Download Wednesday, July 26, 2006 - Westlake Porter Public Library

Volume 5 - Issue 41
August 10, 2009
Slow Long-Term Growth, And Government's Response
By Gary Shilling
This week I am really delighted to be able to give you a condensed version of Gary Shilling's latest INSIGHT newsletter
for your Outside the Box. Each month I really look forward to getting Gary's latest thoughts on the economy and
investing. Last year in his forecast issue he suggested 13 investment ideas, all of which were profitable by the end of the
year. It is not unusual for Gary to give us over 75 charts and tables in his monthly letters along with his commentary,
which makes his thinking unusually clear and accessible. Gary was among the first to point out the problems with the
subprime market and predict the housing and credit crises. His web site is down being re-designed, but you can write for
more information at [email protected]. If you want to subscribe (for $275), you can call 888-346-7444. Tell
them that you read about it in Outside the Box and you will get not only his recent 2009 forecast issue with the year's
investment themes, but an extra issue with his 2010 forecast (of course, that one will not come out until the end of the
year. Gary is good but not that good!) I trust you are enjoying your week. And enjoy this week's Outside the Box....
John Mauldin, Editor
Outside the Box
(excerpted from the August 2009 edition of A. Gary Shilling's INSIGHT)
Beyond the current recession, the worst since the 1930s, lies years of slow growth, as we've discussed in past Insights.
The next economic recovery, which will probably start around mid-2010, will likely be so subdued that it may not feel
like the recession has ended. And economic growth in the bulk of the next decade will probably be slow -- so slow that it
will force the federal government to take continuing actions to prevent high and chronically rising unemployment.
Six Causes of Slow Long-Term Growth
As explored in detail in past Insights, six forces will promote slow long-term growth in the U.S. and, indeed, on a global
basis -- U.S. consumer retrenchment, financial sector deleveraging, weak commodity prices, increased government
regulation and involvement in the economy, protectionism and deflation.
Consumer Retrenchment. First and foremost is the dramatic switch by American consumers from a 25-year borrowing
and spending binge to a saving spree that should extend a decade or more. As we pointed out last month, in the 1980s and
1990s, U.S. consumers regarded their soaring stock portfolios as continually filling piggybanks that would fund their kids'
education, early retirements and a few round-the-world cruises in between. So they slashed their saving rate and pushed
up their borrowing to fund spending growth that consistently exceeded the rise in after-tax income. When stocks
nosedived with the collapse in the dot com bubble in 2000-2002, leaping house prices seamlessly took over to finance
oversized consumer spending growth.
But now stock and house prices -- the vast majority of most Americans' net worth -- are not only depressed but also
unlikely to revive to their former glory days for many, many years. Furthermore, our earlier research found no other major
consumer assets that could be borrowed against. So consumers are being forced to embark on the saving spree we have
been predicting for some years.
Page 1 of 14
For the next decade, we're forecasting an average one percentage point rise in the saving rate annually, raising it to 10% in
10 years. That still would not return the saving rate to the early 1980s level of 12% even though the demographics for
saving have gone from the worst to the best in the interim. And even a decade of vigorous saving will probably not return
household net worth even close to its former peaks or eliminate completely the three decades of ever-increasing household
financial leverage.
Financial Deleveraging. Financial deleveraging will also reduce long-term economic growth. As we've discussed in
many past Insights, the recession really started in early 2007 in the financial arena with the collapse of subprime
residential mortgages. Then it spread to Wall Street in mid-2007 with the complete mistrust among financial institutions
and their assets, too many of which were linked to troubled mortgages. A huge gap opened up back then between the 3month LIBOR and Treasury bill yields, and that panicked Washington into opening the money floodgates. The Fed started
its interest rate-cutting campaign that ultimately drove its federal funds rate target to the zero-to-0.25% range (Chart 1 ).
But the central bank soon found the banks were too scared to lend and creditworthy borrowers didn't want to borrow when
Bear Stearns and Lehman collapsed and other large banks and Wall Street houses were on the brink. So the Fed embarked
on quantitative easing that exploded its balance sheet. And Congress and the Administration joined in with the $700
billion TARP, the $787 billion fiscal bailout and many other programs, as witnessed by the exploding federal deficit.
The Bank for International Settlements recently said only limited progress has been made in clearing up the global
financial system, and any economic recovery will be short-lived and followed by a long period of stagnation unless bank
balance sheets are corrected.
Except for hotels, commercial real estate woes aren't so much the result of overbuilding, as is the case with residential.
Rather, the problems are due to aggressive refinancing and pricing in earlier years as well as current slumping demand. As
retailers close stores or fold completely, mall space becomes vacant. Warehouses are empty as consumer retrenchment
curtails goods imported from Asia and elsewhere. Excess space and weak business and leisure travel is axing hotel room
rates and occupancy. Layoffs result in sublease office space competing with landlords for tenants.
Furthermore, a great deal of real estate debt must be refinanced soon amidst falling occupancy, rents and sales prices as
well as tight credit markets. Estimates are that $155 billion in securitizations are coming due by 2012 and two-thirds won't
qualify for refinancing as prices drop 35% to 45% from their 2007 peaks. Meanwhile, $525 billion of commercial
mortgages held by banks and thrifts will come due by 2012. About 50% won't qualify for refinancing since they exceed
90% of the underlying property value. Lenders prefer loans of no more than 65%.
Page 2 of 14
Deleveraging of the financial sector will obviously have negative ramifications for the real economy it finances. We've
already seen plenty of effects. Many small businesses that depend on outside financing are starving as banks tighten
lending standards. In a sense, many derivatives were financial cobwebs spun among bank and other speculators, but they
did finance much of the housing boom.
Commodity Crisis. The earlier collapse of the commodity bubble (Chart 2) will also subdue global economic growth in
future years. Sure, commodity consumers benefit from lower prices by the same amount that producers lose. But the share
of total spending on commodity imports by consumers, especially in developed lands, is tiny while they account for the
bulk of exports for producers, many of them developing countries such as Middle East oil producers.
Furthermore, security losses last year devastated sovereign wealth funds, many of them in oil-rich countries as well as
Asian exporters. A year ago, they were estimated to hold $3 trillion in assets on their way to $10 trillion. Now the estimate
is $1.8 trillion and optimistically forecast to rise to only $5 to $6 trillion by 2012. Lower oil prices have a lot to do with
the downward revisions. Singapore's huge Temasek Holdings fell more than $28 billion, or 22%, at the end of March from
a year earlier.
More Government Regulation. So, U.S. consumer retrenchment, global financial deleveraging and weak commodity
prices will keep worldwide economic growth subdued for many years. So, too, will vastly increased regulation here and
abroad, the normal reaction to financial and economic crises, as noted in our earlier reports. When a lot of people lose a lot
of money, there is a cosmic need for scapegoats and increased regulation. Sure, many embarrassed financial wizards have
sworn off their wayward ways and will be cautious for years, probably the balance of their careers. But that won't stop
witch hunts.
The Administration has proposed a substantial overhaul of financial regulation. It doesn't plan to combine regulators to
eliminate overlaps and gaps, as originally discussed. Still, it would empower the Fed to monitor financial risks to avoid
systemwide instability; create a Consumer Financial Protection Agency with control of mortgages, credit cards, savings
accounts and annuities; push public companies to give shareholders say on pay; bring hedge funds under federal
regulation; require firms to hold some of mortgage securitizations they create and sell; force derivatives to be traded on
exchanges; beef up oversight of insurance; force industrial loan companies to obtain bank holding company charters; urge
the SEC to stem runs on money market funds and to strengthen regulation of credit rating firms; create a mechanism for
government to takeover large, failing financial institutions; and amends the Fed's lending powers to require the Treasury
Secretary's approval.
Page 3 of 14
The first Obama federal budget also points clearly to more government regulation and involvement in the economy, in
health, education and the environment. Beyond the financial sector, the bailout of U.S. auto producers led to considerable
government control of that industry, almost day-to-day management by Washington.
Rising Protectionism. Without question, protectionism will slow or even eliminate global economic growth as
international trade slumps. As noted in earlier Insights, recessions spawn economic nationalism and protectionism, and the
deeper the slump, the stronger are those tendencies. It's ever so easy to blame foreigners for domestic woes and take
actions to protect the home turf while repelling the offshore invaders. The beneficial effects of free trade are considerable
but diffuse while the loss of one's job to imports is very specific. And politicians find protectionism to be a convenient
vote-getter since foreigners don't vote in domestic elections.
As noted earlier, initially this recession was in the financial arena -- the collapse in the residential mortgage market led by
the Subprime Slime that started in early 2007, and the follow-on Wall Street woes that commenced in the middle of that
year when two big Bear Stearns hedge funds imploded. So it's not surprising that protectionism began in the financial
arena and took the form of competing to safeguard a country's financial institutions. But at least that competition was
positive for financial systems and economies, even if expensive for taxpayers.
Now, however, protection has spread to its more classical import-export arena with the advent late last year of massive
U.S. consumer retrenchment and globalization of the downturn. Both forces are severely depressing the goods and
services sectors as U.S. consumer spending falls the most since the 1930s and unemployment here and abroad leaps.
Since the early 1980s, world trade has functioned in a smooth but unsustainable fashion. The rest of the world produced
and America consumed. In many foreign lands, households were weak consumers and big savers, so production exceeded
domestic consumption. Their production surpluses were exported, directly or indirectly, to the U.S. where consumers
were saving less and less and spending more and more. With their growing trade surpluses, foreign nations had growing
piles of dollars that they recycled into Treasurys and other American investments, helping to hold down interest rates and
making it cheaper for spendthrift American consumers to borrow easily and cheaply to fund their leaping debts.
Now, with American consumers embarking on a saving spree, the U.S. will no longer be the buyer of first and last resort
for the globe's excess goods and services. Furthermore, with slower global growth for years ahead, virtually every country
will be promoting exports to spur domestic activity. When every country wants to export and none want to import, the
pressure for protectionism leaps.
Deflation. Chronic deflation is the sixth reason we forecast slow economic growth in the next decade or so. Chronic
deflation spawns self-fulfilling deflationary expectations. Today, who would have the guts to tell a friend he paid the full
sticker price for a vehicle? Years of rebates have trained car buyers to expect continuing and even bigger rebates. So they
wait to buy. That leads to excess inventories that require even larger price concessions. Buyer suspicions are confirmed so
they wait longer, promoting more inventory buildup, more price cuts, etc. in a self-feeding cycle. A key effect, of course,
is to retard spending and slow economic growth.
Long-time Insight readers know that we have been forecasting chronic deflation to start with the next major global
recession. Well, that recession is here. We earlier forecast chronic good deflation of excess supply because of today's
convergence of many significant productivity-soaked technologies such as semiconductors, computers, the Internet,
telecom and biotech that should hype output and depress prices. As a result of rapid productivity growth, fewer and fewer
man-hours are needed to produce goods and services. Big output growth also results from the globalization of production
and the other deflationary forces we discussed in and since we wrote our two Deflation books a decade ago. With U.S.
consumer retrenchment and a shrinking pool of global imports, export-dependent lands will be competing even more
fiercely for the remaining markets.
In contrast to good deflation, bad deflation reigned in the 1930s as the Great Depression pushed demand well below
supply. Japan also suffered bad deflation over the last two decades after the collapse of her 1980s housing and stock
market bubbles. But in Japan, the lack of demand wasn't caused by a dearth of employment and income as in the U.S. in
the 1930s, but because the government delayed cleaning up her financial institutions while consumers refused to spend
their incomes.
We've consistently predicted the good deflation of excess supply, but we've also said clearly that the bad deflation of
Page 4 of 14
deficient demand could occur -- due to severe and widespread financial crises or due to global protectionism. Both are
obvious threats, as explained earlier.
Few agree with our forecast of chronic deflation. They've never seen anything but inflation in their business careers or
lifetimes, so they think that's the way God made the world. Few can remember much about the 1930s, the last time
deflation reigned. Excessive monetary and fiscal stimuli are also key reasons why most observers forecast chronic and
severe inflation in future years. They may concede that deflation is more likely in the balance of the recession (Chart 3)
for the reasons we've cited in past Insights. Past weakness in commodity prices is still working its way through the
production and distribution system. Surplus inventories (Chart 4) -- the result of producers, wholesalers and retailers
being caught unaware when consumers suddenly retrenched last fall -- are still being worked off and depressing prices in
the process.
Page 5 of 14
Wage cuts and mandatory furloughs for the first time since the 1930s, as well as layoffs are obviously deflationary as they
depress purchasing power. In addition, the excess of supply overdemand has clear implications for deflation.
Nevertheless, the vast majority still maintain that inflation is inevitable in the long run. All the money being pumped out
by the Fed and the Treasury deficits is sure to stimulate too much demand in relation to supply, they believe. But before
money can promote excess demand, it's got to get into circulation, and scared lenders and creditworthy borrowers are
unlikely to convert massive bank reserves into money until rapid economic growth resumes. And that, we believe, is
unlikely for many years. Furthermore, if economic growth and loans mushroom, contrary to our forecast, major central
bankers, with their congenital fear of inflation, will no doubt withdraw much of that liquidity.
Slow And Weak Recovery
We continue to forecast that the recession will extend into early 2010. Only by then is enough fiscal stimulus likely to be
pumped out to stabilize consumer retrenchment. By then, most of the global financial woes should be at least stabilized.
And by then, enough excess house inventories may be absorbed to end the downward pressure on prices.
Excess house inventories were built up in the 1996-2005 boom and still number about 1.5 million new and existing houses
above normal working levels despite the collapse in housing starts and recent stabilization in sales. Excess inventories are
the mortal enemy of prices in any goods-producing industry, especially housing. We continue to believe it will take at
least until the end of next year before excess house inventories are reduced to levels that no longer depress prices.
Meanwhile, prices -- already down 32% from their second quarter 2006 peak -- are likely to fall to reach a total 37%
decline we've forecast for the last two years.
The decline in house prices is evaporating home equity. In the early 1980s, those with mortgages had almost 50% equity
in their houses on average, after subtracting all mortgage borrowing from the market price of their homes (Chart 5). Due
to increasing mortgage leverage and, more recently, collapsing house prices, that equity was only 20% in the first quarter
and continuing to fall.
If house prices drop about 37% from their peak to their final bottom, that equity will be down to about the 15% range. At
that point, over 25 million homeowners, or half those with mortgages, will be under water, compared to about 25% today.
Page 6 of 14
After the recession ends as the economy stops falling, a weak recovery is likely to follow, one so tepid and with such high
unemployment that you may not know it has arrived. The two normal forces that generate economic recoveries are
missing this time. As usual, the Fed eased monetary policy once it saw that the economy was headed for recession.
But unlike the past, Fed action is not reviving housing (Chart 5), given the overhang of excess house inventories. And the
normal pop in production when the liquidation of overall inventories ends (Chart 6 ) will be muted and overshadowed by
the unusually large slashing of consumer spending. It's hard for businesses to cut inventories fast enough to keep up with
dropping consumer demand.
2.0% GDP Growth
A chronic 1 percentage point annual rise in the consumer saving rate for the next decade or so will knock around 1
percentage point off real GDP growth after its effects work their way through the economy. That's a big contrast with 0.5
annual percentage point declines in the saving rate over the previous quarter century that added around 0.5 percentage
points to growth. That total swing of 1.5 percentage points will reduce real GDP growth from 3.6% per year in the 19822000 salad days (Chart 7 ) to 2.1%.
Page 7 of 14
countries, more government regulation and involvement in the economy, rising protectionism and deflation -- our forecast
of 2.0% real GDP growth is probably even optimistic.
With 2% to 3% deflation, nominal GDP might not gain at all. And with slower growth in the years ahead, economic
expansions are likely to be shorter and less robust while recessions will probably be deeper and more frequent.
Consumer Spending Growth
We're also forecasting real consumer spending growth of 1.4% per year in the next decade. That, too, may be optimistic as
consumers retrench and slash real debt which far outran real housing wealth even before it collapsed, outran real annual
growth in real stock wealth before it nosedived, and bested real disposable income growth. Much of the explosion in debt
was residential mortgage-related borrowing in the mid-1990s - mid-2000s housing bubble, fueled by low borrowing costs,
weak lending standards, exotic mortgages and securitization, which distributed toxic mortgage loans to unsuspecting
investors.
The deleveraging of consumers that we expect to continue for years is a reversal of the same longrun phenomenon of past
Page 8 of 14
decades that was measured in different ways -- the decline in the saving rate, the rise in debt and debt service rates and the
rise in consumption's share of GDP, reflecting what consumers did with the money they didn't save and did borrow.
Consumption vs. GDP
With real consumer spending forecast to grow 1.4% annually over the next decade and real GDP 2.0%, real consumption's
share of GDP falls from 71.0% last year to 66.5% in 2018 (Chart 7). That would bring it back to the level of the early
1980s when the consumer spending binge began (Chart 8 ). It may seem inconsistent that we're forecasting a rise in the
household saving rate of 10 percentage points but a decline in real consumption's share of real GDP of only 4.5 percentage
points from 71% to 66.5%. But note that the reverse occurred in the last 25 years -- the saving rate fell from 12% to zero,
or 12 percentage points while consumption's share of real GDP rose from 67.5% to 71%.
These differences are in part because household saving is being measured as a percentage of disposable (after-tax)
income, which is less than GDP, so the effects of the change in the saving rate on GDP are muted. In the earlier 1980s,
real disposable income was about 78% of GDP. Furthermore, the rise in consumption's share of real GDP in the 19822000 boom years (Chart 8) was actually held back by the drop in the real DPI/real GDP ratio. That in turn was largely the
result of employee compensation's share of national income falling while corporate profits' share leaped during those
years.
In the years ahead, however, it's unlikely that DPI will decline as a share of GDP. As we discussed in earlier years when
profits' share was at its zenith, a big decline in corporate earnings' piece if the pie was probably in the cards. In a
democracy, we noted, neither capital nor labor can continually increase its share indefinitely while the other one's share
chronically shrinks. We also suggested that the recession and financial mess we were forecasting, the worst since the
Great Depression, would depress profits. We also opined that Obama Administration and Democratic-controlled Congress
would be adverse to shareholders while smiling on their labor constituents.
Where's The Growth?
If consumer spending grows slower than GDP in the next decade, other GDP components must grow faster. Which ones?
As shown in our forecast table (Chart 7), it's unlikely to be residential construction, which we see growing 1.0% per year
Page 9 of 14
in real terms compared with 5.2% in the 1982-2000 years. Housing should remain weak even after the huge excess
inventory is worked off. Earlier, homeowners were convinced that house prices never declined -- and they hadn't on a
nationwide basis since the 1930s.
But the recent collapse in house prices and the prospect that they will move with overall prices in the future -- which
means chronic declines with chronic deflation -- are shattering the scales that blinded homeowners. So they're beginning
to separate places to live from investments. That means they'll want smaller quarters, and the new houses that are built
will be smaller and less expensive.
Capital Spending
Real spending on nonresidential structures grew only 0.6% per year in the 1982-2000 era as overexpansion in the earlier
years curtailed spending later on. With slow economic growth in the years ahead, demand for warehouse, factory, office
and hotel space is likely to be subdued. Ongoing consumer retrenchment will keep retail vacancies high and new building
low. On balance, we project about the same growth rate for real nonresidential construction, 0.5% per year, in the next
decade.
Equipment and software real spending advanced briskly in the 1982-2000 years, 8.2% annually as new technologies such
as computers, semiconductors, the Internet, biotech and telecom absorbed tremendous amounts of spending. Furthermore,
inflation and interest rates were declining (Chart 9 ) to the benefit of the corporate sector, and operating rates were
generally high while profits growth was robust. Those new technologies will continue to attract heavy spending in the
next decade, but their initial huge bursts of spending are probably over. Furthermore, although the interest costs to finance
capital investment will probably remain low, especially with deflation, profits will probably remain under pressure in an
era of slow revenue growth and deflation. And most important, capacity utilization rates are likely to remain low.
A statistical model that we've run many times over the years and just updated shows that year-over-year changes in
corporate profits, interest costs and capacity utilization in the post-World War II era are all statistically significant in
explaining year-over-year growth in both the equipment and software component of GDP and equipment and software
plus nonresidential construction. But in either case, capacity utilization is much more important with coefficients almost
three times as large as those for interest costs and even bigger relative to those for profits in both models (Charts 10 and
11).
Page 10 of 14
We forecast annual real growth in equipment and software investment of 3.0% per year in the next decade, faster than the
2.0% we foresee for real GDP but much less than the 8.2% in the 1982-2000 golden years.
Imports and Exports
With weak consumer spending growth and overall muted economic advance, real imports are likely to rise only 2.8%
annually in the next decade, much less than the 9.0% growth in 1982-2000 when U.S. consumer spending was booming
and free trade ruled the world. This forecast is even lower than suggested by our 1.4% annual growth in real consumption.
Historically, a 1% rise in consumer spending results in a 2.8% rise in imports, but rising protectionism is likely to dampen
that relationship.
This weakness in U.S. imports will leave profound effects on the many foreign economies that have depended for growth
on American consumers buying the excess goods and services for which they have no other ready markets. The net effect
of subdued growth in U.S. imports will be sluggish economic growth abroad, perhaps even slower in other developed
lands than in the U.S. That should limit the growth in U.S. exports to 3.0% per year compared with 7.4% in the 1982-2000
Page 11 of 14
years (Chart 7). Still, government policies in Asia and elsewhere that promote consumer spending are likely to result in
U.S. exports growing slightly faster than American imports, the reverse of earlier years. Severe protectionism, however,
may stymie even these low growth forecasts for foreign trade.
State and Local Government Spending
Real state and local government spending, as recorded in the GDP accounts, rose slower than real GDP in the 1982-2000
years, 3.2% vs. 3.6%, and no doubt would in the years ahead -- except for federal government stimuli that's spent by
municipalities, as discussed later. State governments are in terrible financial shape and likely to continue so in the years
ahead. In the first four months of this year, state income taxes plunged 26%. In the economic climate we foresee,
corporate, sales and individual income taxes will all remain depressed.
At the local level, collapsed real estate prices will hold down property tax collections in the years ahead while reductions
in aid and revenue-sharing from state governments will persist. In a recent survey, 18 states reported cuts in local aid.
California Gov. Schwarzenegger proposed that low-level crimes like auto theft and drug possession be considered only
misdemeanors so those convicted would do time in county jails. That would reduce state prison expenses and save the
state $1.1 billion in the next three years, but raise local government costs. Furthermore, California's latest budget stopgap
will take, temporarily, $4 billion from local government funds.
We're forecasting 5.0% annual growth in state and local government spending in the next decade, but the majority of it
will probably come from Washington, which will be forced to spend heavily to prevent high and chronically rising
unemployment.
Rescued By Slow Productivity
Some suggest that slower economic growth will bring slower growth in production. That would reduce the upward
pressure on unemployment since more people would be needed for work than with faster productivity growth. But there's
no evidence that productivity growth necessarily slows with a chronically weak economy. In the depressed 1930s,
productivity grew 2.39% annually, among the highest decades since 1900. In that decade, much of the new technologies
of the 1920s -- electrification of homes and factories and mass-produced automobiles -- was being implemented, despite
the Great Depression and its slow growth aftermath.
Similarly, the new tech burst of the last decade or so in computers, the Internet, biotech, telecom and semiconductors will
no doubt promote rapid productivity growth in coming years.
Finally, the mindset of American business will probably promote robust productivity growth in future years. Throughout
this decade, the emphasis has been on producing more with fewer people. Note (Chart 12) that even at the top of the
expansion in 2007, job openings were fewer than in 2000 at the peak of the previous expansion, despite the growth in the
economy in the meanwhile. And since 2007, job openings have collapsed.
Page 12 of 14
Unemployment will also remain high since many of the people who have lost jobs were in construction and finance, two
areas that will probably do little net hiring for many years. Normally, a 2 percentage point drop in real GDP causes a 1
percentage point rise in the unemployment rate. But June's 9.5% rate is 1.5 percentage points higher than this rule of
thumb would predict, given the drop so far in real GDP.
Big Federal Spending
If we're right, then, on our forecast of slow economic growth in the next decade, unemployment will be high and
chronically rising -- absent huge federal intervention. And that intervention is assured since no government -- left, right or
center -- can withstand high and rising joblessness for long. And don't forget current as well as future increased federal
immersion in the economy builds constituencies that fight fiercely to preserve their government goodies.
Some of this federal intervention will probably take the form of more federal employees and direct purchases of goods
and services, which show up in the GDP breakdown (Chart 7). But most of it won't be recorded as the federal spending
GDP component since it will be transferred to individuals as federal unemployment benefits, extra Social Security checks,
etc. and to state and local governments to fund leaf-raking and other make-work projects.
Notice that in 2018, we project real federal spending to account for only 7.2% of real GDP, up from 5.9% in 2008. Of
course, nobody but economists look at these measures of federal spending, but instead concentrate on the ratio of total
federal budget spending to GDP. This ratio mixed apples and oranges since budget spending includes transfers that GDP
does not, but it does measure federal involvement in the economy.
In 2008, federal spending equaled 21% of GDP, outdistancing the 17.7% from revenues. This gap is likely to widen even
after the current extraordinary spending to combat the recession and financial mess is over. Anti-unemployment spending
will jump to higher levels while federal revenues languish. How will the resulting large deficit be financed?
Savers To The Rescue
Page 13 of 14
In the past, federal deficits were financed by foreigners as they recycled back to the U.S. the dollars gained from their
trade surpluses, as noted earlier. The growing U.S. current account deficit measures the increasing gap between domestic
saving and investment, or, in effect, and the need for foreigners to not only finance government deficits but also make up
for declining U.S. consumer saving.
But now, the current account and trade deficits are shrinking as American consumers retrench and slash imports. Further
declines will accrue in future years if exports grow faster than imports (Chart 7), so foreigners will have smaller American
current account deficits to finance. At the same time, much more of federal deficits will probably be financed by rising
U.S. consumer saving.
Household saving is basically what's left from wages, salaries, rent, interest, dividends and transfers like pension benefits
after subtracting spending on durables like autos and appliances, non-durables such as food and clothing and services like
recreation and medical services. That amount, divided by the after-tax income in the period in question, is saving rate.
Saving can be used to either reduce debt or increase assets.
Debt Reduction
Although the stock bulls may salivate over the prospect that increased saving will mean more equity purchases, we
believe that most of the money will go to debt repayment -- the flip side of a saving spree. The 6.9% saving rate in May,
mentioned earlier, was a result of consumers saving their tax cuts and extra Social Security payments, and is
unsustainable. Still, since after-tax income was about $11 trillion at annual rates in May, this saving rate produced annual
rate saving of $769 billion. That money was basically used for debt reduction and since money is fungible, it ended up
financing a major part of the mushrooming federal deficit. As consumer saving grows in future years, it will increasingly
finance the federal deficit, indirectly.
Repaying debt will be attractive to many Americans in future years as they shun many investments after their huge losses
in stocks throughout this decade and their shocking setbacks in real estate. A number will want to be less leveraged as
slower economic growth makes employment less stable and unemployment more likely. Chastened lenders, pressed by
regulators, will be pushing individuals to lower their leverage by repaying debt.
So will the deflation we foresee. Incomes may grow on average in real or inflation-adjusted terms, but shrink in current
dollars. Still, debts are denominated in current dollars and therefore will grow in relation to current dollar incomes and the
ability to service them. This will be the reverse of inflation, which reduced the value of debts in real terms and makes it
easier to service them as incomes rise with inflation.
Future Insights
In future Insights, we'll update our 2006 study that showed that over 50% of Americans depend in a meaningful way on
government spending. The number will probably be much higher in the coming decade of likely slow growth and greater
government involvement in the economy. We also plan to discuss our investment themes for an era of slow growth and
deflation.
Meanwhile, don't expect the burst of federal government spending and immersion in the economy to disappear with
economic recovery. It's likely to persist, not only because it spawns self-perpetuating constituencies, but also because the
slow economic growth in the years ahead and threats of high and chronically rising unemployment will force continuing
high levels of government involvement.
Page 14 of 14