A recipe for disaster
Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world
—from The Second Coming by William Butler Yeats
Signs of an economic meltdown are springing up all around us. The U.S. is almost certainly in a recession now, but the worst is yet to come. The full consumer price index has risen at a 6.8% annual rate in the last 3 months just as GDP growth has likely entered negative territory, raising the Specter of Stagflation. Americans have not faced such dire straits in 25 years.
When the New York Times feels compelled to reassure us that the chances of a full-blown 1930's-style depression are low, you know something is up. See Depression You Say? Check Those Safety Nets, March 23, 2008. The Bear Stearns debacle, a classic run on the bank, took most observers by surprise. This point was brought home to me personally when Standard & Poors downgraded National City's outlook from 'stable' to 'negative' last week, "citing risk from the shaky housing and mortgage markets." National City is my bank. Deposits are insured, of course, but that didn't make me feel any better somehow.
Paul Krugman joined the chorus, warning that we're Partying Like It's 1929. Alan "Bubbles" Greenspan, who oversaw an economy that is now unraveling, writes that "the current economic turmoil is likely to become the 'most wrenching' since World War II." Even as the no-longer-infallible former Fed Chairman tries to squirm out of this one, Ben Bernanke is left to sort out the mess. Helicopter Ben is cutting interest rates and opening credit windows for banks to "replenish [their] depleted capital," a strategy that is further driving down the dollar's value and boosting pre-existing inflationary pressures deriving mainly from high oil prices and biofuels.
Over the next year we're going to learn a lot about global oil demand and prices. We're also going to learn whether American consumption is still the sine qua non of global economic health it once was. Regardless of the outcome, Americans are in for a tough time. Let's go through some recession scenarios.
Oil Demand and Price in a Recession
In Another Wild Ride in 2008, we noted that American oil demand growth has been slow and steady since 1990, despite two mild, short recessions in 1990-1991 and 2001 (ASPO-USA, December 19, 2008). The American economy had its longest expansion in the 1990's and continued to grow after the post-9/11 recession (graph left from the Times, cited above). This recession promises to be different.
According to the EIA's data for oil products supplied, U.S. demand actually peaked in 2005 at 20,802 million barrels per day (b/d). The data set is incomplete, but demand fell 0.6% in 2006 and was flat at the 2006 level during the last 6 months of 2007 (≅ 20,685 million b/d). This is a modest decrease, considering that the oil price has doubled over the last year.
Last week, the EIA reported that demand for petroleum products fell a whopping 3.2% in the 4-week period ending March 14th, coming in at 20,259 million b/d. Much of the decrease was in distillate fuel oils (-5.4%), which is mostly diesel fuel. Diesel prices stood at an all-time record $4.037/gallon on March 22nd according to AAA's Daily Fuel Gauge Report.
Diesel consumption fell in part because of the end of the winter heating season, in part because of the slowing economy—trucks moving fewer goods from place to place—and in part because of the price. By contrast, inelastic gasoline demand showed only an insignificant drop-off of 0.1%. Gasoline prices are also close their recent record-high.
The consumption signals are mixed. No recession U.S. oil demand trend is in place yet as we approach the "summer driving" season, which may be a bust this year as disposable income for travel becomes scarce.
The main effect of the shaky economy so far has been on the oil price, which has fluctuated wildly in the past few weeks. Traders moved their money into commodities—gold topped $1000/ounce—as a safe haven from an unregulated "shadow banking" system populated by a bestiary of exotic financial instruments in which no one knows the true value of the paper they're holding. Oil prices surpassed $111/barrel but then tumbled to values closer to $100. These actions followed another interest rate cut by the Fed.
Paul Horsnell, a commodities analyst at Barclays in London, asked the pertinent rhetorical question about the "dramatic" fall of the oil price.
“We see headlines: ‘Oil collapses to $102.’ Is that really a collapse?”
If the U.S. economy tanks and oil demand does take a swan dive, what will happen to global oil demand and the price? The answer depends on whether the American consumption still drives the global economy and its thirst for oil.
The Dangers of Decoupling
The term "decoupling" refers to the degree of economic independence of the developing economies from the American market. In Prospects For China, it was argued that 1) Chinese GDP growth, and hence their import levels for oil and other commodities, must eventually slow down to prevent overheating and tame inflation; and 2) China must function within the globalized economy, which implies that they can not push commodity prices up to levels that cripple the economies of their export markets (ASPO-USA, January 16, 2008). China has effectively underwritten debt-financed American ventures like the occupation of Iraq with their massive $1 trillion treasury bond holdings. So it would appear that the U.S. and China are locked in a mutual dependency— if the U.S. economy falters, China's will too.
This "coupling" of the two economies is rapidly losing steam. The decoupling debate, an analysis in the March 6th issue of The Economist, contains data to back up that assertion—
Sales to America will obviously weaken. The point is that [emerging economy] GDP-growth rates will slow by much less than in previous American downturns. Most enjoyed strong growth during the fourth quarter of last year, and some speeded up, even as America's economy ground to a virtual halt [0.6% growth] and its non-oil imports fell...
The four biggest emerging economies, which accounted for two-fifths of global GDP growth last year, are the least dependent on the United States: exports to America account for just 8% of China's GDP, 4% of India's, 3% of Brazil's and 1% of Russia's. Over 95% of China's growth of 11.2% in the year to the fourth quarter came from domestic demand. China's growth is widely expected to slow this year—it needs to, since even Wen Jiabao, the prime minister, warned this week of overheating—but to a still boisterous 9-10%.
Two possible outcomes follow from a substantial decoupling of the American and developing economies and neither is good news for American consumers. First, lower U.S. oil demand would have little effect on oil consumption in the emerging economies. China, Russia and others will likely gobble up the decrease, leaving global demand unchanged. The oil price would thus remain above $90-$100/barrel or continue to rise in a stagnant American economy, giving consumers little reprieve from higher fuel and food costs. See Would a U.S. recession lower oil prices? Not necessarily by the unfailing Jad Mouawad (International Herald Tribune, January 23, 2008).
The second, more speculative, outcome is that the Chinese may lose interest in propping up American spending when they realize that their growth can be sustained without relying heavily on the U.S. export market. Here's a quote from Prospects For China—
As [Atlantic Magazine's] James Fallows points out [in The 1.4 Trillion Dollar Question], whenever a Chinese official raises a trial balloon even hinting at the possibility that the Chinese might start unloading dollars and investing them to subsidize rapid growth in their own economy, "phrases like 'run on the dollar' and 'collapse of confidence' [show] up more and more frequently in financial newsletters." China has deliberately chosen to inhibit their own growth to keep their export customers, especially the United States, happy.
Although the Chinese are heavily invested in the U.S, they may decide to cut their losses, especially if highly leveraged American consumers are no longer buying much of their stuff in a prolonged, deep recession. Imagine the consequences for the shaky American economy should China start unloading dollars. This would give new meaning to the phrase "Cut & Run."
A Meltdown for American Consumers
As if the possibility of China abandoning its investment in the United States weren't bad enough, there is mounting evidence to suggest that American consumers are about to get seriously squeezed. It's not just the investment banks that have a liquidity crisis.
In Not Fixing To Walk, we explored the standard view of economists that rising oil prices have not affected U.S. demand because energy spending is still fairly low as a percentage of all household expenditures, and discovered that this percentage started to rise toward levels last seen in the 1970's and early 80's in 2003 after a brief spike during the post-9/11 recession (ASPO-USA, November 14, 2008). This trend is poised to get worse.
Bear in mind that wages have not nearly kept up with GDP and productivity growth throughout the Bush years, while oil prices have tripled since the beginning of 2002 (graph above left, cited by Jerome á Paris at The Oil Drum:Europe). The media was looking at this topic back in 2006. The Wall Street Journal's Wages Fail to Keep Pace With Productivity Increases, Aggravating Income Inequality was typical (March 27, 2006).
Since the end of 2000, gross domestic product per person in the U.S. has expanded 8.4%, adjusted for inflation, but the average weekly wage has edged down 0.3%...
Some factors aren't in dispute. Since the end of the recession of 2001, a lot of the growth in GDP per person -- that is, productivity -- has gone to profits, not wages... Since 2000, labor's share of GDP, or the total value of goods and services produced in the nation, has fallen to 57% from 58% while profits' share has risen to almost 9% from 6%. (The remainder goes to interest, rent and other items.)
It's easy to overlook rising household expenditures for food or fuel when easy credit is available in the form of Visa cards or home equity loans. It was also possible to refinance and take money out of equity. Credit is now drying up for indebted consumers as housing prices plunge, which puts the bill paying burden on stagnant household income alone. Nine million households have negative equity, i.e. their mortgages exceed the market value of their homes. Mortgage defaults are way up. Here are three among the many recent examples indicating distress—
- By the end of 2007, 36 percent of consumers' disposable income went to food, energy and medical care, a bigger chunk of income than at any time since records were first kept in 1960, according to Merrill Lynch. (Associated Press)
- Americans' percentage of equity in their homes fell below 50 percent for the first time on record since 1945, the Federal Reserve said Thursday... That marks the first time homeowners' debt on their houses exceeds their equity since the Fed started tracking the data in 1945... Economists expect this figure to drop even further as declining home prices eat into the value of most Americans' single largest asset. (Yahoo Finance)
- The Great Unwind has begun, Citigroup warns — Avoid leveraged companies, countries and consumers, bank's strategists say... "Easy money encouraged many to buy a bigger house, a bigger car or a bigger speculative position... But now, any behavior that relied upon continued access to easy money is being dramatically reassessed," [Citigroup] added. "Leveraged banks must lend less, leveraged consumers must consume less, leveraged companies must acquire or invest less, and leveraged speculators must speculate less." (MarketWatch)
There you have it: continuing high energy and food costs, contracting credit, stagnant wages and increasing property debt. Highly leveraged or poor American consumers—this is just about everybody who isn't among the richer rich—are about to get nailed. The day of debt reckoning has arrived as the U.S. receives a long overdue margin call (Wall Street Journal, March 15, 2008).
Consumer spending makes up about 70% of GDP. The money squeeze is a recipe for disaster. Household finance will be getting more unmanageable for Americans, who have been living the high life made possible by easy credit following from rising house prices. The only silver linings are that American exports are up and we're getting more foreign tourists because of the shrinking value of the dollar.
On the oil front, it appears that reduced demand in a cash-strapped American economy is unlikely to lower oil prices much as the recession unfolds, but all bets are off—no one knows how much demand will be affected yet. If China and the other emerging economies truly are "decoupled' from American consumption trends, it won't matter much if U.S. demand falls off significantly in any case.
The Chinese will be partying at the Beijing Olympics while Americans be scrambling around trying pay their mortgages and make ends meet at the fuel pump. Kind of symbolic, don't you think? Here's an idea—why don't we build some light rail systems?
Contact the author at the original article.