, it is hard to see how we can absorb enough of the workforce that way on a long term basis.

So is it inevitable that the American worker is destined to see continued deterioration in their standard of living? Well, ultimately, if the trend were to continue long enough it would self correct as it became cheaper to manufacture here and employment would rise, of course at much lower rates than previously. However part of the problem there is that the cost of manufacturing here is not limited to labor costs, but also the cost of taxation and regulation. We need to reduce those burdens, or at least spread them better if we want to preserve and revive manufacturing in this country. We also need to address the cost of health care and how much of that burden is passed on to employers. It is a significant employment cost driver.

It seems unlikely that we will reform the tax system to one that will tax consumption instead of production and ingenuity. Simply if we had a national sales tax instead of the taxes we have now, everyone who sells product in this country would share in the burden of maintaining America. It would also encourage investment, local enterprise and saving, all of which ultimately would increase wealth and prosperity. Unfortunately, we seem determined to pursue policies for political purposes that lead in a different direction.

American ingenuity

There are some analysts who think the United States is going to undergo an even greater economic recession than the one we are currently experiencing. In many cases this is based on their belief that the actions taken to combat the recession actually compounded the problem by increasing the National Debt and increasing the money supply to a point that will lead to a severe additional contraction in the economy after the initial stimulus passes.

I don't really know the future, but I do know that this country and the people who live in it still have tremendous potential. There have been people who lived beyond their means and recently many of them have been paying the consequences for that, but most Americans have been much more prudent than that.

Whatever the current unemployment rate is, 9.4 or 16% if you count part-timers and those who have stopped looking, it still means 85% to 90 percent of Americans are still employed. American companies saw a lot of demand disappear so they reduced costs and capacity to the point where they are turning profits even with lower revenues. I believe we are moving out on the development of domestic energy and renewable energy sources that will further reduce our balance of payment issues. Right now there are entrepreneurs who are going to buy up "toxic assets" and turn them back into profitable assets.

In other words, Americans are reacting to the problems in the economy and taking appropriate actions. Those who look at statistics and predict doom are ignoring the most important factor, the great ingenuity and spirit of the American people.

Inflation - Deflation?

There are still many who predict the United States and its citizens are doomed to undergo a major depression because of the tremendous debt and the Government intervention in the free market system. Dire predictions like these have been made many times before but in times of severe economic contraction they get a lot more attention.


There are competing doom scenarios, one that predicts severe inflation and one that predicts severe deflation. Now both end up with quite dire forecasts and it sort of reminds me of a Robert Frost poem Fire and Ice.

We have been experiencing deflation recently, although it is not fully represented in the CPI. The June CPI shows an overall decrease of -1.4 year over year. A lot of this reduction is due to the change in oil prices and it would have been much worse if the Medical and Services areas didn't continue to have price increases. The oil prices from last year are clearly a short term phenomena and do distort the index. However, I think most of us feel that whatever the official statistics show, the actual cost paid for many things is significantly less than it was one or two years ago. Consumer spending is down significantly and with less demand, the price curve goes down.

Now in order to combat weak demand and potential deflation, the Fed has lowered interest rates and the Government has increased deficit spending. This takes us to the inflation scenario, one in which proponents of monetary theory believe the increase in money supply can take us no where else.

It does seem that considering supply and demand, an increase in the money supply without a corresponding increase in demand will lead to a lower price for the dollar and therefore inflation. Of course this assumes the real money supply has increased, which may be debatable considering the higher reserves held at banks and loss of wealth (i.e. money) due to the drop in housing and equities.

So would either deflation or inflation be disastrous? Depends on ones definition of disaster.

Concerning deflation, one can look at Japan which has been in a deflationary period since the mid 1990s. There was some belief that it was starting to emerge from it, but recent events call that into question. The main problem with deflation is that economic activity slows, borrowing becomes difficult as debt becomes more expensive over time and economies tend to stagnate. However, looking at Japan over the period of deflation, does not indicate that society as a whole collapsed, and the standard of living for most Japanese had been maintained at respectable levels.

As far as inflation goes, there are a number of examples of ruinous inflation, perhaps most notably the Wiemar republic. Inflation there completely devalued the Mark, led to the fall of democracy, the rise of Nazism and ultimately World War 2. Now, other countries have also had sever inflation without having a World War as a result. Inflation makes everything seem more expensive and is particularly hard on those who live on fixed incomes. It certainly makes foreign imports more expensive but makes domestic exports cheaper leading to improvements in the balance of trade. Clearly, the rate of inflation has a lot to do with the ultimate impact. If prices grow at a slow to moderate pace it is not particularly problematic. It would be sudden and rampant inflation that would cause the most disruption. The other factor, is if inflation is expected, people demand higher returns to offset the expected devaluation of the dollar, causing borrowing to get more expensive and driving down the market p/e ratios.

Now, in our current scenario, we have seen the economy contract by about 15% over the last 4 quarters. This drop in demand is what has caused the recent deflation. It seems that the stimulus and cheap money policies may be bearing fruit and demand is starting to increase. However, we know that there is significant slack in the economy related to labor and commodities that would offset any significant inflationary trends.

Now, if the dollar continues to fall internationally, it makes American products cheaper and foreign products more expensive. It is possible that increased exports can reduce the slack in domestic consumption and lead to an increase in production, potentially fueling the inflationary fires.

So what will it be? It seems that we are at the bottom of the price reductions and that as demand starts to increase we may see modest price rises. Of course, it will take awhile for these prices to return to pre-recession levels and if we make significant progress in areas such as renewable, domestic energy sources, we may find the amount of dollars going outside the country significantly reduced. We also know that Americans are saving more, and those savings are reducing the amount of money in actual circulation, just as the increased bank reserves are.

So inflation is not guaranteed. I would like to think that as the economy picks up we take an intelligent approach to deficit reduction and debt retirement. The biggest challenges there include the cost of foreign energy and health care. I am pretty optimistic about both of these and think its time we fixed them.

Thoughts on the economy

Whether you are a student of economics or not, it can be important to know something about wealth. Wealth is accumulated value and all wealth is subjective. You may say feel some things are not subjective (i.e. gold) but the value of gold is dictated by what people are will to pay for it, and we have seen gold go from very high levels to very low levels. Money of course is subject to changes in its valuation and if you are familiar with history, there are many examples, such as the German Wiemar Republic, where money became essentially worthless in a very short time.

The world creates a certain amount of real goods each year (crops, ores, oil, lumber etc.) that can be said to increase the amount of wealth. These basic products are then turned into manufactured goods and value is added to them creating more wealth. Of course the third stage are the services provided to deliver these goods to the market as well as other services.

As nations develop, they usually start as producers of real goods, commodities, which they sell to more developed nations that turn these items into manufactured goods of some sort and provide services. Of course, some commodities require very little intervention to be marketed while others require quite a bit.

The reason all wealth is subjective is because ultimately the value of anything is dictated by demand. It wasn't very long ago that housing in some parts of this country demanded prices that were double what they can be sold for today. In a dollar denominated system, they have lost 50% of their wealth. Of course, if you own one of those houses, you own exactly the same thing you owned previously, and if you don't have a mortgage, you may actually be better off since it is likely your property taxes may be adjusted, but you would feel poorer.

By the same token, the prices we pay for many other items have also decreased as demand has withered and producers are forced to discount items in order to move them. The big danger here is potential deflation. Now the problem with deflation in a credit driven economy is that it leads to debt exceeding perceived value. If I have a $500,000 mortgage on a $750,000 I perceive that I'm doing OK. If the value of that house drops to $400,000, I am now paying the bank more than I believe I should. It makes better economic sense (depending on how you feel about your credit score) to simply walk away and let the bank have the house. Of course doing that makes the loss real, and you may very well feel that over time the value of your house will recover, but that is a gamble of sorts and requires a certain faith in the economy, or at least a belief that inflation will return.

So what is the natural outcome of an economic downturn, where wealth is lost? With or without Government intervention, prices will drop to a point at which demand is restored. Once demand is restored, the economy will stop contracting, and having eliminated the excesses that led to the downturn, it will start to grow once again. How fast it grows depends on many things, but clearly, as demand grows, employment will grow, helping to increase demand further at some rate.

In the bubble years, we had tremendous demand that was based on credit secured by housing wealth and to some extent loose credit policies that encouraged consumer spending. In fact our economy became dependant on consumer spending, and to a large extent the rest of the world is dependant upon our economy being successful. When we saw the housing wealth decline, that spending declined with it.

Now it would seem that in many parts of this country, housing has neared a bottom. However, because of the reduction in demand, we have greatly increased the number of unemployed individuals and reduced their income. Further, even if housing has stabilized (and it may still decline some more) it is not going to suddenly jump in value (at least not everywhere) so that wealth and associated credit needs to be discounted from the market for some time.

An additional factor is that many Americans have now been scared into saving. They have also been scared into safe investments. These investments simply do not create monetary wealth very quickly.

What does this mean? In a very simplistic way it means that the new American economy is going to be smaller than it was. This can be computed simply enough if you make some basic assumptions. For argument's sake, lets assume the amount of disposable income overall remains stable. This plus credit becomes the amount available to spend. Now credit spending unrelated to housing is down from 2008 levels but very close to 2007 levels. However, housing values in this country are down significantly. Ignoring primary mortgages for now, in the 2004 to 2007 period, there was a tremendous amount of refinancing done in order to tap equity. For a while the number of refinancing averaged over 800,000 a month. Currently more refinancing are done to lower interest rates and the numbers were below 200,000 a month. The implications of this should be apparent, consumer spending will increase/decrease year over year based on the following formula, d-s+c+m to d1-s1+c1+m1 where d and d1 equal discretionary income 12 months apart, s and s1 equal savings for those same two points in time c and c1 represent consumer credit and m and m1 equal cash out refinancing. In the best case scenario, m1 current is much lower than m of 2008. Now as time goes on, m1 will become m and the new m1 may actually be higher than current levels. This will create growth in consumer spending but I can't imagine anyone believes that a year from now cash out refinancing will be anything near where they were a year or two ago.

The formulas can be revised to be more precise, but with savings up and cash out refinancing down, the amount of consumer spending will be significantly less than it was, probably around 20%. If nothing else was to change, and consumer spending equals 70 of the economy, we can expect a fairly permanent contraction of 14-15%. That is about the contraction we have experienced which is why we are likely at the bottom of the downturn and starting to recover.

Now, discretionary income is simply not going to increase dramatically and I don't expect home prices to skyrocket either. Consumer credit is likely to increase somewhat as employment increases but realistically it is very hard to see growth in consumer spending going up fast.

Other sources of demand for the economy include exports and this can be an area of significant growth in the future.

One argument against a rapid improvement in the economy is the amount of foreign debt the nation is issuing. Interest payments on foreign debt will require money being removed from the economy and sent to the foreign holders of this debt. Now, this impact can clearly be mitigated to some extent if we improve our balance of payments and get those countries to use that money to buy US goods. Of course, this does not need to be a direct transaction, if China for example buy a lot of commodities from Russia and Russian spend that money on American products, the money does return to us ultimately. A lot of commentators like to discuss the likelihood of Chinese consumerism, and of course if we can sell items directly that will work, but it doesn't really matter if it is direct or indirect if exports can increase enough.

Can the US handle its debt? The answer is that in one way or another we will, the question is how disruptive will managing the debt be. What needs to be remembered is that every year the US produces tremendous wealth in commodities, manufactured goods and services, and this wealth will increase in value as the economy recovers. After WW2 the US had tremendous debt that the country was able to manage and prosper at the same time. To a significant extent that period was fueled by the redevelopment of Europe and Japan. I believe in a few years we will look back and see that the new prosperity was fueled by the development of China and India and the opportunities they will create for this country.