August 22nd, 2011

Today’s author is a well known financial analyst and Gold expert from South Africa. When he last wrote at this website,  it was 2002 and gold was selling for less than $400 an ounce. … Obviously things have changed.

Today’s essay, just written in August of this year, comes to us from the Le Metropole Cafe, Inc.


The 2011 State of the US Economy

Daan Joubert

It is no longer news that the US economy is in trouble. This essay reviews certain key features of the US economy and how these might influence the outlook for the US over the near to medium term. The conclusions, unfortunately, are gloomy.

The theme for the analysis is set by a quotation from the book, “This time is different: Eight centuries of Financial Folly”, by Ken Rogoff and Carmen Reinhart. Near the end of the book, the following appears:

“The lesson of history, then, is that even as institutions and policy makers improve, there will always be a temptation to stretch the limits. Just as an individual can go bankrupt no matter how rich she starts out, a financial system can collapse under the pressure of greed, politics, and profits no matter how well regulated it seems to be. [Much has changed . . .]

‘Yet the ability of governments and investors to delude themselves, giving rise to periodic bouts of euphoria that usually end in tears, seems to have remained constant. No careful reader of Friedman and Schwartz will be surprised by this lesson about the ability of governments to mismanage financial markets, a key theme of their analysis.

‘As for financial markets, we have come full circle to the concept of financial fragility in economies with massive indebtedness. All too often, periods of heavy borrowing can take place in a bubble and last for a surprisingly long time. But highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked.

‘This time may seem different, but all too often a deeper look shows it is not. Encouragingly, history does point to warning signs that policy makers can look at to assess risk—if only they do not become too drunk with their credit bubble-fueled success and say, as their predecessors have for centuries, “This time is different.”

One can argue long and hard about the causes of the ongoing financial crisis of the past 3-4 years, but it will be generally admitted a few factors played a key role in fomenting the crisis. Underlying it all is a change in social climate that took root in the US after WWII and subsequently found fertile soil in many other places, predominantly in the western world. There was a change from the old standard where society was rated more important than the individual; it would seem that with the increased rights of the individual came a “me first” attitude that meant one was entitled to break society’s rules and even laws when in pursuit of personal benefit.

Leaving this more philosophical factor aside, it is self evident that reduced or even lack of oversight in financial markets, a too free and easy monetary policy, new and free-flowing sources of credit, a free-spending Federal government, manipulation of official statistics and the free trade climate have all at various times and to different degrees contributed to the complex mess that erupted in 2007 when Bear Stearns announced that their mortgage funds were in deep trouble. Of course, it took the Lehman collapse to bring home the magnitude of the developing crisis.

Despite initial assurances that ‘the mortgage problem is contained’ and later that the ‘green shoots are sprouting all over’, then that ‘economic growth is slow but steady and the end is in sight’, it should be evident that the American economy is not well. The real question now is not so much whether we will see a double dip, but whether the ongoing recession will drag on until the economy can show new growth or if it will deepen into a more severe recession, even depression. If the latter, which is the anticipated future here, the question of how long and how deep becomes relevant.

Background

The licentious way the mortgage market was exploited by the US financial system was the eventual trigger for the financial crisis of the past 3 years. It has left much debris in its wake, but is no longer a direct factor in the further development of the US economy. Key factors expected to play a significant role for the near to medium term (next 1-3 years) are:

The Federal budget deficits
The impoverishment of America
Changes in government policy
The actions of other countries, notably Asian and European countries

These are not the only factors to play a role. However, it will be shown that these four factors, together with their anticipated effects, will dominate the US future.

Federal Budget Deficit

On August 2nd president Obama signed a new Federal debt limit into law. The new limit is $16,7 trillion – an increase of $2,4 trillion over the previous limit and designed to avoid a fresh debate on a new limit prior to the 2012 presidential election. The $2,4 trillion increase is $500 billion greater than the previous record, which, as chance would have it, was also signed by president Obama, i.e. within the past 3 years.

The increase in the ceiling is about $8000 per man, woman and child, bringing the total Federal debt, once fully committed, to $55 000 per individual American. That is about $220 000 for every family of four and the top people in the US are confident that it can be repaid in full once growth kicks in again, or so they say. The question whether the US economy can resume the kind of growth needed to repay the debt within a reasonable time frame and without undue loss of value to the lenders is discussed in the next section. The answer is ‘No’.

The only way the US can get rid of its national debt is by default – in itself fraud if by intent – or to massively debase the dollar through inflation and repay the debt with near worthless dollars.

Either flagrant debasement of the currency – which many commentators seem to think is already happening – or default, will effectively mean the end of the US dollar as the reserve currency and trigger extreme loss of value when large holders of US debt are compelled to sell the US currency at any price. That would leave the US as a country with whatever manufacturing industry it still has and with reduced ability to pay for imports manufactured elsewhere – not a pleasant prospect at all.

The effect of these events on the US economy and on the standard of living of most Americans is well beyond recent experience and not easy to imagine.

After reading the next section, the reader may want to ponder the ability of the US economy to grow to at such a rate the US is able to avoid default on its obligations.

The Impoverishment of America

America may well be on its way to living standards associated with the developing countries or perhaps even the third world

Chart 1. Sources:

Wage and salary disbursements: Bureau of Labor Statistics:A576RC1

Disposable Personal Income: DSPI: U.S. Department of Commerce

Federal Reserve – St. Louis (FRED): US CPI, cumulative – (CPI-U): CPIAUCSL

Shadow Government Statistics (SGS) – alternative CPI derived from CPI chart

The above chart (from “The Coming Great US Depression” – d joubert 2011: 4 parts, available on request) shows real total employee disbursements and total disposable income discounted by the official US CPI and the traditional CPI as calculated by www.shadowstatistics.com. The chart is normalized in January, 1964.

In effect, the chart shows the ability of American households to maintain a standard of living, as measured by the real purchasing power of their income, relative to what they enjoyed in 1964. From 1964 to the early 1990s households enjoyed an improving standard of living according to both measures of the CPI – it was really only then that the Clinton administration began with hedonic and other adjustments to how the CPI is calculated to show lower increases in the consumer price index. Doing so brought all manner of benefits to the Clinton administration and it is no wonder that the hedonic CPI was subsequently maintained by Bush and Obama.

Disposable income, including total employee disbursements, continued to outpace the official CPI after 1990, as a combination of wage increases and a greater number of participants in the economy increased total income. On the face of it, working and earning Americans were doing well and the boom period in the economy, from 1990 to the beginning of the financial crisis, seem justified.

The situation changes drastically when viewed in terms of changes in the true cost of living. In terms of the real purchasing power of earned income, the US as a whole is now back where it was in 1964.

The decline in real purchasing power of domestic America means that as time passes, a greater fraction of income has to be spent on the essentials of living. For America as a whole this has already happened; for individual households the situation is much worse, with real purchasing power substantially below what it used to be in 1964.

Initially during such a trend of declining purchasing power, there is a cushion that enables households to reduce discretionary spending in order to afford the food and energy and transport needed to survive in reasonable comfort. As the situation gets worse, less funds are available for discretionary spending. Finally, households have to decide which of their normal expenses they can leave out of the budget in order to be able to pay for the essentials of living.

Of the typical fixed expenses – bank loans, credit cards and mortgages – the latter is the one that, if not paid, gives the longest breathing space before penalty action gets taken against the household. No wonder then that, according to DSnews.com at latest count more than 8% of all US mortgages not in foreclosure are in arrears by at least 30 days. That is about one in twelve houses not already in foreclosure being on their way to that same status and bodes ill for the US housing market.

Finally, when things continue to deteriorate, households need assistance in order to eat and they have to apply for and rely on food stamps to survive.

According to nationalpriorities.org, in 2007 52 million people were eligible for food stamp assistance, but only about half were actually receiving it. Even if that fraction has improved substantially since then, it implies that the number of Americans that are in need of some kind of assistance substantially exceed the more than 45 million Americans that were on food stamps at the end of May – 14%+ of the population or more than one in seven of all Americans.

The number of households receiving food assistance were 21,5 million, which makes it almost 20% of all US households. The actual number of people and households that are currently eligible for food aid is not known to the author.

Fig 1. Food stamp participation.

As the chart shows, the rate of increase is steep, having increased from about 26 million to about 45 million since January 2007 – 20 million more people who do not make a significant contribution to the economy, but are a drain on resources.

The reason for this sustained, steep increase in the need for food assistance is clear when the change in the real purchasing power of average individual incomes is displayed. The essay, “The coming great US Depression – daan joubert” examined the average income of different sectors of the US economy in terms of the official CPI as well as the SGS CPI, calculated by Shadow Government Statistics using the original method for calculating the CPI when it still reflected a constant standard of living

Employers for obvious reasons linked wage and salary increases to the lower official CPI. As time passed, the incomes of working America increasing lagged behind the more steeply rising cost of living as reported by the SGS CPI. Their reduced real purchasing power of US working households have now reached crisis levels.

The four demographic sectors whose average income was used are: hourly paid workers, weekly paid workers, disbursements to employees and disposable income. The first three sectors including different groupings of employees, while disposable income included all Americans who earn an income.

The sources of the data are:

Disposable income per capita: Bureau of Labor Statistics: A229RC0

Average hourly earnings of production workers: data.bls.gov: CES0500000008

Average weekly earnings, production workers: data.bls.gov: CES0500000030

Total non-farm employment: Bureau of Labor Statistics: PAYEMS

Wage and salary disbursements: Bureau of Labor Statistics: A576RC1

CPI data used are as for the previous chart.

Chart 2: Real earnings for groups of Americans as per the SGS traditional CPI

This chart essentially is a demographic breakdown of Chart 1. Working America, employees on wages and salaries, just about managed to sustain their standard of living from 1964 to 1990, while all Americans – i.e. including the elite who earned their incomes other than from wages or salaries – could enjoy a much better standard of living than they enjoyed in 1964 until the early 90’s. The real purchasing power of all Americans then also started to decline and by 2006 the average American too was worse of than almost 40 years earlier.

The degree to which working Americans have lost real purchasing power is more than disturbing. One can imagine after 1990 most households with a single bread winner found it difficult to survive. Households with two people earning an income were better off, but even these households are likely to have made extensive use of the easy credit available until quite recently to manage their budget.

Now that credit has become tight, it is no wonder that mortgage default is becoming more endemic and that the number of people on food stamps are rising steeply.

Over the past few decades, America has become impoverished; as a country, but, worst of all, for the disaster that official policy casts onto individual households. The fact that this is likely also to have happened in other countries where hedonic CPI’s are calculated, is poor consolation.

Should this trend of decreasing purchasing power – the result of wage and salary increases linked to the official CPI – continue, as is anticipated, then the probability that the US can enter into a new intrinsic growth period is negligible or even nil. If there is no natural growth, the US is unable to begin to repay its debt; instead, it will have to run continuing deficits to fund the entitlements. The deficits are here to stay, irrespective of any plans to cut Federal expenses by piddling amounts over however many years. Someone has to pay to keep the wheels rolling; households can’t do it.

Changes in government policy

All indications are that one should not hold one’s breath while waiting for a change in government policies. The CPI will still be calculated using hedonic adjustments – which means wages and salary increases will remain too low to sustain the current standard of living, let alone enable households to improve their living conditions.

Consumer spending is increasingly being limited to essentials for survival. Increases in consumer spending are reported as good news, while at least part of the increase often is the effect of rising prices for food, energy and transport – which reduces the money available to spend on other things. This is not positive for growth.

The government will keep on trying to use stimulus to create jobs and get consumers back to the checkout tills, probably using credit cards since they do not have excess funds to spend. It will not have much success under the conditions as described here. Employers will not hire until the economy picks up, which it is not expected to do.

There is bound to be an overt or covert QE3 to enable the government to continue to spend deficit dollars. This will not be enough to support the GDP in the absence of sustained consumer spending and the economy will sink into recession, or worse.

Deficit reduction is a joke. Hoping to cut umpteen trillions of dollars from the budget over a period of ten years is a farce. If the US continues to run a deficit of more than $1 trillion over the next two years, given the deteriorating trend in 70% of the US economy represented by consumer spending, US dollars will be worthless. Fitch and Moody’s will be compelled to desert their loyalist stance and also down-rate US debt – and not only down to AA+, but much lower.

Given the worsening situation and ruling trends, current policies are untenable over even just the medium term. Unfortunately, choices are limited and the alternatives are politically impossible to contemplate. Unfortunately, the opening quote from Rogoff and Reinhart applies and history will have to run its course, in a spiral of ever worse conditions.

The actions of other countries, notably Asian and European countries

The way that US households are being impoverished and with little chance that the trend will be reversed soon, the odds that enough economic growth can be realized to repay the mounting Federal debt within a reasonable time frame, if at all, are very small to negligible. In due course, all foreign holders of US debt will be compelled by the reality of the situation to act on this knowledge.

While an official CPI that since 1998 ranges around 7% below the true increase in the cost of living has managed to present a not too pessimistic view of the US economy, this painting over of cracks in the economic foundation of the US cannot continue indefinitely. Sooner or later the catastrophe wrought by the artificially low CPI on US households, combined with the effects of other unproductive government policies and sustained deficits, will trumpet how worthless US Federal debt has become.

That could be the trigger for foreign countries to end their support for the US dollar and their hopes that the US could haul a rabbit out of the economic hat. At that time it will be too late to consider change, as the US will find itself deserted by countries keen to isolate themselves from the US fall out.

Europe has troubles of its own, some say even worse than the US. It would not surprise if Europe begin to distance itself even earlier from the mess developing in the US and try their best to find a workable solution for their own troubles along the austerity path they have adopted.

While Asia may pay occasional lip service to their loyalty to the US and the dollar, it would be most surprising if they are not even now doing all they can to isolate them and their wealth from the consequences of what is happening in the US.

There is little doubt that while other countries will be affected by what happens in the US, America will largely suffer the most and alone.

 

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