The Waters Begin to Churn
During my return to graduate school a few years ago, I had enrolled in a class on international political economy and a requirement, naturally, was to complete a paper. I elected to write on Japan’s “Lost Decade.” Before I dove into the topic’s research, I only held a sketchy picture of Japan’s long recession, one that started in the early ‘90s due to a collapse in that country’s commercial real estate market, and assumed that by 2004 – the year I wrote the paper (rewritten for a general audience as A Roadmap to Follow, now posted on Scribd) – the recession would be over. Nevertheless, I was intrigued by such a lengthy economic downturn.
As my research unfolded a clearer picture, I started to see that, far from moving on, Japan was entering its second consecutive “Lost Decade,” and that the country was truly suffering from some intransigent economic problems. Despite enormous amounts of fiscal stimulus from Japan’s national government, its economic woes had taken root and were not going away. As I drilled through the various arguments as to why this reality took hold – the commercial real estate bubble, Japan’s government propping up failed banks, and a stubborn deflationary cycle, to name a few – I started to understand that the true root causes could be traced back to the 1980s.
It was then that, in response to the United States levying steep tariffs to protect the domestic automotive industry during the Reagan administration, Japanese automakers responded by building manufacturing plants here in the U.S. There were no grand strategies at play here: Japan’s automakers were simply responding to a threat to their ongoing viability as companies. What no one – to the best of my knowledge – perceived at the time was that this offshoring of manufacturing would eventually open the flood gates for Japanese companies from across the industrial spectrum to send more and more jobs overseas.
This bleeding of middle-income jobs took an immediate toll on Japan; the commercial real estate collapse was merely the triggering device. That it happened so soon in Japan can be explained, I argued in the paper, by the fact that Japanese are net savers, a then-culturally ingrained tendency. As a result, Japanese consumers did not lift their country’s moribund economy by spending on credit; they simply did the rational thing and stopped spending. As time went on, this created a deflationary spiral downwards. It took five years after the real-estate collapse before deflation appeared on Japan’s radar and nine years before deflation took a particularly nasty – and entrenched – turn. There was simply no demand to be found anywhere in the country.
In the United States, manufacturers also started to offshore jobs during the ‘80s, but no long, severe recession turned up. The difference? When Japan’s middle incomes stagnated, Japanese tightened their belts and stopped spending. Americans, on the other hand, responded by going on a spending binge, increasing credit card debt to new highs, taking out equity loans on their abodes, and buying new homes. When home prices reached record heights due to demand, Americans signed on to ever more sophisticated mortgages that allowed little or no down payments, with low monthly payments for the first few years (balloon mortgages). Americans didn’t care: They assumed that before the reset took effect, the house would be sold and another one bought. In short, Americans made up for a lack in increased in wages with an increase in credit lines.
I wanted to make this parallel at the end of the paper, and show that the U.S. was following the same track. Data from the Federal Reserve and the Census Bureau were showing the rising indebtedness versus stagnant incomes but at the time, the American economy was doing fine, brushing itself off after a quick downturn in the wake of the technology bubble bursting in 2001. “Stick to Japan,” my professor suggested. “Anything else is just conjecture on your part.”
Sage advice for the time, but by 2007 my instincts proved correct. In March of that year, I caught a glimpse of a news story about a mortgage company – New Century Financial – that had specialized in subprime mortgages and was now in trouble. In the paper on Japan, I noted the ravaging effects of deflation on home prices, but did not necessarily foresee that the economic collapse in the United States would emanate from the housing market. Who could have guessed banks and financial institutions would hand out mortgages to borrowers in no position to repay? Perhaps when banks have to reach out to the subprime market to issue more credit, that’s an indication the prime credit markets are saturated, not a good thing. Nevertheless, the number of defaults, primarily buyers who had purchased homes using subprime mortgages, was increasing at New Century and causing the company financial stress.
I knew it was only a matter of time.
Japan pursued a failed policy of propping up its large banks in the ’90s, and just as the U.S. has ignored those lessons during our credit crisis so, too, are U.S. policymakers ignoring another critical lesson from Japan.
In the wake of the U.S. credit crisis and scarce money, there has been no shortage of blame to pass around. Conservatives blame subprime mortgage holders, liberals blame Wall Street, Libertarians blames the pressure of too many regulations, and Progressives blame a thin regulatory structure. Other blame includes chartered banks, Congress, Freddie Mac and Fannie Mae, investment banks, the Treasury Department, the mathematicians and physicists who designed the toxic Collateralized Debt Obligations, the current Administration, past Administrations, the Federal Reserve, the SEC, and the rating agencies.
But very few have identified the most critical lesson to learn from Japan’s two-decade economic slump: Forget the largely supply-side of this blame equation and start focusing on the real root cause of our present calamity. It can be found in the lower 80 percentile of household incomes, wherein the last two decades have produced single-digit percentage increases in household incomes versus triple-digit percentage increases in consumer debt. This trend could not continue indefinitely.
The idea that the fortunes of the citizenry affect the fortunes of its leaders and hence the overall success of an economy (or a nation) is quite old. The 17th-century English philosopher Thomas Hobbes believed the power and strength of the ruling class depended upon the power and strength of their citizens: Both suffer when leaders undercut the citizenry by depriving them of income and property. While our present political and business leaders do not want to recognize this, the massive offshoring of jobs essentially drained the reservoir of our economy: There is no water left to flow through the dam to generate power.
A very brief data set compares increases household income to increases in household indebtedness from 1989 to 2004. Some discrepancies are noted, as the data did not allow apple-to-apple comparisons at the upper 20 percentile of household incomes versus household debt. The discrepancies, however, should prove minor, as it is the lower 80 percentile that remains critical.
Typically this comparison is made as the ratio of household debt to disposable income. However, “disposable income” is defined in many ways, and can lead to obscuring the dialogue rather than clarifying it. For instance, “disposable income” can be defined as the total income used by a household for either consumption or saving during a one-year period.
I prefer gross household incomes since taxes can vary in locations, as do costs such as food, clothing and shelter. And as one can see, the rise in household debt over household incomes is staggering during the period investigated.
Any tax increases in the future, particularly those in the lower 80 percentile, will be highly damaging. Most American households are living so close to the edge of financial insolvency, that any decline in after-tax incomes will be immediately felt, with the inevitable consequences close at hand. One should also note that after 2004 household incomes started to decline across the percentile spectrum discussed here.
Comparing annual household incomes to total household indebtedness on a dollar basis is not particularly meaningful, as any household has more than one year to retire its total indebtedness. What is important are the vast differences between the rate of increases in household income increases versus the rate of increases in total household indebtedness, the single-digit versus triple-digit percentage upswings already mentioned.
A Question of Sustainability
Did the Federal Reserve bother to review its own data? (Two Federal Reserve researchers, Dynan and Kohn, finally investigated the issue in 2007 in “The Rise in U.S. Household Indebtedness: Causes and Consequences,” part of the Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs of the the Federal Reserve Board) Why did Greenspan and Bernanke ignore the rapidly rising rates of total household indebtedness? No one could have reasonably assumed sustainability of this massive movement upward in debt unless they believed annual double-digit increases in household asset values – particularly home values – were indefinitely sustainable, which they most certainly were not.
Everywhere one looks, our artificially inflated prices were sustained by nothing more than credit, creating a mirage that carried us forward 15 years until the American consumer could no longer shoulder additional debt loads. Eventually, in the second half of 2006, we started to close in on the brick wall (although signs that we were approaching the wall were out there before the credit crisis).
In The Constitution of Liberty, F.A. Hayek wrote on his fears concerning monetary expansion, and there are parallels with the present discussion. He negated the idea that wage increases fueled inflation, explaining that if “the supply of money and credit were not expanded, the wage increases would rapidly lead to unemployment….” So the increase in wages throughout the late ’40’s and ’50’s (Hayek published this book in 1960), failed to create massive unemployment thanks to concurrent monetary expansion.
This negative cycle is inevitable, Hayek wrote,
“until the rise of prices becomes sufficiently marked and prolonged to cause serious public alarm. Efforts will then be made to apply the monetary brakes. But, because by that time the economy will have become geared to the expectation of further inflation and much of the existing employment will depend on continued monetary expansion, the attempt to stop it will rapidly produce substantial unemployment. This will bring a renewed and irresistible pressure for more inflation” (Chp. 18).
Purposely Spinning the Data
No one should claim that inflation has been tame and thus Hayek’s argument is no longer valid. Using 2013 dollars for comparisons, between 1989 and 2004 home prices rose 15.3%, gasoline rose 24.2%, natural gas 30.5% and college tuition 51.4%. All the while, the median household income during this period rose a mere 0.7%. If monetary expansion via bank-debt (or “inside”) money was not possible, then prices would have been restricted to rising around a rate of 0.7%.
And this doesn’t tell the entire story: The conversion to 2013 dollars relies upon using the Consumer Price Index (CPI), a seriously inaccurate index. The Consumer Price Index (CPI) is widely used as a cost of living index but, in fact, it is not. The CPI measures the average change in prices paid by urban consumers, over time and with a relatively fixed market basket of goods and services. This basket can vary widely with the actual experience of an individual.
More importantly, in 1995 the index was revised so that the Federal government wouldn’t have to issue higher cost-of-living adjustments to Social Security recipients. Thus, the index began to assume lifestyle adjustments. For example, if a New York strip steak became too expensive for a consumer, he or she would start buying sirloin steak. If sirloin steak became too expensive, it would be substituted with hamburger. It is a sliding scale that eventually becomes meaningless: After all, how does one eventually measure dumpster diving for breakfast?
Therefore, the percentage increases are probably far greater than what is being reported here.
A true cost-of-living index would measure changes in the amount consumers need to spend for a given standard of living, over time. (For a summary critique of the problems with the CPI, see “6. Problems with the CPI,” posted on the DePaul University website). We simply do not have an accurate handle on what inflation has been costing us.
Bottom line: The only means by which any inflation could have occurred when the median income stagnated was through monetary expansion using bank-debt money, i.e., credit. And this discussion hasn’t even touched on the issue of how households are increasingly losing more and more of their income to interest payments on their debts.
A Sea of Debt
The deficiencies within the CPI allowed the “experts” to proclaim inflation has remained largely under control. If not for the CPI, could someone make such a claim, and welcome the comparison of the average price of homes, food, automobiles, energy or college tuition between 1989 and 2004? While household incomes only rose by single digit percentages, these categories of consumer goods rose at a much higher rate in the same time frame.
In our present economic downturn, the “brakes” Hayek wrote of were applied by households’ inability to assume any additional debt (the equivalent of tightening the monetary supply). Since the economy was “geared” to “depend on continued monetary expansion,” the credit crisis “rapidly produced substantial unemployment.” And the current economic downturn is aptly named a “credit crisis,” since monetary expansion from 1989 to 2004 (and continuing to this day) emanated largely from the creation of credit. Whether you believe this is accomplished by loans preceding deposits, or simply as a money multiplier, misses the point.
According to the Federal Reserve’s Flow of Funds Accounts of the United States (3Q, 2012), between 1989 to 2004 total borrowing by the household sector increased 279.8% (peaking in 2005 at $1.17 trillion), by the business sector 134.9% (peaking in 2007 at $1.29 trillion), and by the foreign sector 1,422.5% (peaking in 2006 at $332.6 billion). Everywhere we look – private, foreign or the public (government) sectors – we are awash in debt.
Bailing the Hull
Thus, it should come as no surprise that the Federal Reserve’s first response to the credit crisis was to decrease rates, hoping to spur more borrowing and that “irresistible pressure for more inflation.” The problem, and one that likely worries the Federal Reserve, is that since households’ ability to shoulder more debt has been severely compromised, the Federal Reserve cannot force households to borrow and thus resume consumption. Until households regain the ability to spend (or we come up with a better idea than basing an economic system on unceasing credit expansion and discretionary consumption), the economy will not move forward, precisely for the same reasons as Japan, still suffering after 20 years of economic stagnation.
That the credit crisis originated in the subprime mortgage market is simply identifying the trigger point. Of all types of household indebtedness, mortgage and home-equity loan debt climbed at the highest rates from 1989 to 2004. In addition, those in the lower income brackets – those that make up the majority of subprime mortgage holders – would have felt first the financial stress of large debt loads while incomes stagnated and declined. Under these conditions, the subprime mortgage market naturally would be the most vulnerable to any massive de-leveraging of consumer debt.
The Federal Reserve is now trumpeting the rise of household assets: “The effects of a rally in asset prices – much of it prompted by expectations of the Fed’s new $600 (billion) round of quantitative easing (QE2) – was visible in flow of funds numbers on household net worth,” reports The Financial Times. “Although housing wealth continued to decline, the value of household assets less liabilities rose by $1.2 (trillion) over the quarter to $55 (trillion). The Fed thinks that higher asset prices are an important channel through which (quantitative easing) affects the economy by making households wealthier and more willing to consume.” If this is what the Federal Reserve truly believes, then The Fed doesn’t seem to be aware that this “increase” in assets is likely to be due from households’ continuing deleveraging of liabilities, not from any real gain in assets. And increases in home values of late are artificial, as banks slow the foreclosure process, creating an artificial restriction in the supply of homes. As Bloomberg New reported in December, 2012:
“Default, auction and repossession notices were sent to 180,817 homes in November, down 19 percent from a year earlier and 26th straight month with an annual decline, RealtyTrac said in the report.”
One can only hope this is simply spin and that The Fed isn’t so deluded as to think that any deleveraging action will make households “more willing to consume.” Besides, the quantitative easing action of The Fed is flowingcapital to investors in commodities, equities and overseas economies (foreign direct investment, or FDI). Any belief that quantitative easing will somehow “trickle down” into U.S. middle-class households is seriously misplaced.
The Perfect Storm is Still Coming
In closing, as the lower 80 percentile of household incomes stagnated, this segment substituted meaningful income increases with debt (and others, such as Bloomberg News, have taken notice of this trend as well). The after-effects lingered: By February, 2011, while many consumers felt the economy was on an upswing, their own financial health continued to suffer. Two months later, even the optimism for the economy left.
This stagnating income/increasing credit cycle was akin to fighting off a hangover with more alcohol. The binge could not last indefinitely, and this dysfunctional cycle cannot return under present realities.
Considering the path of destruction left in the wake of this economic storm, that’s probably a good thing. But in the end, it’s highly unlikely we will be unable to outflank the pain.