When analyzing the recovery prospects before the U.S. economy, no analysis is complete without a detailed look at the capacity of the U.S. consumer, that dynamo that has always managed to pull the economy out of whatever hole it managed to find itself over the past 80 years. However, permanent structural changes to the economy and the first credit-based recession in decades, could mean the proverbial "this time it may be different" is applicable. Furthermore, the non-homogeneous nature of the concept known as the "U.S. consumer" implies there are many different forces that will shape consumer behavior both now and for the years to come. In this article we attempt to put some of the pieces together and draw some preliminary conclusions.
The delevering consumer
Most of the global political and economic events in recent history can ultimately be traced to the motivations and actions of the US consumer, who directly and indirectly, via an intertwined political /Wall Street complex, has been responsible for not only the bulk of US economic growth, but also was the primary reason for global growth in the last decade. A summary report by McKinsey provides the following frame for the key issues over the past decade (emphasis added):
"Between 2000 and 2007, US households led a national borrowing binge, nearly doubling their outstanding debt to $13.8 trillion. The pace was faster than the growth of their incomes, their spending, or the nation's GDP. The amount of US household debt amassed by 2007 was unprecedented whether measured in nominal terms, as a share of GDP (98 percent), or as a ratio of liabilities to disposable income (138 percent). But as the global financial and economic crisis worsened at the end of last year, a shift occurred: US households for the first time since World War II reduced their debt outstanding.
Over the past decade, rising US household spending has served as the main engine of US economic growth. From 2000 to 2007, US annual personal consumption grew by 44 percent, from $6.9 trillion to $9.9 trillion - faster than either GDP or household income. Consumption accounted for 77 percent of real US GDP growth during this period - high by comparison with both US and international experience."
Yet despite McKinsey's claims, the Flow of Funds report demonstrates that total household debt has stayed relatively constant, mostly as a function of substantial and flat mortgage debt :
And even though total household debt has been relatively flat, consumer debt has indeed been following a deleveraging path, with the most recently released data indicating a $70 billion decline in consumer debt year over year.
At this point it is conventional knowledge that the primary culprit for the consumer credit bubble was Greenspan and his policy of keeping interest rates too low for too long (a policy repeated by his successor), encouraging a borrowing binge:
"Household borrowing rose along with incomes for decades. But after 2000, interest rates fell well below their long-term average because of the combination of US monetary policy and rising foreign purchases of US government bonds by Asian governments and oil exporters. When low rates were combined with looser lending standards, consumer borrowing soared. From 2000 through 2007, the ratio of household debt to disposable income shot up from 101 percent to 138 percent - as much in seven years as in the previous quarter of a century. Even with low interest rates, the ratio of household debt service payments to income rose to a record high.
Most of this borrowing fueled consumption. For instance, from 2003 through the third quarter of 2008, US households extracted $2.3 trillion of equity from their homes in the form of home equity loans and cash-out refinancings. Nearly 40 percent of this - $897 billion, an amount bigger than the recently approved US government stimulus package-went directly to finance home improvement or personal consumption. And much of the remaining 60 percent of extracted cash was used to pay down credit card debt, auto loans, and other liabilities, thus financing consumption indirectly. The money not spent on consumption was invested, helping fuel gains in stock markets and other financial assets."
The biggest concern from a reversion to the mean perspective is that if the ongoing deleveraging trend were to follow its full course, household debt-to-income would have to decline by 27 bps to its long-term trendline, in effect extracting $2.8 trillion from the economy.
One direct consequence of the trend of cheap credit has been an inverse move in the saving rate since the early 1990's. The sharp recent upswing in the chart below indicates that consumers on average are commencing a paradigm shift to frugality as the "wealth effect" evaporates: the increase in consumer wealth lead to an increase in consumption financed by rising asset values. While in the 90's this was facilitated by rapidly rising equity values, its most recent incarnation was manifested in home equity withdrawal as a result of spiking home prices, which translated asset inflation monetization into consumption. The double whammy of a collapse in both the equity market and housing values will ultimately result in an increase in savings rates to long-term averages in the 9-10% range. And, as pointed out above, the adverse economic impact of this transformation in the consumer psyche will likely be in the $2-3 trillion range.
Producer countries provided the US consumer with cheap financing
One of the artifacts of recent binge consumption was a shift in the global trade balance, whereby economies with an advantage in cheap labor or productivity ended up with material positive trade balances (excess exports), while increasingly service-based economies like the US and the EU would not only purchase any excess production, their cheap purchases would be financed by the producing countries transferring their savings indirectly into the US consumer. This explains the desire of China and other sovereigns for US bonds and mortgage instruments. Implicitly, the rapid quenching of the US consumer's insatiable desire for "Made in China" products is the primary reason why the Fed has stepped in so forcefully with purchase replacement mechanisms such as QE which seek to take the place of traditional security purchasers.
The problem in China is the inverse: with the trade balance shrinking rapidly and currency reserves declining, the Chinese government is subsidizing internal production in domestic currency, to stimulate exports to the US, however at lower price points (a deflationary phenomenon), while taking the resultant dollars and funnelling them back into the US in the form of additional bond purchases. The result is a massive credit bubble, as Chinese banks are repeating US mistakes from the early/mid part of the decade and providing cheap stimuli to its producers in an attempt to perpetuate a broken system. Whether or not this is sustainable, one only needs to look at the credit implosion in the US. The question of when the bubble ultimately bursts, however, is much more difficult to answer. However, unlike the one in the US, the Chinese credit bubble will likely have dramatic impacts on both the US and China, due to the intertwined nature of the two economies, both of which are trying desperately to hold on to a world in which the US consumer accounted for 70%+ of US GDP. Of course, with that world now gone, except in the imaginations of Federal Reserve economists, the longer the (anti)symbiotic relationship between China and the US persists, the more painful its unwind will be for both countries.
The stratified US consumer
One reason why delevering trends in the US consumer base are not equal, and have to be analyzed separately, is due to the dramatic schism within the consumer population, specifically the purchasing capacities, limitations and motivations of various income classes in US society. This is an approach that is all too often missing from traditional analyses of the US consumer. In order to properly analyze some of the major undercurrents within the consumer population, Zero Hedge relied on the most recent Survey of Consumer Finances, as well as an August 6 report by Bank Of America, "The Myth Of The Overlevered Consumer."
Three primary drivers determine one's willingness to spend - credit quality, disposable income, and wealth. Yet as the table below demonstrates, there is a substantial disparity in how these three factors impact the two critical classes of US society - the Middle and the Upper class.
What is immediately obvious is that based on estimates by Bank of America, the 50% of US population which makes up the middle class, is responsible for the same amount of total consumption as the 10% of the upper class. Another observation is that the balance, 40% of population considered Low-Income consumers, is responsible only for 12% of total consumption.
A drill down of disposable net income (after tax) and net worth, demonstrates why any discussion of "generic" consumers should be much more properly phrased as an observation of the "Wealthy" and "Everyone else".
The disposable income difference between the richest 10% and even the next richest decile is staggering: a 3x order of magnitude. And a fact that Taleb fans would likely appreciate most, the pretax income difference between the median and mean for the top decile is shocking: $206,900 versus $397,700. This is skewed by a statistically low number of outliers earning an abnormally large amount of disposable income.
The deleveraging of the middle class
Probably the most dramatic observation appears when evaluating relative leverage of the various consumer classes.
It is apparent that the problem of consumer (de)leveraging is actually one of a Middle class burdened with excess debt. The debt-to-income ratio for the middle class is on average more than 200%, almost double that of the highest decile, "Upper Class."
The divergence among the classes is even more obvious when comparing aggregate net worths:
While 10% of the population collects 40% of disposable income, it represents 57% of net worth! This is an impressive conclusion: on a lowest common denominator, the Net Worth variance between the 10% of the population that make up the wealthy and the 50% that comprise the middle class is over 8x! No wonder the aspirational consumer was the most vibrant retail category at the peak of the bubble: if the middle class can not accumulate 8x the net worth it needs to migrate into the top decile, it can at least dress like it. Unfortunately, it did these purchases on credit and is now paying for it (or not).
A derivative and somewhat surprising observation, is that the significant decline in the 1990-2000 decade was driven almost exclusively by the top 20% income earners, who benefitted the most from increased wealth. A 2001 working paper by Maki and Palimbo concludes that as the stock market ramped higher toward the end of the last century, the wealthy benefited the most, and as a result were the income class that reduced its savings activity by the greatest proportion.
The 20% of the population, who benefited the most from the second to last equity bubble (a comparable conclusion can be drawn for the most recent cheap credit-driven bubble), were in fact responsible for a -9.3% change in savings within their own strata over the 1992-2000 period, even more disturbing is that this change accounted for 98% of the overall shaft in the saving rate over the same time period. The consequence of this datapoint is that the recent hike in savings is likely dictated by the wealthiest 20% of the populating saving much more in earnest.
As noted the primary reason for the decline in savings in the late 90's was due to the richest stratum of society benefitting abnormally compared to the "poorer" percentiles. One explanation for this comes in the form the consumption function, which was extrapolated by Case, Quigley and Shiller in the analysis of the wealth effect. It formulaic definition is as follows:
57%*Percentage Change in Pretax Income + 8.4%*Percentage Change in Housing Market Wealth + 5.6%*Percentage in Stock Market Wealth.
The practical application of this formula is that consumers change consumption by 57% of the percentage change in pretax income (or almost 100% of after tax income), with the balance going to taxes and savings. Additionally, a 1% change in housing market wealth leads to a 8.4% change in consumption, while the stock market, perceived as the least permanent, leads consumers to change consumption by only 5.6% per 1% change in stock market wealth.
There are several consequences of this consumption function: primary among them is that the recent push by the administration via various channels to inflate the stock market actually has a much less pronounced impact on the end consumer, as even a 10% increase in the stock market will be undone by merely a 1% change in pretax income (assuming housing values are flat when in reality they are consistently declining). As recent macroeconomic data have demonstrated, the massive slack in the job pool has caused real wages to decline materially. In fact, for an end consumer, a 5% real or perceived decline in pretax income would offset all the "beneficial" implications of the 50% increase in the S&P since the March lows (not even considering the 30% market decline from its highs). The reason for the Fed's nervousness is evident: the truth is that all three of the key psychological metrics that determine consumption are plunging, and absent the recent aberration driven by the abnormal market action over the past 5 months, the consumer has no reason to be cheerful about the future, and to go forth and spen and drive the US (and global) economy forward.
Yet one of the side-effects of this function is that when looking at data historically, it is once again the top decile, or the "Upper" Class the benefitted consistently over the the past 15 years, to the detriment of both the low-income and the middle-classes, which represent 90% of the population.
It is probable that the dramatic increase in savings as disclosed previously, is an indication that at long last the richest 10% of America may be finally feeling the sting of a collapsing economy. Yet estimates demonstrate that even though on an absolute basis the wealthy are losing overall consumption power, the relative impact has hit the lower and middle classes the strongest yet again.
The main reason for this disproportionate loss of wealth has to do with the asset portfolio of the various consumer strata. A sobering observation is that while 90% of the population holds 50% or more of its assets in residential real estate, the Upper Class only has 25% of its assets in housing, holding the bulk of its assets in financial instruments and other business equity. This leads to two conclusions: while average house prices are still dropping countrywide, with some regions like the northeast, and the NY metro area in particular, still looking at roughly 40% in home net worth losses, 90% of the population will be feeling the impact of an economy still gripped in a recession for a long time due to the bulk of its assets deflating. The other observation is that only 10% of the population has truly benefited from the 50% market rise from the market's lows: those better known as the Upper class.
And to add insult to injury, the segment of housing that has been impacted most adversely in the current downturn, is lower and middle-priced housing: that traditionally occupied by the lower and middle classes. The double whammy joke of holding a greater proportion of net wealth in disproportionately more deflating assets is likely not lost on the lower and middle classes.
The next consumer shock
As this post has demonstrated, so far the lower and middle classes have borne the brunt of the recession. Is it safe to say that the wealthy have managed to game the system yet again and avoided a significant loss of wealth, while maintaining sufficient access to credit? If in fact that is the case, a case could be made for a consumer lead-recovery, granted one that is massively skewed to the 10% of the population which consumes 42% in the US. Yet, in doing all it can to avoid an economic collapse, the administration may have planted the seeds of its own destruction.
In order to finance the burgeoning budget deficit, Obama and his advisors will inevitably be forced to raise taxes, either across the board (contrary to Obama's campaign promises but in line with recent disclosures by the White House), or progressively. The latter is the most worrying, as it seems inevitable that be it to help finance the budget deficit or Obama's healthcare reform action, it is precisely the topmost wealthy decile will be the portion of population impacted the most, and one can argue, that one that has the highest marginal power to determine consumption. And as the consumpion function above indicates, a progressive increase in tax rates, effectively reducing disposable (or after tax) income for the wealthiest will undo virtually all the benefits from both an increase in the stock market, as well as the unprecedented purchasing of MBS and agencies by the Fed in order to prevent a collapse in housing prices across the board.
While for the time being, the administration may have prevented a slide into a depression, the biggest swing factor - the consumer, and more specifically the 10% that comprise the richest stratum thereof - is very weary, and for the time being the Upper class which seems to be the only fragment of US consumption that is propping up the economy, is likely to retrench very soon, absent a dramatic change in stance by the administration. Yet with a budget deficit spiraling out of control, and a policy that for the time being has advocated softening the blow now, at the expense of deterioration in the future, there is no reason to believe that President Obama will approach this problem effectively, and will likely continue relying on government spending to prop up GDP as long as possible, until eventually the key component of the real driver for the US Economy, the "consumer" finally lets go, and the economy spirals into its preordained and inevitable next crisis.