The Great Deformation

by David Stockman

  At bottom, the fundamental thrust of bubble finance has been a tidal shift of economic activity and employment to the HES complex. The Fed’s dollar trashing and massive balance sheet expansion (that is, bond buying) has enabled fiscal financing to a nearly unlimited extent; this surge of artificially financed demand, in turn, has drafted millions of jobs into the HES complex that would otherwise not exist.

  This channeling of economic activity to the HES complex camouflaged a reality that was never hinted at in any of the triumphal pronunciations by the monetary politburo; namely, that the payroll of the American economy has been shrinking outside of the HES complex for more than a decade. But indeed it has. In January 2000 there were 106.6 million jobs in the American economy outside of the HES complex, but by September 2012 that figure had shrunk to 102.8 million.

  For all practical purposes, therefore, a decade of Fed money printing and Wall Street coddling has hollowed out the Main Street economy, backfilling it with fiscally financed expansion of the HES complex. Needless to say, the health sector does not create new wealth; it consumes it. And given the vast public monopolies which dominate most of education, the net returns in that sector are debatable as well. In any event, with the federal government now coming hard upon the limits of Peak Debt, a continuation of the last decade’s faux prosperity centered on robust expansion of the HES complex is virtually impossible.

  BORROWED RECOVERY ON BORROWED TIME

  The Fed’s post-crisis money-printing polices gifted Wall Street speculators, as intended, but they also delivered an utterly botched recovery on Main Street. The latter was thinly disguised by an uptick in the conventional cyclical markers: purported “green shoots” like jobs, consumer spending, and inventory rebuilding. Wall Street economists touted this smorgasbord of traditional signposts, contending that even if halting and subpar they added up to another conventional business cycle recovery.

  Nothing could have been further from the truth. Beneath the paint-by-numbers simulacrum of recovery espied by Wall Street was a drastic lapse into “borrow and spend” that was a veritable affront to economic rationality. By September 2012, the American economy was fifty-seven months past the late 2007 peak, but there was no rejuvenation of its capitalist engines—just a tenuous bounce in the spending accounts that was plainly unsustainable and unhealthy.

  Personal consumption expenditures, as indicated, had risen by $1.2 trillion during that five-year period. Yet $625 billion, or half of this modest gain in PCE—the preponderant 70 percent sector of the GDP—had been financed with transfer payments. This was literally off the historical charts: transfer payments had never previously financed even 20 percent of the five-year gain in PCE after a cyclical top.

  Worse still, the sources of consumption spending outside of these government subventions were equally cockeyed. Another $330 billion came from wage and salary disbursements from the service sector, consisting heavily of fiscally driven gains in the HES complex. Thus, behind the tepid expansion of consumption—averaging just 2.4 percent annually in nominal terms during the five years—was a massive amount of federal borrowing, not an organic recovery of incomes.

  Indicative of the flagging condition of incomes is the data for wage and salary disbursements to workers in the breadwinner economy. At the peak of the second Greenspan bubble in December 2007, these jobs generated about $3.4 trillion of annualized wages and salaries. Five years later that figure was only marginally higher, having risen by just $70 billion. In other words, wage and salary disbursements in these core sectors of the American economy had amounted to only 6 percent of the $1.2 trillion gain in consumption spending, and had actually shrunk by 7 percent after adjustment for inflation.

  Likewise, there had also been only a trivial gain of $25 billion over that five-year period in the other major source of private income; namely, the $3.4 trillion accounted for by proprietors’ profits, rental incomes, and interest and dividends. These accounts were also down by about 8 percent in real terms, a five-year shrinkage that had never before occurred in the postwar era.

  The $7 trillion core of the American economy’s income ledger has thus plateaued. The sum of proprietor’s profits, rents, and financial income plus breadwinner wages rose by a trivial 1.4 percent during the five years after the December 2007 bubble peak, and has accounted for less than 8 percent of the PCE growth during that span.

  This, too, was freakishly off the historical charts, as is evident in the comparable figures for the five years after the late 2000 cycle peak. During that period these same core income components grew by $1 trillion, not $100 billion, and they accounted for 50 percent of the gain in PCE, not 8 percent. In short, the historical income-based recovery of consumption spending had now been replaced by a modest rebound coming mainly from the fiscally supported periphery.

  The American economy was thus still in a debt-push mode, but was losing traction rapidly. During the five-year period ending in September 2012, and notwithstanding the massive fiscal medication after the Wall Street meltdown, PCE grew at only a 0.7 percent annual rate after accounting for inflation. This was a sharp fall from the 3 percent annual rate during the preceding five-year period, and the source of this deceleration was not hard to identify; namely, there was no more MEW; the home ATMs had gone dark.

  Not surprisingly, the failure of core income components to recover was echoed in other key macroeconomic performance variables. As indicated previously, fixed business investment in plant, equipment, and software is the sine qua non for long-term economic growth and health, but the anemic rebound that began after June 2009 had already rolled over by the third quarter of 2012.

  This was a startling development because it meant that capital spending was now retreating even though it was still 7 percent below its peak of five years earlier in constant dollars. Needless to say, there was no historical parallel. Five years after the 1981 peak, for example, real fixed business investment was up by 11 percent and even after the modest 2001–2002 downturn real business investment rose by 5 percent during the next half decade.

  MAIN STREET IN THE FED’S POTEMKIN VILLAGE

  Five years into the Bernanke bubble the Main Street economy was still languishing. In all of the previous postwar cycles the prior top had been substantially exceeded sixty months later, but this time there had been no gains in breadwinner jobs, business investment, or the core components of national income. Even the consumption accounts were stagnant. They appeared to have gained new ground only because they had been puffed up with borrowings from future taxpayers that had been intermediated through transfer payments and expansion of the HES complex.

  To be sure, the latter had been enough to trigger a spurt of inventory replenishment, especially in sectors like autos where a drastic liquidation had occurred in late 2008 and early 2009. In turn, that fueled an associated boost to rehiring and capital stock replacement. Yet the vicar himself was at a loss to explain the tepid multiplier effects from the initial rounds of re-stocking goods and variable labor, lamenting that a newly invented condition called “escape velocity” seemingly remained just out of grasp.

  The reason the Main Street economy refused to follow the Keynesian script, however, could not be found in the texts of the master or any of the vicar’s uncles. The Keynesian catechism has no conception that balance sheets matter, yet Main Street America is flat broke, and that is the primary thing which matters. In fact, half of the nation’s households have virtually no cash savings and live paycheck to paycheck (or government check), and most of the remainder are still too indebted to revert to borrowing and spending beyond their current stagnant and often precarious paychecks.

  The simple reality is that the household balance sheet is still way over-leveraged, and for the first time in the postwar Keynesian era this leverage ratio is being forced down on a secular basis, thereby permanently restricting the rate of consumer spending. It goes without saying that this dynamic is the inverse of all previous postwar cycles.

  The long
-standing Wall Street mantra held that the American consumer is endlessly resilient and always able to bounce back into the malls. In truth, however, that was just another way of saying that consumers were willing to spend all they could borrow. That was the essence of Keynesian policy, including the Reagan tax cuts.

  At the 1981 peak, for example, the household leverage ratio (household credit market debt divided by wage and salary income) was 105 percent, but this had risen to 117 percent five years later as the economy rebounded and interest rates fell. Likewise, households cranked up their leverage still further during the 1990–1995 cycle, causing the ratio to rise from 130 percent to 147 percent. Then during the five years after the 2000 peak, households took on mortgage and credit card debt with reckless abandon, pushing the leverage ratio from 165 percent to 190 percent, and finally topping out at 205 percent in 2007.

  So the fundamental history of post-1970 business cycles is that household leverage was being stair-stepped radically upward. Indeed, that was the true foundation of the endlessly resilient American consumer. Yet according to Stein’s law, any trend which is unsustainable tends to stop, and that is exactly what has finally happened.

  When the second Greenspan bubble burst, household mortgages, credit cards, car loans, and the like amounted to more than two years’ worth of wages. That lamentable condition would have shocked any prudent banker in 1970, and it finally shocked most American debtors when both Wall Street and Main Street buckled violently in the final months of 2008. This trauma brought the reversal of a thirty-five-year trend of steadily increasing household leverage—a turnabout which fundamentally slackened the expansion capacity of the nation’s consumption-driven economy.

  In an exercise that is just plain perverse, however, the Fed’s zero interest rate policies have given households exactly the wrong signal. The effect of radical interest rate repression has been to eliminate the sting of excessive debt by reducing the interest carry on current obligations. The natural impulse of households to sharply curtail consumption and materially reduce debt under current circumstances has thus been vitiated.

  By contrast, had the free market been allowed to work its will, interest rates would have likely soared, causing a dramatic escalation of defaults as well as prudentially driven voluntary pay downs of debt. In that manner excess debt would have been dramatically liquidated, and the economy would have been given a chance to “reset” on a healthy basis.

  Not surprisingly, since Fed policy has had the opposite aim only modest deleveraging has occurred, and even that has been concentrated in foreclosures on the worst of the subprime home and auto loans. Thus, by mid-2012 the household sector still had just under $13 trillion of credit market debt outstanding, amounting to nearly 190 percent of wage and salary income.

  It is perhaps a tribute to our debt-besotted age that most Keynesian economists, whether in the hire of Wall Street or simply enthralled by doctrine, have interpreted this modest rollback as evidence that the household sector has substantially repaired its balance sheet. Under this happy scenario households were said to be on the verge of a new spree of borrowing and spending, meaning that the deleveraging crisis was over and that the American economy would soon regain its former gait.

  But why is that plausible when the household leverage ratio is still nearly double its pre-1980 norm? Surely that earlier marker has some validity, given the overwhelming evidence that the US economy performed far better during the golden era after 1954 than it has during the last two decades of explosive debt growth. In fact, Keynesians are drastically misinterpreting the situation with respect to household leverage because they have been lulled into the financial repression trap.

  As a result of the Fed’s yield pegging, the interest carry on household debt is artificially low, thereby generating far less liquidation and financial distress than would an equivalent burden of debt financed at much higher free market interest rates. Yet to accept the current situation as benign is also to deny that interest rates will ever normalize. The implication is that Bernanke has invented the free lunch after all—zero rates forever.

  Implicitly, then, Wall Street economists are financial repression deniers. Their favorite statistical chestnut, in fact, dramatically underscores this delusion. The so-called debt service to DPI (disposable personal income) ratio has fallen sharply, from a peak of 14 percent to about 11 percent by September 2012. This is held to be a signal that “escape velocity” will be achieved any day now because the American consumer will soon become his or her former free-spending self.

  The two things profoundly wrong with that ratio, however, are the numerator and the denominator! In a normalized financial environment, the interest carry cost of current household debt would be 50 percent to 100 percent higher than at present. At the same time, the disposable income denominator is not nearly what it’s cracked up to be. It doesn’t measure ability to pay, as implied, because nearly 50 percent of the $1.34 trillion gain in DPI over the last five years is due to transfer payments, and much of the remainder stems from the fiscally swollen HES complex.

  So in yet another twist in the endless Keynesian circle of debt and more debt, the household sector is now purportedly ready to borrow again because its debt service-to-DPI ratio has been artificially deflated by deficit financed transfer payments and central bank interest rate repression. In truth, the household sector’s trivial amount of deleveraging to date is just the beginning of its corrosive impact on PCE growth and GDP expansion. The nation’s households are not even close to having repaired their balance sheets, meaning that the next phase of deleveraging will actually result in a body slam to the Keynesian aggregates.

  PEAK DEBT AND THE WAGES OF KEYNESIAN SIN

  The proximate cause of this recession waiting to happen is the federal government’s unfolding encounter with Peak Debt. The latter is not a magical statistical point such as a federal debt ratio of 100 percent of GDP, but a condition of permanent crisis. From the failed election of 2012 forward, every dollar of additional borrowing will induce new political and financial pressures while every dollar of spending cuts and tax increases will further impair the rate of GDP growth.

  The mainstream notion that there is a choice between fiscal austerity and fiscal stimulus is wishful thinking. It does not recognize that owing to the triumph of crony capitalism and printing-press money America has become a failed state fiscally. Deficits and debt have now reached the point where they are too large and too embedded in social, economic, and political realities to be resolved. Accordingly, what passes for fiscal governance will become a political gong show that will make the New Deal contretemps pale by comparison.

  What lies ahead is a continuous, mad-cap cycling back and forth—virtually on an odd-even day basis—between deficit cutting and fiscal stimulus to the GDP. Thus, deficit cutting will be in play every twelve months or so in order to purchase enough “conservative” votes to raise the federal debt ceiling by another trillion dollars or so. Yet every upward increment will become harder to pass in the House and Senate, ever the more so as the debt ceiling soon breaks above the $20 trillion mark and begins to soar well above 100 percent of GDP.

  The fact is, the great unwashed masses on Main Street know full well that Washington is trifling with national bankruptcy, so the debt ceiling votes have become the one clarifying legislative moment in which they can demand a halt to the madness. Accordingly, the template from the August 2011 debt ceiling crisis will become the recurring framework of fiscal governance: in return for more debt ceiling, the reluctant House and Senate majorities which are finally assembled will get a new package of fiscal restraint in the form of targets, promises, and processes to develop plans to implement budget savings.

  Before the ink is even dry on these deficit reduction packages, however, they will become part of the permanent, rolling “fiscal cliff”; that is, a recurrent series of pending tax and spending shocks that would cause negative GDP prints and adverse job reports if implemented. In effect, the Main
Street economy will appear to be continuously confronted by the prospect of a “fiscal recession” or a dip in activity because it will be viewed as too weak to absorb the tax increases and spending cuts needed to close the nation’s yawning and unshakeable budget gap.

  And so short-duration fiscal support measures like the payroll tax holiday and extended unemployment benefits will be enacted on even days in order to bolster a faltering economy. These “stimulus” measures, needless to say, will only exhaust the available debt ceiling headroom and accelerate the next debt crisis.

  This impending struggle with Peak Debt, in turn, will unleash a hammer blow to household consumption spending that will be orders of magnitude more severe than was the loss of MEW after 2007. This threat is owing to the fact that the fiscal gong show now unfolding will almost certainly trigger a drastic upward lurch in both the savings rate and the tax rate on household incomes.

  These inexorable developments will mark the beginning of the great unwind from decades of borrow and spend. Needless to say, the Keynesian doctors and their Wall Street fellow travelers have not even begun to contemplate the repudiation this will bring to their model of printing-press prosperity.

  As detailed below, there will now be relentless tax increases and spending cuts as far as the eye can see. This fiscal sword of Damocles will hang over the American economy on a permanent basis, cutting down to size that great artificially swollen edifice known as the American Consumer Economy once and for all.

  One prong of this shift will be a drastic increase in the household savings rate because chronic threat of cutbacks in Social Security and Medicare will finally drive home the need to save for retirement. As indicated earlier, the pre-1980 household savings rate averaged 8.5 percent of disposable personal income at a time when the baby boom was only entering the labor force. Now with 4 million boomers scheduled to reach retirement age each and every year until 2030, the fiscal basis of the New Deal’s Faustian bargain on social insurance is certain to buckle.