As Herb Stein Might Say
Let’s take A Look at Our Cumulative Debt. The topic seems to be much in the news, so maybe a little data would help understand just where we are.
The statistics (from the Federal Reserve’s Flow of Funds Report) are usually divvied up into segments and those segments tallied to give a total picture of where we stand. That may clear things up, but it also requires some clarification as well. We are going to look at the debt side of the balance sheet, ignoring the asset side. By and large, every debt we incur is offset by some asset we acquire, be it dinner at Red Lobster or a new car. Some of those assets we will look back upon and say, “It wasn’t worth it.” Most of those assets will give us enough utility or enjoyment or value to justify the debt incurred. We will largely leave it to you to decide which is which.
The US government as of March, 2010 owed some $8.167 trillion. This number should include all Treasury debt outstanding plus agency debt but does not include the debt of the government sponsored entities like Freddie Mac and Fannie Mae. Those get lumped into the financial sector coming up in a couple of paragraphs. Also, a lot of the debt of the Federal government is owed to itself, in what are called SLGs or slugs for State and Local Government but actually are mostly IOUs at the Social Security Administration and other agencies; these are also not counted as outstanding as they would otherwise be double counted, so this number differs wildly from the amount of outstanding Federal debt. Since we do owe it all, if even to ourselves, the gross numbers are both more chilling and probably a somewhat view of the total debt. Unfortunately, the only source for most of the rest of these numbers is the Fed and this is the way they choose to count government debt.
State and local governments owe a paltry $2.38 trillion. This is probably the cleanest number on this page since it has relatively few outrageous ‘corrections’ to it.
The business sector owes some $10.921 trillion of which corporations owe about 70% and small businesses owe the rest. Just a note, the S&P 500 has just over $1 trillion in cash on their cumulative balance sheet as a partial offset. So, it tends to be more privately held businesses that are indebted while publicly held businesses tend to have cleaner balance sheets. Also, this would include any commercial mortgage debt not of a financial company.
The household sector owes $13.542 trillion of which mortgage debt is $10.235 and $2.469 is other consumer debt, credit cards, auto loans, etc. More on this segment in a minute as this is one of our rants today.
The financial sector owes $14.971 trillion, which is always a special case and needs a lot of explanation. The financial sector is the counterparty to many of the other obligations above. They are the issuer of almost all the credit card debt, the corporate loans and small business loans. The money they borrow to make those other loans counts in this total, but keep in mind that a lot of the numbers you have seen and are about to see include some substantial double counting. There is also the element of some $2 trillion of foreign financial companies operating in the US.
The total, if you haven’t been adding it up yourself, is $35 trillion, plus or minus, which excludes the financial sector because of all the double counting issues.
For comparison purposes, US current dollar GDP through the first quarter (as all the other data is as of the first quarter) was $14.446 trillion. Again to make it easy on you, we owe just over $2.42 for every dollar of GDP. That ratio had been rising steadily for a long, long time until recently.
So, do we owe too much? For the Calvinists in the audience, the answer is simply yes. For everybody else it may be a yes or maybe a no, ‘it depends’ is probably the best answer. We owe far too much on vacations, fancy dinners, and other consumables that have no lasting economic value to the debtor. We clearly owe far too much for homes that aren’t really a one-way ticket to affluence after all. For a long time, the ratio of our mortgage debt to just about everything else, incomes, net worth, other debts, stayed pretty stable until about the year 2000, when we started levering up to buy houses during the tail-end of the housing bubble. Since then, we have had a historically high commitment to housing and a concomitant historically high debt in the form of mortgages. Today, over 75% of our household debt is for the household itself versus a long-term range of between 60% and 65%. That is an anomaly that probably can’t hold up, even with very low mortgage rates.
It has been over two years since the US consumer decided that they weren’t going to live on credit any more. Our outstanding debt has been falling for two straight years. We owe less on the mortgage and less on everything else than we did in 2007. That is a good thing, but it has a dark side. We have consumed less than maybe we would have otherwise and that has slowed economic growth. That dinner at Red Lobster isn’t going on the credit card, but it isn’t getting ordered either, so the waiter isn’t working, the cook isn’t working, the mortgage on the place isn’t getting paid and no one is getting hired to re-surface the parking lot. (No wonder the number of illegal aliens crossing the border is down.)
The business sector has also trimmed their outstanding debt. Most of that decline is centered in real estate related debt and small business debt. Corporate debt has risen.
The issue that seems to have everybody’s dander up is the Federal debt. Assuming we do have a deficit of over $1.5 trillion next fiscal year and that the debt outstanding will grow to over $14 trillion (which obviously differs from the data above due to the inescapable double counting and offsets) what will that mean? It does not mean that we have the same inescapable problems that beset Greece earlier this year. Unlike Greece, we have a monetary policy that we control and a central bank that will purchase our debt in unlimited quantities if need be. We also have that persistent ace up the sleeve that our currency is the de facto world reserve currency. So, we will have a much easier time than the Greeks. That isn’t saying much, however.
Having to finance trillion dollar deficits might take some steam out of our financial markets and will be another barrier to rapid growth. What really matters is what we get for the trillion dollars. If we get income maintenance for a lot of people and relatively little increased production, that wouldn’t be the optimal outcome. If we got a sustainable economic recovery, that would be pretty good. How you view this is largely a political assessment on your part, but some of it is clearly economic. The supposed stimulus bill of March 2009, which launched the bull market, was surprisingly short on stimulus (roughly 15% of the dollars by most estimates). We have lots of bridges that need to be fixed, highways to be repaved, airports to be expanded, electricity grids to upgrade, water systems to improve and there isn’t a lot of that in that trillion dollars. That was supposedly addressed in the last stimulus bill, but the need is still there.
Issue of the Week
We’ve had to answer several questions lately about deflation. First, what is deflation? Deflation is the opposite of inflation, a persistent trend to lower prices for many goods and services. So, what is wrong with that? Actually, lower prices are a good thing for most of us, but not a good thing for those who produce the lower-priced good or service.
One of the big reasons we’ve had lower inflation (disinflation) over most of the last twenty-plus years is that American producers of all sorts of products have had to compete with imports made in places with much lower labor costs. The lower labor inputs mean that about 70% of the value of the US built car is US manufactured. The remainder is parts delivered from Mexico, Korea, or elsewhere. Most of the electronics we readily consume are manufactured in Asia, especially Taiwan. The areas where we have seen a lot of inflation in the past twenty years are in goods that don’t compete with foreign sourced goods or services. Healthcare costs and education costs are almost 100% American, so those are much higher than twenty years ago, small household appliances or apparel aren’t.
There are other reasons for deflation than only direct competition with cheaper goods. The biggest one is a lack of cash. Persistent tight monetary policy can produce deflation if it is kept tight long enough. (To paraphrase Herb Stein, Nixon’s Chief Economist, deflation is too little money chasing too many goods.) Back when the US was on a gold standard, we had long bouts of deflation. Most of the later half of the 19th century was one long period with falling prices for most commodities, for labor and for land. The gold strike in California in the 1840s and the silver strike in Nevada in the 1850s boosted the US gold supply and hence the money supply. After that huge increase in the money supply, the next fifty years were largely lacking in big increases in money. With persistent growth in the population, the economy, productivity and jobs, the price paid for nearly everything slowly eroded. It was only the huge Alaska gold find in the 1890s that loosened the grip of deflation on the land.
The gold standard and inflexible banking laws were a detriment to growth throughout that era, but also helped keep the US economy in recession for not quite half of the latter 19th century. The overall growth rate was good, but only because the expansions tended to be more productive than the recessions were destructive.
After the turn of that century, and after the Panic of 1907, the government decided that a central bank was needed to help control the money supply, interest rates and credit. The Fed was created in 1913 and given the job of maintaining stable prices; the full employment thing would come later. Since the Fed arrived, there was less deflation and more inflation, with the Great Depression as a notable exception to that rule. Growth in the real economy has also been much faster since then. The deflation during the Great Depression was akin to that experienced by Japan in the last twenty years. Destruction of wealth from property and financial collapse, reduction in credit and falling incomes were exacerbated by monetary policy mistakes to make the deflation persistent.
From the end of World War II, the US economy has been on a tear. Much of that growth was due to the simple fact that the US largely escaped the destruction suffered by the other industrialized nations during the war. Another element was the emerging role of the US as the principle creditor to the rest of the world. We had a marked change in our economic outlook during the sixties when consumer credit became much more readily available and when inflationary thinking took hold of most American’s. The role of inflation can not be overstated. When you believe that goods will be much more expensive next month or next year, there is a huge incentive to get it now. With ample credit, that was easy to do. We started borrowing and spending and rest is history.
Nixon took us officially off the gold standard in 1971. That took one huge pro-deflation element out of the equation. With a purely fiat currency (one where the government says the money is good, so it is good) we have had a persistent inflation problem. We depend on the Federal Reserve to keep inflation under control. We have not had to really worry about deflation recently.
The biggest risk to deflation is that once we accept the idea that stuff will always be cheaper next year or next month, there is no impetus to buy it now. There is certainly no reason to go into debt to buy it or to buy it any sooner than you need it. There is no reason to have an extra one sitting around for when the current one wears out. There is every impetus to delay buying stuff you don’t really need. So, rather than borrow and spend, we save and wait. During the 70s, 80s, 90s, 00s, we consistently bought a little bit more than we really needed. We accelerated demand, buying 101% or 102% of what we needed. If we have deflation, we won’t do that anymore. We will decelerate demand. We will only buy 98% or 99% of what we need and postpone the rest until it comes on sale. If that attitude becomes prevalent, we will slow down the whole economic cycle a little bit. That adjustment largely explains the severity of the last downturn and the slow recovery as much or more than anything else.
The America of today has another issue to deal with, labor. The big trouble with labor is the price. Most folks won’t volunteer to take a pay cut, they’d rather be unemployed. So, in a deflationary epoch, unemployment would be chronically high, like in Europe. Since wages would be sticky, there would be every reason to substitute capital for labor or foreign labor for US labor. Incomes would not grow as fast as the rest of the economy. Some element of this has already been going on in the manufacturing economy for a long time (when was the last time you spoke to a currently employed machinist?). The entire temperament of the economy would be worse. Recessions might be more common, perhaps less severe, but more common.
So, do you see why the Fed is worried about deflation? If the choices are a little bit of deflation or a little bit of inflation, the Fed will choose a little bit of inflation. We suspect that they will tolerate more than a little bit of inflation to be sure not to get a little bit of deflation. The only question is whether they can engineer a little bit of inflation. We think they can handle that. That’s why they have the printing press down in the basement.
The ISM manufacturing index came in at 55.5%, down from 56.2% in June but still ahead of the average guess by Wall Street’s economists. What seems funny to us is the persistent pattern of painting every economic release in as negative terms as possible by the media. One headline read “Factory Sector Slows Again in July” which is not only misleading but inaccurate. The factory sector is still expanding, just at a mildly slower rate. This headline makes it sound like bad news, when it is unadulterated good news. Anyway, you could tell the difference because we have gone over the whole diffusion index thing a few times now and you know that any number above 50% is a good number. That makes 55% a real good number, just not as real good as 56%.
The ISM non-manufacturing (or services) index came in at 54.3% in July, comfortably above the 50% level that indicates growth in services. Interestingly, the employment sub-index showed a level of 50.9 which argues that the service sector is again expanding its workforce. That employment reading had been below 50% in the last several months. This argues for future, upward revisions in the employment report below.
The Commerce Department announced that US Consumer Spending was unchanged during June. Personal Income was also unchanged for the month. At the same time, consumption and earnings for April and May were revised lower. The savings rate is estimated to be 6.4%, the highest in a year.
The Payroll report was mildly disappointing to Wall Street, but not a disaster. The street was expecting a decline in overall jobs and that’s what they got. The end of the line for some 143,000 census workers was a big move to counteract. There was a gain of some 71,000 private sector workers including 36,000 in manufacturing. There were gains in a few other areas as well, notably healthcare. Government lost a total of 202,000 workers including the above 143,000 census workers. The trimming at the state and local government level continues. The unemployment rate stayed steady at 9.5%.
Wages rose 0.1% to $19.04 an hour on average. In the past year hourly wages have risen over 2%. Hours worked also gained with the average workweek rising 6 minutes to 34.2 hours.
This report really doesn’t tell policymakers very much at all. It could have been better and it could have been worse. The negatives probably outweigh positives for the month. Also, revisions to prior months’ tallies cost the economy a further 34,000 jobs. The economy will have to create roundly 150,000 jobs a month on a regular basis to lower the unemployment rate. So far in this recovery there have been only a couple of months that have cleared that bar. But, we have seen the jobs picture improve dramatically from where we were last summer, when we were losing 300,000 to 400,000 jobs each month.
The week started off with a blast last Monday with a huge day. Since not much changed in the US that day, the answer was things changed somewhere else, that somewhere was Europe. Economic growth in most of Europe continued despite the sovereign debt crisis. Italy had some growth, though not very much at all, and Germany did well above expectations. It seems that just because one piece of the economy isn’t able to work smoothly, the other parts aren’t compelled to suffer along with it. There is a lesson in that for all of us.
Monday’s big up didn’t carry into the rest of the week as three of the other four days were down, though none seriously by the close. Friday’s action was curious as we had the poor employment report, but we turned the market around to cut what would have been big losses into a very small drop by the close. We made the high for the week on Monday, but we were close to that level by the close on Friday.
The large caps saw gains of roughly 1.5% while the small cap Russell 2000 hardly budged. We think the late charge on Friday came too late to help the secondary stocks. Global indexes were generally good with most developed markets gaining 1% to 2% and emerging markets generally higher as well.
Most bond markets were also better on the week. Treasuries were setting new lows in rates for much of the yield curve. This is very odd this late in the recovery. But, gains were also registered in corporates, municipals, and especially high yield. Most major foreign bond markets were also up. The dollar was down.
Real estate securities were broadly higher, following financial stocks. Commodities were a mixed bag with energy prices higher, precious metals higher and most other areas in the commodities complex seeing gains.
Have a great week.
Karl Schroeder, RFC, CSA
Investment Advisor Representative
Schroeder Financial Services, Inc.