Why the U.S. economy is weak

My friend Rob Parenteau says "most professional investors are high frequency macro data and short run asset price driven."  He basically means they have no real macro analytical framework to use when making investment decisions. Rob says "it is just a video game for them, where they trace and extrapolate the recent momentum." Rob is talking about recency bias. And I agree 100%. Recency bias was also on display on the way down I might add.

So given the spate of underwhelming macro data coming out of the U.S., you should be asking yourself why is the economy so weak? Answers like "Businesses are losing confidence in the President" or "the tax picture is unclear" will get you gonged. Even the somewhat better "aggregate demand is weak" will get you a "…and the survey says 0." You have to have a macro framework. And that means you have to avoid extrapolating the last batch of macro data and take a 30,000 foot view based on a consistent methodology.

What’s my answer? It’s the debt, silly. Households in the U.S. are up to their eyeballs in debt and this is significant as consumption represents over 70% of U.S. GDP. The U.S. economy is weak because people deep in debt don’t increase spending unless they feel comfortable they can meet their debt repayment schedule through money from income or wealth. So if incomes or asset prices are increasing, people feel safe to take on more debt. But if on aggregate both are stagnant or falling, you get a balance sheet recession. And goosing aggregate demand through stimulus quick fixes is not going to change this – at least, not until the balance sheets have recovered.

The framework I use to discern what this means over the short-to-medium term as well as the long-term is a modified Austrian framework. I’ve shown you this before. The first time was March 2008. The last time was in June when I wrote Why Stimulus Is No Panacea. The point I make connects interest rates to credit growth, debt and bubbles.  Mainstream economists like Paul Krugman don’t believe "excessively low policy rates were a key reason for the housing bubble." But he misses the connection between credit growth and changes in monetary policy. When the Federal reserve holds interest rates low for long periods of time, it encourages the accumulation of debt by acting as a tax on savers and a subsidy to debtors. It also lowers risk premia as investors need to reach for yield. This is a boon for high risk projects and is what allowed bad actors like Enron and WorldCom to run amok. But it necessarily means that uneconomic projects are subsidized artificially and specific economic sectors relying on cheap funding are overbuilt.

In the late 1990s I worked in the high yield bond area and saw what low interest rates did to goose interest in telecom infrastructure plays. During the Russian crisis, bonds gapped down and bid/ask spreads widened to where no trades happened in ‘hundred-year flood’ fashion. But after the Fed orchestrated a bailout of LTCM and lowered rates, all was well. Telecom bonds from the likes of NTL, Telewest, Turkcell, and Jazztel dominated the marketplace. When the TMT bubble collapsed in a heap, so did these bonds. Many of these companies needed to be restructured – or, like Iridium, had to be liquidated. These are classic examples of uneconomic ventures and overbuilding due to cheap access to capital.

In the next decade, the Fed continued to goose the asset side of the balance sheet artificially as a solution to the balance sheet problem. Specifically, it targeted asset prices in lowering interest rates. Stock markets were weak well after recession ended in November 2001. So the Fed kept the foot on the accelerator. The result was a major credit bubble with housing at its center.

Raghuram Rajan makes the same point in a recent post:

Ultra-low rates encourage people to borrow to acquire assets, and are partly responsible for both the over-building in housing, the over-indebtedness of households, as well as the over-leveraging of the financial sector. More generally, a subsidy to capital will imply greater capital intensity (and waste) of capital, greater short term leverage, and excessive growth of sectors that rely on either fixed asset investment or credit. Is this the appropriate way to go (especially if we want more labor intensive sectors to grow to provide the jobs that are needed), and is it sustainable?

That’s the key question – sustainability. The household sector debt levels are simply not sustainable. So government pump-priming without reference to debt is a losing long-term proposition. Here’s my thesis for three approaches to this problem from last November:

The only question we have to ask ourselves is whether we want to reduce debt by:

  1. The Liquidation Scenario. decreasing aggregate demand and precipitating a major depression in order to liquidate zombie companies and malinvestment. This would cause a massive wave of defaults and decrease debt burdens significantly through bankruptcy and debt repudiation. or;
  2. The Glide Path Solution. increasing aggregate demand by maintaining government spending while trying to liquidate zombie companies and malinvestment. This would allow the private sector to decrease debt burdens significantly over time through increased savings. It also has the benefit of reducing dependency on foreign sources of capital. The downside is a major increase in government debt, the spectre of big government and a long muddle through.

As I have said previously, the Obama Administration is doing neither of the above. It has opted for a third Herbert Hoover solution:

  • The Hoover Status Quo. decreasing aggregate demand and precipitating a double dip recession in order to reduce government deficits. This would cause a wave of defaults and decrease debt burdens through bankruptcy and debt repudiation. Meanwhile they will try to prop up zombie companies and maintain malinvestment. This would simultaneously prevent the private sector from decreasing debt burdens through increased savings and maintain dependency on foreign sources of capital – all without ending the spectre of big government.

I have advocated the glide path solution. But I see the liquidation scenario as much better than the present path – especially since, with the present course, we are witnessing crony capitalism on a massive scale. The problem with the liquidation scenario is a lower standard of living and the prospect of geopolitical tension, social unrest, poverty, and war.

The Herbert Hoover solution we are now using leads to a Japanese outcome at best or a Great Depression outcome at worst.

You should recognize the first solution as the one the Greeks, Irish and the British are trying  – an Austerian one (a term invented by my friend Rob Parenteau, who I referenced at the outset, by the way). The second solution is the one I have advocated for the US. The third solution is my least preferred outcome and is the path we are presently on (President Obama has now reversed himself and has backed away from his anti-deficit approach). The approach is heavily biased toward the status quo but is also politically unsustainable as I pointed out at the end of my "not a recession but a depression" piece.

With this macro background, where does that leave us today?

  1. With still weak job and income growth. (Consumer Spending -Income impact)
  2. With a 12-month supply of existing homes and still elevated home price to income ratios. (Consumer Spending – wealth impact)
  3. With still indebted consumers still near peak debt service to income ratios. (Consumer Spending – debt impact)
  4. With a large and politically unsustainable budget deficit and a declining addition from stimulus already in the pipeline. (Fiscal Policy)
  5. With a Fed chastened by its foray into fiscal policy and near zero interest rates that leave no way to stimulate via rate cuts. (Monetary Policy)

Consumers are dead in the water. Fiscal policy is also dead unless Obama opts to extend the Bush tax cuts. The monetary authority always acts last, plus the Fed is out of bullets on rates and so it’s not going to get funky here by conducting fiscal policy until recession actually hits. Residential investment is going to be weak with so much existing home inventory. So that leaves a pick up in non-residential business investment or exports over imports to lead us out of this recession.

I have said previously I expected 1-2% growth at best in the second half of this year. Given the data I am seeing now, I would revise that to 0-1% at best. And since we’re hanging our hat on trade (where things are deteriorating) and on business investment, the risk is clearly to the downside.

That’s why the U.S. economy is weak and why it will be weak for some time to come.

  1. Jon says

    Great synopsis and diagnosis, Edward. Much appreciated.

    What do you think of this analogy: the US economy is addicted to heroin (low interest rates – would Greenspan be Avon Barksdale or Stringer Bell?), and more heroin is needed for the time being, in order to get to rehab with a fighting chance for survival.

    Higher interest rates would lead to 5, 10, 20% of American homeowners entering foreclosure? Which would lead to how many of the big banks becoming (obviously) insolvent? I just don’t see how this scenario is beneficial regardless of the current economic malaise.

    In order for the liquidation path to be a potential one, I think there needs to be a serious analysis about what this path entails – for example tell me what percentage of Americans and banks go belly up. If you’ve done this analysis or referred us to it, I’m sorry I missed it. Point me to it, and I’ll get reading.

    1. Edward Harrison says

      We are in a policy cul-de-sac right now. The Doom Loop of ever lower rates and ever rising household sector debt burdens and ever rising financial service leverage is at an end. See here:

      That necessarily means the options are limited going forward. What should the government do then? The approach at present is predicated on goosing aggregate demand and leaving incumbents who have been poor stewards of capital in play. That won’t work as crisis will return in due course.

      The liquidiation scenario is scary frankly. As I said: “The problem with the liquidation scenario is a lower standard of living and the prospect of geopolitical tension, social unrest, poverty, and war.” So I’m not advocating this. Would higher rates lead us in that direction? At this juncture, perhaps. The time for higher rates would have been in early 2010. But the key for banks and debtors is the yield curve. Steep now with low nominal yields, that is the best of both worlds for debtors and banks. Right now the curve is flattening in a way that is bad for banks and good for debtors. Raising rates would flatten it even more and that would certainly spell trouble.

      This is why I have proposed the third option.

  2. Jimtchen says


    Thanks for your thoughts. I have a question. How is it that private sector savings increases in the Glide scenario, but not in the Hoover scenario? Is it because of the US macrosectoral balance identity? That an decrease in public sector deficit in the Hoover scenario must be offset by a decrease in private surplus (less saving) and/or a smaller current account deficit, whereas an increase in public sector deficit in the Glide scenario must be offset by an increase private sector surplus (more saving) and/or a larger current account deficit.

    1. Edward Harrison says

      The Hoover scenario – as I wrote it at the time – is one in which double dip was mixed with a status quo bias. During the depression, debt distress meant savings rates turned negative. That’s would one would expect under austerity and a double dip. Eventually, however, the Obama Administration saw a weakening economy and backed away from the deficit/austerity language. They still have a status quo bias – i.e. pumping up incumbent economic actors and they are back at trying to increase aggregate demand – which doesn’t promote savings.

      The goal should be deleveraging and private sector saving without economic collapse and you don’t get that through austerity or through pure aggregate demand/asset-based policies.

  3. Element says

    Great summation as usual Edward,

    The ‘corporate cash’ on the sidelines meme is an interesting quandary as well. Hussman and did Mish did nice sumations of it, but in more practical speak, it’s like this;

    Companies borrowed short-term debt to build reserves of cash and assets as a buffer, in case things went bad. They’ll hold a big reserve until they either think things are getting significantly better, or until they need to repay it or roll it over, if they still can. It’s short-term debt, they have to pay it back soon, with interest, so you can’t spend it or waste it on any giant splurges. No smart company is going to do that. If it were invested it would have to be done carefully. Get it wrong and you’re toast.

    Hence this ‘cash’ remains a standing emergency buffer on the sidelines.

    But things ARE getting worse, the recovery Summer is turning into the Autumn of our political discontent. So the buffering purpose of that ‘cash’ is now more relevant than ever. Spending it on a punt is out of the question. There won’t be any delirious gush of corporate spending and hiring to save the day. Indeed, the reverse becomes more likely. That debt will suddenly be seen as just debt that must be repaid soon, even during a negative growth phase, where earnings will fall lower, as will capacity to repay, and recovery will be slower with lower demand. And who knows what new taxes and level of unemployment will be suppressing the economy in QTR1 2012?

    So a cashed-up company in Aug 2010 knows it has to be extra careful, so is more likely to cut earlier and hold fewer staff, spend less and make sure it can survive to repay or roll over (if it still can). In that uncertainty this cash is not a boost, as the need to repay dampens willingness to spend more than is absolutely necessary.

    But let’s suppose the economy does drop into negative growth, and the money is used to successfully buffer and preserve the company. What if this is really a Depression? This is what everyone in business will be wondering.

    Let’s suppose it isn’t a depression; we all still know that if this were a double-dip of the GFC it would still be way-worse than the early 1980’s. 1982 did not have a synchronous -27% multi-month decline in global trade volumes. Will there be increased final-demand on the other side of a second negative growth phase in 2011? In your company’s sector? Even a once cashed-up business survivor from that double-dip situation would have big debts to repay and few reserves left, with a skeletal staff, in a low demand environment, reduced credit, combined with synchronous global-trade carnage in export markets and sovereign debt balloons ready to pop.

    This is incomparable to 1982-84 (which was fairly tame).

    So I’d definitely want a fat cash buffer right now, but I sure wouldn’t borrow to get it, even at cheap rates. I’d pare costs down and sell assets and inventory to pay down debts, hibernate and hope this would be enough to see me still operating in a recovery in 2012 (my family’s needs require I play this safe). I would not want to go into a double-dip with a big short-term debt as cash as that would just wipe me out on the other side. That is not for me thanks.

    “…Brett Arends of MarketWatch puts present levels of corporate cash in perspective: “According to the Federal Reserve, nonfinancial firms borrowed another $289 billion in the first quarter, taking their total domestic debts to $7.2 trillion, the highest level ever. That’s up by $1.1 trillion since the first quarter of 2007; it’s twice the level seen in the late 1990s. Central bank and Commerce Department data reveal that gross domestic debts of nonfinancial corporations now amount to 50% of GDP.” – Hussman, August 9, 2010

    Corporate and SME wipeout is now in play. Small business is already a wipeout. I wish we were able to do something but it’s already happened. We only see historic data from the momentum dynamic that’s already way ahead of us, playing-out relentlessly. So all I have been able to think about is how do we get out of this? I see no way out. Among other things, fiscal stimulus is a problem of scale and time. Sustaining a billion-dollar bandaide over a multi-trillion-dollar sharkbite, for five years.

    Guess what? You still bleed out.

    We’re watching an underlying momentum of contraction. Picture a falling tree in a slow accelerating fall arc, gathering speed and kinetic energy as it goes down. The stimulus didn’t alter its trajectory much in 2009, because by the time massive stimulus was applied, the ‘tree’ already needed 3 to 4 times more equal but opposite kinetic energy (and some) to reverse the fall and prop it up vertical, than was actually available. You got a deflected shove upwards, better than nothing, but the tree did not rebalance, it remained very out of balance, and the tendency to fall immediately resumed. i.e. previously unimaginable levels of stimulus were nowhere near enough.

    Ordinarily, you would never give up, because you really can succeed in very bleak or ‘hopeless’ situations more often than you might expect. But when you’re dealing with a non-linear change, you literally can’t impact it much, because by the time you respond, what is then required is more than you thought you would need. We are looking at (mass x velocity) squared. So a tree builds up energy faster than you can counter it, unless you catch it very early. The economy simply wants to go into negative growth and it can do this longer and faster than either currency or politics can combat it. The economic giant-redwood is way out of balance, and you can’t do enough quickly enough to rebalance it, because its been toppling un-noticed for about 6 years. During late-2009 we entered the phase where all that’s left is to get out of the way.

    According to CMI data the economy was coming down fast precisely when it should have been going up fast. The formal QTR4 2009 GDP figure was already way behind events. This told me it is not going to stop, it’s already coming down, the contraction momentum is far too much for the US to stop it and it’s way ahead of policy makers. They won’t sufficiently fiscal stimulate even if politically they could, because you now can’t do enough fast enough to make any difference. It was possible to catch the tree in 2006 and maybe still in 2007, but in 2010? – NO.

    The contraction momentum had already won in H2 2009. In real world practical terms we are about 4 years too late to catch it (to avoid creating a huge bubble).

    I’m sure the US could have entirely avoided this situation. But not via any US administration or leadership of the past 30-years. Not one of them would have done what was needed. What this implies is Government processes can’t keep up, or else are unresponsive or paralyzed, thus create very dangerous systems that superficially appear to be functioning (to media) but actually aren’t functioning. The mechanism to prevent the tree falling over is either broken or it just doesn’t exist in practice, it only ‘exists’ in theory.

    And we actually need practice, not theory.

    The steady economic contraction has been gathering pace under the cover of sustained low-interest rates, pork, tax-cuts, growing deficits and massive corporate welfare and other waste over the past decade. The growth in deficits and the fall of interest over that time mirrors the rate of growth in contractionary momentum. It was not just TARP/TALF that was not enough in 2008-09. Enough has not been supplied for most of a decade to halt the contraction momentum. Even so, all those efforts just blew bubbles. The bubbles then masked the underlying contraction momentum so allowed it to grow unseen, and still unrecognized.

    In mid-2007, people in the US finally collectively looked up and noticed the top of the tree seemed to be moving alarmingly to one side – but were assured it was ‘contained’. Push a button, pull a lever and hey presto! … um, hang on, … press a button, pull two-levers, then push another button … and … hey! … what the? … are you seeing this Ben!?!

    Bear Sterns fell out the tree soon after.

    This can not be fought via masking it which is what TARP and extend and pretend accounting does. This has more momentum than Barry, Ben and Tim have remaining windows-of-opportunity for levers and buttons to work. i.e. the dynamics are about to change because the capacity to alter the momentum of contraction has reduced with time. In other words, the effect of the buttons and levers are now an order of magnitude too small to make a difference.

    The US is floating along within the catchment area of a huge spiral whirlpool. The water has powerful momentum but the US has almost none. Swim fast away from it or you’re going in. Do nothing and you’re definitely going in. Swim aimlessly, you’re going in. Swim too slowly, you go in. But the whirlpool’s radius has also been expanding faster than you can swim out of it, and now you’re tired.

    You’re ‘assets’ are going ‘underwater’ mate.

    That’s what H2 2009 and H1 2010 has been about, swim, get tired and get sucked back in because you were too far inside the catchment already. What is coming is an irreversible process. You don’t get to control the outcome, or unscramble eggs, you only get to try and live with the outcomes. Irreversible change means permanent changes. And it’s uncontrolled change. Washington’s act of swimming hard suggests it is in control still (waving not drowning). But it’s the water that’s moving the swimmer.

    This is not U.S. specific, it’s Global. Every country is now somewhere within the catchment and we are all going in at some point. Necessity (not to mention desperation) being the mother of invention, means we are going to find an economics of what will work in a world where neither of the following two is viable;

    1) global-total-war with nukes
    2) global-total-greed with outsize financial sectors

    Both are too dangerous.

    In other words, this is one of those exceptionally rare times when PRIMARY changes to global behavior are likely. We are facing the necessary elimination of the routine practice of Global-Total-Greed. We can see we need humans and countries to interact differently with wider aims.

    The end of WWII saw every Govt on Earth institute the UN, specifically to find ways to prevent item #1), a global-total-war with nukes from wiping us out entirely. We were sufficiently afraid of this that we all agreed to eliminate colonial empires, crazy ideologies, and adopted a universal code of human behavior, rights, heath development and education, so that we behaved in ways that did not lead to a global total war. The common phrase heard after WWII was, “never again!”. And it actually worked, so far.

    After this Depression whirlpool we are likewise going to become equally afraid and motivated to find ways to prevent item #2) global-total-greed plus outsize financial sectors, from wiping out the global economy, and creating war, mass-suffering and deprivation.

    The ‘respectable’ financial sector’s rape-and-pillage-engine generated the whirlpool you and your family are about to go through. When things get really bad say these words to yourself, “never again”.

    Then make sure it really is, never again.

  4. Matt Stiles says

    Good post, Ed. I’d be an advocate of the liquidation solution. Mainly because the glide path solution requires “good governance” – something I have concluded is impossible.

    You implied, but did not elaborate, on how low interest rates skew the structure of production. I think this is key to understanding the lack in job growth from the recent bounce in overall activity. Interest rates are a function of “time preference” – the rate at which people value present (or near term) goods over future goods. So when the rate is manipulated downward, people value the distant future (10-20 years) less and the near-term future more. This results in less investment in things that will enhance our standard of living in the future. These are typically high intensity capital goods – requiring more labour.

    Well, that future has arrived. And we now have an enormous deficit in infrastructure and productive capacity for things that we need, while we have excess capacity for things that we don’t.

    The political focus on the near term “aggregate demand” has influenced monetary and fiscal policy, destroying entrepreneurs’ ability to calculate economically on any endeavour longer than a few years.

    Because political incentives are inherently clustered in the short-term, I don’t see any chance of this changing through “good governance.” Liquidation, reallocation of scarce resources, a stable accounting unit and minimal exogenous (intervention) risk are required to get people investing in the long-term.

    1. Edward Harrison says

      Matt, I have to admit the stimulus we have seen to date demonstrates the political nature of how these funds are appropriated. Nevertheless, a liquidation scenario leads to a deep Depression which is very volatile – think revolution, military expedition, authoritarian government.

      1. Matt Stiles says

        Well, if a massive tranfer of wealth is socially destabilizing, what does a lack in social mobility do? I have a hard time believing people are just going to tolerate the status quo, where the financial services types skim off rewards from credit expansion at the expense of the elderly and low income workers.

        Both situations will eventually lead to social instability. For me it is a matter of which solution is ethical – and if the ethical restructuring is undertaken, fewer people will feel wronged (we’re talking the top 10% that will feel the most) than if the current system is attempted to be patched up.

        1. BOLT says

          “I have a hard time believing people are just going to tolerate the status quo, where the financial services types skim off rewards from credit expansion at the expense of the elderly and low income workers.”

          Large parts of the US population is more than happy to go along with it, witness the Glen Beck rally. Many of those folks are conditioned to kick down, not punch up. After all, the big bankers are just astute businessmen, right?

  5. BOLT says

    “Fiscal policy is also dead unless Obama opts to extend the Bush tax cuts”. Not accurate. It is well proven that the “Bush” tax cuts did nothing positive and will do nothing positive if extended. The millionaires and billionaires who are really the only beneficiaries will not cycle the money back into the US economy. In fact, extended them will make the situation worse by adding to the deficit which in turn sets-off the austerity crowd.

    1. Edward Harrison says

      That’s not the point. The point is that the reliance on monetary policy
      comes from the reluctance to use ANY kind of fiscal policy as a policy
      remedy. Fiscal policy will not be used as a policy tool except to the degree
      the Bush tax cuts are extended. Whether the specific policy remedy is
      effective is another story.
      Edward Harrison
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