Shutdown economics 101: Kudlow versus Reich (Part 8 of 10)
The below graph reflects the dynamics of savings and investment in the US versus consumption and corporate profits. The yellow line reflects an ongoing decline in the national savings rate from roughly 20% of gross domestic product (or GDP) to 12% of GDP today. Plus, personal savings (the green line) as a percent of disposable personal income have declined from around 10% during the Reagan years to a low of closer to 2% during the housing bubble, though they have recently bounced back to near 7% today as a result of the weak economy. As for investment, the grey line reflects an ongoing decline from around 20% of GDP to closer to 15% of GDP today, while the long-term fixed-asset component of private domestic investment (the blue line) has declined from 8% levels in prior to 2001 to more recent levels averaging closer to 4%. This decline in fixed investment is of key concern to prior Federal Reserve Chairman Alan Greenspan, and it’s examined in further detail in a related series. This article examines trends in savings and investment versus consumption and corporate profits, and considers the implications these trends may have on US equity markets.
Consumption and corporate profits
The thick black line (note the left axis) reflects personal consumption in the US. It has risen from approximately 62% of GDP in 1981 to approximately 70% of GDP today. So the composition of US GDP has seen consumption grow by around 8%, while investments have declined by 4%. Increased government spending and trade deficits account for the other 4% of GDP. The trade deficit had been close to zero in 1980, though it reached 6% of GDP by 2005 and currently stands at 3% of GDP. The government budget deficit reached nearly 10% of GDP in 2009, though it stands at closer to 4% of GDP for 2012. Despite the decline in investments, strong consumer spending patterns, in conjunction with large government deficits, have kept corporate profits (the bold red line) on a positive trajectory—exceeding 12% of GDP in 2012, and estimated at $2 trillion for 2013. This is record-setting data for profits.
Shutdown economics: Who is to blame?
With the federal government facing a growing shutdown, and rumors of default possibilities circulating, you wonder who’s to blame for these large deficits. As the above graph suggests, it would appear that the US has no one to blame but itself. Especially since the Clinton Administration, the US economy began to suffer from a recession in investment—especially in the area of long-term fixed investments, which include factories and long-term use structures.
Kudlow’s supply-side baby in the bathwater
Faced with such a decline in items that would enhance the future productivity and purchasing power in the US, did the country tighten its belt and consume less after 2001? No. Quite to the contrary, the US consumed even more—and saved even less. As Larry Kudlow would be quick to point out, the Bush Tax Cuts of 2001 and 2003, in conjunction with low interest rates, seem to have led to a temporary turn around in fixed investments—most likely the result of the US housing bubble. However, when the housing bubble burst, all of the above data was hit hard. Yet most of the post-crisis recovery has reflected in strong corporate profits and sustained levels of consumption, despite high levels of unemployment in the broader labor pool. From Kudlow’s perspective, you should be careful of throwing the supply-side policies of low taxes and small government out with the 2008 financial crisis bathwater. You should be careful to distinguish between the economic effects of lower tax rates on the economy and the effects of “well-intentioned” financial regulation gone awry. This is particularly true in the sub-prime area of the US housing market, which was also encouraged by the Clinton Administration’s changes to the Community Reinvestment Act, and Democrat Larry Summers’s financial deregulation efforts.
Reich’s Keynesian defense
While Robert Reich might acknowledge the positive effects that lower taxation had on the US economy from Ronald Reagan through Bush Jr., he would likely remind us that these historically low rates have, in the long run, led to an increased level of income and wealth inequality, which, after thirty years, has finally hollowed out the American middle class. And as a result, the entire spectrum of economic data is finally showing signs of deterioration, as reflected in the above graph. In short, the fertile soil of the American middle-class consumer-driven society has been leached, and the top few percent have made off with the majority of the wealth these short-term-thinking policies have created.
Excess consumption post-2001: How did this happen?
Economists such as Alan Greenspan suggest that the US has relied too heavily on debt-financed consumption to grow its economy in recent years—both in the private and public sectors. As a result, investment data has remained chronically weak, especially since 2001—with the exception of the housing bubble from 2003 to 2007. The 1999 Gramm-Leach Billey Act (also known as the Financial Services Modernization Act) repealed parts of the 1933 Glass-Steagall Act, which had prohibited banks from essentially competing with investment banks. Plus, ongoing regulatory changes associated with the Community Reinvestment Act (or CRA) from 1992 through 2008 appear to have led to improving credit to lower income borrowers—essentially giving birth to the subprime market.
With the increase of adjustable-rate mortgage products and enhanced competition between commercial and investment banks due to the essential repeal of Glass-Steagall, lower FICA scores entered the mix, and large amounts of subprime mortgages grew rapidly. Investment banks made increasingly aggressive loans, and used higher levels of leverage—retaining razor-thin equity cushions to protect them in case of worsening credit conditions. Eventually, the subprime mortgage pools performed worse than anticipated, despite their AAA ratings from Moody’s and Standard and Poor’s. The credit crisis ensued, taking out investment banks such as Bear Stearns and Lehman Brothers, and aggressive mortgage lenders such as Wachovia and Washington Mutual (or WAMU). Only the “too-big-to-fail” banks survived, also known as the “SIFIs”—systemically important financial institutions.
Continual voter’s rage: The end of the wealth effect
As a result of the ensuing financial crisis, the average American, who had the large majority of their wealth in their home, was hit very hard, with the Federal Reserve Bank estimating that the average American lost 40% of their net worth in the financial crisis. Housing prices have recovered 50% from their lows according to the Case-Shiller Index. Though it’s estimated that nearly 25% of all US homes are still worth less than their mortgages (Zillow negative equity report). Essentially, after a long period of excess consumption and insufficient investment, consumption post-2001 was fueled by the home equity bubble. With that bubble burst, the US must now look to more sustainable means of economic growth, or confront a combination of rising government deficits in conjunction with less consumption. Essentially, this will mean a lower standard of living.
Which, but the shutdown’s end could not remove…
As the last gasp, the post-2003 housing bubble has come to an end. The government has doubled its publicly held debt under the Obama Administration since it would appear that the government shutdown, and veiled threats of default, are the inevitable consequences of this ongoing dramatic tragedy. The ancient grudges of tax policy and government spending have manifested themselves in the divided Republican House and the star cross’d Democratic Senate—the modern-day Montagues and Capulets. Which, but for the shutdown and resolution, has yet to remove the continuance of voter’s rage. The high-stakes drama continues, with an estimated climax on October 17, when Treasury Secretary Jack Lew will have to make some very deep spending cut decisions. While it’s highly unlikely that the US will miss payments on interest or meet Treasury Securities redemption requirements, there are a lot of spending programs in the front of the line that could be hit very hard.
Shutdown investing: Outlook
Should Congress and the President fail to make progress on budget discussions, investors may wish to consider limiting excessive exposure to the US domestic economy, as reflected more completely in the iShares Russell 2000 Index (IWM). Alternatively, investors may wish to consider shifting equity exposure to more defensive consumer staples–related shares, as reflected in the iShares Russell 1000 Value Index (IWD). Plus, even the global blue chip shares in the S&P 500 or Dow Jones could come under pressure in a rising interest rate environment accompanied by sequester-driven declines in consumption, investment, and economic growth. So investors may exercise greater caution when investing in the State Street Global Advisors S&P 500 SPDR (SPY), Blackrock iShares S&P 500 Index (IVV), or the State Street Global Advisors Dow Jones SPDR (DIA) ETFs. Until consumption, investment, and GDP start to show greater signs of self-sustained growth, investors may wish to exercise caution, and consider value and defensive sectors for investment.
Browse this series on Market Realist: