Pete’s blog

Was all ready to write this email, when I thought I should have a quick look at the numbers. I’m glad I did because I was just about to perpetuate the popular view. A handy tip – always check the numbers and beware of ass-umptions. Just because everyone says one thing and just because it makes sense, does not mean that it is correct.

So this week I’m going to have a look at what has been going on in America. I think the decade of 1999 to 2008 is going be one of the most popular case studies in future economic papers. An interesting time and a complicated time.

Currently in America there is a massive debt crisis, everyone has gone on a massive spending spree lately, racking up huge amounts of debt, buying lots of houses and now no one can afford their credit bills and everyone is defaulting. Right? WRONG! Here is the surprise – I was seriously expecting to see a surge about 5 years ago in consumer spending and debt in America, but it is not there! Consumer debt has been steadily rising, yes it might be getting to be too large a percentage of their income, but the rate of increase has been constant for over a decade. There has been no large jumps in consumer debt. Now I am going to say this in big bold letters – the current crisis in America is not due to a change in consumer behaviour! If anyone tries to accuse the man on the street of being irresponsible and causing the current crisis, they are wrong. The man on the street is doing nothing different.

But now this conclusion leads to a whole host of questions. Clearly Americans are in distress, clearly there is a financial crisis, clearly something has gone seriously wrong in the last few years to cause these problems… I’ve been thinking seriously about all these questions and I am still struggling to work out the answers. I need a few economic doctorates to help me out here, but I’m going to have a go at this anyway.

The best theory I could come up with starts with the basic assumption that the American economy should have been in recession/low growth phase for a longer period than it was – instead of a recession just for 2001, it should have lasted at least till 2004. Instead, from 0.8% real GDP growth in 2001, the GDP growth was already up to 3.9% by 2004. A 3.9% real growth rate is very respectable. But surely growth is good and recession is bad? This is where the American situation just gets a little bit weird and I am sure will get its own economic catch phrase sometime soon. I’m going to put my lot in and call it a period of high-growth recession Everything about the US economy for the 2001 to 2005 period screams major recession, yet the GDP growth rates don’t. Household incomes were constant/falling in that period, total industrial capacity growth was virtually zero, usage of manufacturing capacity was at historic lows, exports were flat, spending on non-residential fixed investments was flat – in short a recession. What was happening in that period that caused this recession? The dot.com boom was over, the US was distracted by wars in Afghanistan and Iraq, cheap Chinese goods were competing all over the world with American goods and the US dollar was far too strong, propped up by both the Chinese and the US policy makers.

So why the high GDP growth rates? If I tell you the GDP growth was led by spending on durable goods, residential structures and federal government spending, you should have a suspicion. Interest rates. The Federal Reserve rate fell rapidly from 2001 to hit a low of only 1% for the year of July 2003 to June 2004 – the prime rate in America for this period was only 4%. So with such low interest rates everyone starts buying residential property – no one buys industrial property or manufacturing capacity, because manufacturing is in a slump and there is already spare capacity. Investors buy residential property instead of business. House prices start rising rapidly and suddenly home owners have access to more credit and can sell their houses and upgrade. Rising house prices also motivate people to renovate and improve their houses (durable goods sales). At the same time, cheap Chinese imports are entering the market and inflation is averaging about 2.5% for the period – people can buy more stuff for the same price. And of course the federal government is very concerned about a recession so they are spending large amounts to prop up the economy.

Remember how at the beginning I said that growth in consumer credit was constant and that there was no major jump in consumer debt? But doesn’t what I just said contradict that? No, you see the growth in consumer credit was constant. With household income levels remaining constant and the economy in principle in recession, people should have stopped borrowing money and consolidated their spending. However no one told them to. Interest rates kept falling, allowing people to continue borrowing money even though their salary was the same, and house prices were soaring, increasing the value of their assets. At the same time low inflation and cheap goods allowed them to continue expanding their lifestyle as they had done during the past decade. Everyone was being told that the economy was growing – why be fiscally prudent during economic growth? So here is the full conclusion in nice bold letters - the current crisis in America is not due to a change in consumer behaviour, it is due to consumers not changing their behaviour! The Americans were deceived by economic slight of hand, their economy was in a severe recession for the period of 2001 to 2005 – they should have been tightening their belts, becoming more efficient, spending less and borrowing less. However, because the Federal Reserve’s mandate includes looking after economic growth and due to pressure from the US government to avoid a recession at all costs, the recession was cunningly hidden by pouring money into the economy. But there was no return in industrial production, since there was spare capacity and the Chinese were being too competitive, so all the extra money started chasing residential property.

Which leads us to the present crisis. The good times are over – rising oil and food prices and a plummeting dollar have pushed up inflation in America. Rising interest rates since 2004 have taken the shine off residential property. Household income and industrial production have only just started increasing above their 2000 levels. At the end of the day, the Americans bought 3 years of growth when they should have been facing a recession – and now they are paying the price.

If there are any qualified economists reading this – I’d love to hear what you think. Let me know if you want to co-write a paper

And just for the record, the statistics I used are mostly from the US Federal Reserve, the US Bureau of Economic Analysis and the US Census Bureau.