Warning: Recession ahead
Although the world economy continues to grow, the economic health of the United States is at risk. There are several potential problems. In this essay we examine three of them, and conclude a recession is highly probable. If America does experience a recession, or even a period of declining GDP, the resulting economic malaise will spread to all of its trading partners.
That’s one of the “benefits” of globalization.
Is America’s Debt Profile Sustainable?
America has developed an irresistible affection for debt. According to the Federal Reserve, Total credit market debt, domestic and foreign has increased from 29.3 trillion in 2001 to over $44 trillion in 2006. That’s (roughly) a 50 percent increase in 5 years. Federal Agency and GSE-backed security debt increased by more than 31 percent from 4.9 Trillion to $6.5 trillion. Mortgage debt climbed from $7.4 trillion to over $ 13.0 trillion – up more than 74 percent. Corporate and foreign bond debt increased by 62 percent to $8.8 trillion. Treasury obligations now exceed $ 4.8 Trillion (up 43 percent), and municipal debt exceeds $2.3 trillion (up 46 percent). And finally, we doubled the debt load of asset backed securities to approximately $3.4 trillion, - mostly on the incredibly imprudent assumption that real estate investments would never depreciate.
Can you say “Debt Bubble”?
Intensive price competition from low wage nations has been, and will continue to be, a double edged sword. On the one hand, it is the basis for the reduced rates of inflation Americans have enjoyed since the 1980s. Foreign companies have flooded American markets with low priced goods. Everything from shirts and shoes to television sets and vehicles. Imports have climbed to 18 percent of GDP. But – although low priced foreign goods reduce the cost of living, they also take away American jobs and are the primary reason why American workers have experienced low rates of real wage growth for more than 20 years.
Even though America is a primary force in the global economy, it is now interdependent with most of its trading partners for roughly 33 percent of its domestic investment. Americans send money to foreign nations to purchase goods and commodities (such as oil). Thus far, these nations have been using a substantial portion of these proceeds to purchase American debt instruments, artificially driving down American interest rates. Because of this flow of funds, Federal Reserve interest rate increases have had little impact on the rate of interest Americans pay for mortgages and consumer debt, or the interest various agencies pay to fund Government operations.
Globalization means money flows freely through the world banking system, seeking either safety or profit. Leveraged buyout transactions have driven a huge increase in junk bond (rated CCC) debt. Financial institutions and funds continue to plough capital into extremely leveraged buyout debt on the promise of dramatic valuations, asset looting, cost cutting, and market prospects. Instigators plan to dump their risk by collateralizing the debt as securities and derivatives contracts.
But we must ask a simple question. What happens to inflation and interest rates if the flow of foreign funds into the United States decreases? The simple answer: inflation and interest rates go up. American consumers face a double setback. The cost of everything they buy goes up and - at the same time - the cost of financing restricts their purchasing power. Debt defaults increase. The cost of rolling over America’s massive trade deficit goes up. Government obligations become more difficult to finance (forcing up interest rates) just as tax revenues stagnate or decline. If history is any guide, the loss of junk bond principal could easily exceed 60 percent from par value.
It’s a wonder the financial markets have not become unglued. The size of the high yield corporate debt market has exploded to about $1 trillion. High yield? It’s high yield because the debtors are in trouble. Corporate bond defaults, now running at less than 1 percent, could easily top 8 percent if the economy goes into recession. Debt defaults are certain to increase. Private equity firms, hedge funds, and Government Sponsored Enterprises will all need help (along with some mutual funds, pension plans, banks and brokerage firms).
Thus far, struggling debtors have been buoyed up by a liquidity glut. But we must ask ourselves: how long will that generosity last?
Only until lenders perceive it is in their selfish-best-interest to bail out.
Real Estate Bust?
The Mortgage Bankers Association recently reported the delinquency rate for mortgage loans on one-to-four-unit residential properties stood at 4.95 percent of all loans outstanding in the fourth quarter of 2006 on a seasonally adjusted basis. The delinquency rate increased 13 basis points for prime loans (from 2.44 percent to 2.57 percent), 77 basis points for sub prime loans (from 12.56 percent to 13.33 percent), 66 basis points for FHA loans (from 12.80 percent to 13.46 percent), and 24 basis points for VA loans (from 6.58 percent to 6.82 percent). This quarter's NDS results cover over 43.3 million loans (33.3 million prime loans, 6 million sub prime loans and 4 million government loans).
Over $6.2 trillion of real estate debt is held by mortgage pools or trusts whose financial instruments depend on the asset value of the underlying properties. Much of this debt has been turned into Mortgage Backed Securities (MBS) for sale to banks, mutual funds, pension funds, insurance companies and the public. Unfortunately, these securities act like bonds. If interest rates go up, the value of the MBS goes down. The financial stress of a debt crisis could easily force interest rates up, thus decimating the balance sheets of dozens of financial institutions.
Obviously, the run-up in real estate values is unsustainable because these paper profits had to be supported by a corresponding increase in debt obligations. Loan originators created exotic products to make these purchases appear affordable. Common sense underwriting rules were broken with abandon. It should have come as no surprise that sub prime mortgages would take the first hit from delinquencies. Unfortunately, just as the originators were entering the financial market to refinance the mortgages they had to repurchase, regulators were encouraging lending institutions to tighten their lending standards. Since sub prime loan funds were no longer available, these originators quickly became financially unstable.
That means an unusually high percentage of existing home real estate loans are at risk. Since the majority of sub prime loans are packaged into mortgage-backed securities and sold to investors, the repercussions from a mortgage meltdown could impact sub prime lenders and their shareholders, consumer banks, investment banks, loan insurers, and the owners of mortgage backed securities. In addition, defaults will put additional homes on the market, depressing real estate values even further.
Companies that originate loan securities face uncertain times as average securitized mortgage collateral declines and the availability of new financing at attractive rates dries up. In addition, the mortgage industry continues to face rising early payment defaults, increasing repurchase activity, a compression of net margins, and a decrease in the fair market value of derivatives.
If my analysis is correct, one to four unit residential loan delinquency rates will exceed 4 percent for 33.3 million prime loans, and 18 percent for 10 million sub prime and government insured loans by the end of 2008 (versus 2006). Total non performing consumer loan obligations, including mortgage and consumer debt, could exceed $ 700 billion. In order to reduce the collateral damage from these non performing loans, lenders have been aggressively trying to renegotiate them with extended payment plans. Never-the-less, loan originators, along with the banks and institutions that funded them, are faced with a massive asset devaluation as home prices and mortgage backed security investments decline in value. Banks (such as Bank of America, Citigroup, and Washington Mutual), and financial institutions (such as Vanguard, Fidelity and Putnam) will be reporting the impact of these emerging devaluations on their balance sheets over the next 8 quarters.
Given the large inventory of unsold homes, new home housing starts should decline by more than 15 percent relative to 2006. Financing restrictions will reduce home remodeling activity. Both trends will increase unemployment in the construction industry.
It is likely real estate will be a drag on America’s economy through the end of 2008.
The Oil Factor
In 2006, the United States consumed an estimated 20,700,000 Bl of oil a day, or approximately 7,555,500,000 barrels of oil for the entire year. That’s the equivalent of 65.3 barrels of oil for each and every one of the 115,677,000 households in America. The bill for refined oil products, such as gasoline, diesel, and heating oil fuels, along with the consumption of refined oil as a material used in the manufacture of other products, now exceeds $ 860 billion per year (about 6.5 % of GDP).
In the following chart, the world price per barrel for oil has been plotted against America’s annual average oil consumption per household. Oil is purchased as a refined product by consumers (gasoline, diesel, propane and heating oil fuels, etc.), and by manufacturers who use it as a feedstock or in the processing of other products (plastics, pesticides, cosmetics, pharmaceuticals, etc.). This chart shows it took roughly four years for consumption to decline after the price shock of 1979. On the other hand, the price reduction of 1986 and the lower prices of 1986 through 1999 encouraged only a marginal increase in consumption. The price increases of 2000, 2004 and 2005 have yet to cause any significant change in oil consumption.
Thus, on a per capita and on a per household basis, oil consumption has been relatively inelastic since 1986. (For a discussion of elasticity see “The Elasticity of Oil Production and Consumption” at http://www.culturaleconomics.blogspot.com/). At this point in history, it will take a significant recession, an incredible shift of consumption to alternative fuels, or a deep transformation of lifestyle to bring down oil consumption.
The relationship between oil consumption, expenditures and recessions has been graphed in the chart below. Significant increases in the amount of money America spends on oil (1973, 1979, 1990 and 2000) were followed by a recession. Yes. Other factors contributed to the decline in GDP that characterized these recessions. However, one can not escape a nagging fear that sharp increases in oil expenditures may cause a subsequent recession. Do the huge increases that occurred in 2004 and 2005 suggest the possibility of a coming recession in the 2007/2008 timeframe?
Sharp, sudden, increases in foreign oil purchases are not only inflationary (because they contribute to the devaluation of the dollar), they often mirror subsequent decreases in GDP growth. In the following chart we adjust annual GDP growth for inflation and then compare GDP growth with U. S. foreign oil purchases per person and periods of recession. The key point of this chart is tied to the huge increase in foreign oil purchases that occurred in 2004 and 2005. Prior economic response patterns suggest a possible period of weak or negative GDP growth in the 2007 to 2008 timeframe.
Historically, there has been a good correlation between U. S. oil purchases per person and the rate of inflation. Although there was a lag to the increase leading up to the 1974 recession, spending more on oil has always meant higher inflation (see “Will Higher Oil Prices Fuel Inflation?” at http://www.culturaleconomics.blogspot.com for this discussion). The real puzzle? Why have we not seen a comparable – or even greater – increase in the rate of inflation during this cycle? This chart suggests a period of much higher inflation is just around the corner.
When constructing and analyzing charts like these, there is always the possibility of making a mistake in the process of data collection or analysis. But the odds of a recession induced by sharply higher oil prices (and possible shortages) is consistent with my world oil production and consumption model. Given the evidence, the odds of oil playing a role in either triggering or exacerbating a worldwide recession before the end of 2008 are very high.
Will Lower Interest Rates Help?
Pumping more monetary stimulus into the economy will not do much good because Americans will just send much of it to foreign nations for goods, commodities and debt payments. The value of the dollar (which is already moribund), would most certainly go into a precipitous decline. Because globalization moves money and the means of production around so easily, a surge in fiscal stimulus may not do much to create new jobs in America (or for that matter, in Western Europe or other OECD nations – they all have the same problem). Smaller Federal budget deficits become impossible. Raising taxes would only exacerbate the consumer’s financial quandary. Taxing the rich only serves to increase welfare spending and encourages high rollers to send their money elsewhere.
This scenario will play out – no matter which political party is in power. Liberal ideology hates globalization, but it is reality. Conservative ideology likes to think in terms of global markets, but there is no way to control the economic outcome.
So. We must confront THE essential question. What event, what trend, and/or what circumstance will prompt foreign nationals to decide they must - in their selfish-best-interest - dump American debt?
- It could be the stock market. As of the date of this essay, both the American and the international markets appear edgy. In my opinion, another leg down is certain. Decreasing stock values will rattle the currency markets and increase the fear factor among debt holders.
- It could be a growing fear of recession. In my opinion we are heading for a period of declining GDP. Weakness in the housing market, along with trends discussed elsewhere in this essay, work against the economic health of the world economy.
- It could (easily) be an event in the oil market. Iraq and Saudi Arabia remain vulnerable to disruptive attacks on their respective oil production and transportation infrastructures. American refining capacity is tight, particularly in California where increasing demand is on a course to collide with inadequate supply. Both Iran and Argentina would like to disrupt oil deliveries to the United States. (Although that remains a possibility, both nations need a flow of oil revenues to support their economic and social programs.) And there is always the panic of a disruptive weather event.
So. What is the risk? Will the fear of unknown probability cause more panic than the event itself? In the currency markets, perception is often more important than reality.
It should be obvious the interest rates on America’s debt, and the availability of additional credit, are far more likely to be influenced by decisions made in Beijing or the Middle East than in Washington, DC. Fear and greed drive the international currency markets. If it is perceived that America’s debt burden has become untenable, or if increasing international conflict appears to be inevitable, funds will flow to whatever safe heaven appears appropriate at the time.
Low and middle income consumers are caught in a bind. Do we buy food? Purchase gasoline? Or pay the mortgage? When Congress voted for the corn ethanol program, it basically mandated a permanent increase in the price of food. Competition for arable land insures eating will be more expensive. (see “What is the Real Cost of Corn Ethanol?” at http://www.federalenergypolicy.blogspot.com/). Unless there is a recession, products made from oil – such as motor fuels – are vulnerable to further price increases. For many American homeowners, ARM interest rates are going higher, and it would appear that homeowners are not going to be able to pull much more cash from their real estate loans because housing values are decreasing. These simple facts will force a curtailment of consumer spending. Add growing unemployment, and one could project a devastating consumer financial crisis.
So here we have it. A rather bleak outlook for America. Food prices are headed UP. Energy prices are likely to remain high. It is becoming more difficult to make mortgage and consumer debt payments.
Something has to give.
It’s time to face reality. Based on available evidence, it would appear the United States could experience a recession (as officially defined by the Feds) before the end of 2008. It would appear the odds are better than 90 percent. But that’s not the whole story. It should not surprise us to see declining GDP before the end of 2007, leading to higher rates of unemployment and declining consumption.
If so, the trend to recession will feed on itself. The world economy is at risk for several quarters of sub-par performance.
Ronald R. Cooke
The Cultural Economist
Please note: This essay is presented without any warranty what-so-ever.
References: All data used in this essay may be found on the WEB sites of the United States Department of Commerce, Department of Labor, or Department of Energy.
What do you think? Leave a comment below.
Sign up for regular Resilience bulletins direct to your email.