Why This Recession Will Be A Doozy

The last recession was mild. The stock market and corporate profits tanked, but consumer spending--long the major engine of our economy--danced merrily on through. In recent decades, it has ever been thus: bearish analysts and strategists have been underestimating the voracious spending habits and resilience of the US consumer for 50 years.

Unfortunately, at risk of invoking the four most expensive words in the English language, "this time it's different."

Why?

Because the US consumer is finally broke. For thirty years, we piled on debt and then spent almost every new penny we got. This borrowing spree was made possible by a smorgasbord of no-money-down lending products and ever-appreciating asset prices. Unfortunately, the situation has now changed. The lenders who created those products have now been demolished, and asset prices are falling fast. And this is leaving American consumers with no choice but to cut back.

A few exhibits:

US debt has risen from 163% of GDP in 1980 to 346% in 2007. Household debt, a subset of this, has risen from 50% of GDP to 100%. (Please click here if you would like to see charts that illustrate the points I'm making here)

Have we been dependent on this growing debt to finance our spending? You bet.

Analyst John Mauldin explained this week how growing consumer debt in the form of Mortgage Equity Withdrawals allowed consumer spending to power right on through the last recession (What's home-equity withdrawal? When your house price rises, you borrow more, keeping your debt to house-value percentage the same. Then you spend these "earnings.").

Thanks to the housing crash, consumers have less and less mortgage equity to withdraw, so this source of cash is rapidly disappearing. As consumer net worth shrinks, other sources of financing--credit cards, home equity loans, car loans, student loans, etc.--will follow a similar path, and consumers will increasingly be limited to spending what they make.

Jeremy Grantham's quarterly letter takes a more macro view. Specifically, he explains the difference between the growth of an economy in which consumer debt is continually growing as a percent of GDP and one in which it is shrinking. Jeremy's bottom line is that household borrowing has added 1 point to annual consumer spending growth for the past 25 years. It won't be doing that anymore.

Jeremy's explanation of this effect is complex but important, so here it is:

We were all spending... as if we were much richer than is in fact the case. Particularly here in the U.S., increasing household debt temporarily masked some of the pain from little or no increase in real hourly wages for 20 to 30 years. Household debt since 1982 has added over 1% a year to consumer spending. Unfortunately, this net benefit does not go on forever.

In the first year in which you borrow 1% of your income, the interest payment barely makes a dent and your spending is close to 101% of your disposable income. But each year you borrow an incremental 1%, your interest load grows. After 15 years or so in a world of an average 7% interest rate, the interest on the accumulating debt fully offsets the new borrowing when one looks at consumers collectively.

Well, we in the U.S. are closer to a model of 30 years of borrowing an incremental 1%, meaning that we passed through break-even years ago and now pay much more in interest than we borrow incrementally. This is a situation favorable to an overfed financial structure as long as everyone can and will pay their interest, but it is no longer benefi cial to aggregate consumption compared with the good old-fashioned way of waiting until you had actually saved up to buy a TV set. Indeed, a visitor from Mars examining two countries, one with accumulated consumer debt of 1.5 times GDP and the other with zero, would, I am sure, notice no difference except for the reduced number of consumer lending outlets.

This generally unfavorable picture gets worse when you consider that we are likely to have, for the next 10 years or so, a modest annual reduction in personal debt of, say, 0.5% of gross income per year as well as a continued interest payment. So the debt accumulation effect reverses as does the illusion of the wealth effect from overpriced stocks and
housing, especially the illusion of a decent accumulated
pension.

As we said two years ago (embroidering on Buffett), when the tide of overpriced assets goes out, it will be revealed not only who is not wearing swimming shorts, but also who has a small pension! Our silly joke has become a sick one in just two years.

This reversal of the illusory wealth effect added to deleveraging will be felt worldwide, but especially in theso-called Anglo-Saxon countries, and will be a permanently depressing feature of the next decade or so compared with the last decade. It is indeed the end of an era.

Bottom line, the outlook for consumer spending over the next couple of years is lousy. On a real (inflation-adjusted basis), it went negative in Q3 for the first time in decades. September's awful retail sales suggest that the pain is just beginning.

See Also: Stocks Could Drop Another 50% But Still Time To Start Buying

Comments

[Vurz]

Not everyone borrowed and borrowed. Some of us lived within our means, bought a house for shelter, a car for travel from point a to point b, inexpensive tv, etc. We're fine.

[wendynyc]

This is the no-Regulation Big - Corporate Agenda as supported by the GOP for the last 30 years.

I heard someone on CNBC this morning say how great Reagan was and how Kennedy, Carter and Clinton had been bad for the US Ecopnomy!

[wendynyc]

I saw a young woman on CNN the other day - recent graduate with $40,000 in college loans had just lost her job, her apartment and now her car was towed away as well. She was so depressed and bewildered.

[chendri887]

Thanks, American right. You've done a fine job of destroying this country.

[MikeJo]

Its been clear to me for year that what a huge mistake the USA was making. I just dont see how so many can be brainwashed into believing that exporting all the baseline industries a nation needs to be a power is somehow good. At the same time the boarders were thrown wide open while unions were discouraged in every way possible. Wages have been suppressed ruthlessly except for the CEO class.

Yet I see some folks fighting so passionately for this policy. They have been so thoroughly brainwashed by the trickle down theory . You know , the one that has so completely proved a lie. It was trickle out, now down . They took their assets offshore , kept there snout in wallstreet and handout in mainstreet The better to thoroughly milk the hardworking bill paying borrow crazy public that were convinced that you should NEVER EVER make a corporation pay tax or answer to the public for there actions.

I could go on and on but you get the point i hope

[WritusMaximus]

Recession trumps the best of plans. Another title/subtitle for the article:" Why Obama will ditch his agenda to raise taxes and expand government." Then again he might throw caution to the wind and go full steam ahead, guaranteeing Obama of being a one-term prez and the Clintons' "Hillary in 2012" agenda.

[leftcoastindy]

What does less consumer spending, and less incurred debt have to do with raising taxes on the wealthy? Are you suggesting that the people going into debt were the ones making over $250K?

Raising taxes on the wealthy can happen no matter what the economy does.

Lowering taxes on the wealthy was done to supposedly jump start the economy. I must have missed the bump, but I did stay at Holiday Inn Express.
I also took out loans on my house to buy the big screen. Now I can watch the economy go bust in HD.

[Konnie]

it ain't over.................there are a couple more shoes to drop folks..........mortgages have lead the way............next will be the car loans and leases...........wait till ford and gmac come cryin' with their hands out...............then after them it will be the credit card issuers...........they can lower minimums and raise interest rates until the cows come home, but if the card holders are unable to scrounge up enough to pay for their home and car, they certainly aren't going to pay for a credit card. just wait until mastercard and visa come to washington.................then it will be the cities and towns across the country who can not collect property taxes.............all those cops and firemen are going to be laid off without some assistance...........and then when the jobs are gone, and the health insurance has dried up..........the hospitals are going to be squeezed..........thanks wall street! i think all of you bastards should be in jail and everything including your belly button lint confiscated and given to the treasury.
your houses turned into condos for extended families...............and everything else sold off.

[MilwaukeeDan]

Mr. Blodget, investor Peter Schiff has been harping about this for years,www.europac.net, but who listens to him? The smart money does. He predicted most of this mess years ago. He and his clients are doing quite well.

[DuganS1]

Schiff is an interesting guy, although a bit crazy. Keep in mind he's been a short seller for ages, long before the current downturn, and thus was wrong about the economy for many years and lost his clients a lot of money until finally he recently became right. Roubini is the same. He's been a doomsday theorists every year for the last 20 and now is seen like some kind of profit because over these last two months he was finally right.

[americaforme]

Why does it take us so long to digest these predictions? We need to swallow hard, and face our new poverty. The rich wont escape this 360 turn either. Shop until you drop, was an obsession of the average American. I have friends who left bags of junk and stuff in the car. Thats the way many were raised, it was a high to buy, buy, buy. Shopping Malls loomed on our horizon, like a call to Mecca. When the outsourced goods quality was poor, nothing like American made, we still stuffed our carts full. I even embarrassed myself with my addition, to spend, spend, spend. I've turned the corner now and like any addition, the desire has left. I can even pass Barnes and Nobles, without a sigh. I wish jobs would come back, industries that were lost in the last 30 yrs. we need the pride of American made. Our kids need vocations, in earlier yrs. to be prepared for our industries. Nano Tech. should be Americas goal, robotics into the future. We can do it, we can stop buying junk and stuff too.

[DuganS1]

The mortgage debt is mainly concentrated in a few areas (CA, Miami, Vegas, Phoenix) and should correct through the large population growth in those areas as well as by the banks and institutions holding the mortgage backed securities taking most the losses. The "outsourced" goods have been a boon for consumers by keeping prices down, by increasing the total number of goods and services available, and by increasing the quality of goods at low prices points. This phenomena should maintain itself over the next years and China keeps their currency low relative to the dollar to maintain market share. Many of the "industries lost in the last 30 years" were simply inefficient and/or didn't make any money and went out of business or went away.

[MilwaukeeDan]

DS, you obviously didn't read Mr. Blodget's blog, it's about household debt, personal debt and consumption and it's affects over the last 30 years. Your first sentence is totally false, foreclosures are all over the country and California, Florida, Nevada and Arizona are not Montana, those states are 20+% of the US population. If you read Mr. Blodget, you would see that we will soon no longer be able to afford the junk outsourced goods you talk about and it's hard to compete with slave wages. "Outsourcing" is the quickest way to third world status, give it a couple more years.

[Kassandra]

You're whistling past the graveyard, my friend.

The poverty of the next several years is going to shock and awe America. I too had a spending addiction in the late 90's and early part of this century. when it caught up with me, I was VERY glad I'd paid attention to what Bush and the Neo-Cons were doing to this country; especially the "Bankruptcy Reform" where the average person can no longer TAKE bankruptcy and if you DO get some relief, it's taxed. Yup. taxed.

The corporations who've sold this country down the river CAN take bankruptcy, but you and I lose everything. I got out just in time; because I was paying attention while other people were calling it "politics".

That "Bankruptcy Reform" law HASto be doen away with or we'll all be out in the streets. The future looks pretty dim right now for everyone who has leveraged their lives.

Needless to say, I pay as I go now. That's why Obama or McCain(god forbid) HAS to raise taxes. We have been spoiled, not only lied to over the last 30 years, and this is truly the end of the world as we know it. The Christains can take heart from that!

[EinChicago]

As a liberal, we have to hope Mr. Blodget is wrong. If Obama wins, he will get at most 18 month sto turn the economy around before the re-election cycle kicks in. 2007-2008 as established the 2 year election cycle. It used to be that the population's impression of the economy was set by labor day. Now it is more accurate to say it is set by Indepndence day of the preceding year.
Iif Mr. Blodget's prognostications are true, we're likely looking at another Carter type scape goat term ushering in 12-16 years of GOP rule again. for all our sakes, we better hope he is very, very wrong.

[joebaggadonuts]

If he's not wrong, 18 months is all we get to edumacate the populace.

[Kassandra]

There you go.

[Kassandra]

We can "educate" the populace with prosecutions of the criminals who've stolen America.

Let's start with the vote suppression tactic so they never happen again and move along to the corporate thieves...this has already begun.

[KillTheMessenger]

What an eloquent explanation. Sadly, just like two years ago, nobody is listening. Bernanke of the Fed (somebody get me some coconuts, we need to borrow background sound from Monty Python) just declared that "it's just a flesh wound" and he will kick the economy's ass with lowered interest rates.

Go figure... how much longer is this insanity to go on?

[MajorKong]

"little or no increase in real hourly wages for 20 to 30 years"

Note to Corporate America: You did this to yourself.

The American worker whose job you sent overseas now can't afford to buy your product. The Chinese slave laborer who now does that job doesn't make enough money to buy your product. So now who's your customer?

[Paul]

Exactly.

[KillTheMessenger]

It's called "un-development", that's when you take a developed country with a working health care and retirement system and living wages and you un-develop it into a third world country with lots of poverty and a Banana Republic for the political system.

[rich misty]

The GOP is so proud of all they have done to destroy our country.

[DuganS1]

The "real wage" statistic is meaningless. It has barely increased in 35 years. One reason is that it's not a good reflection of how much money folks actually have. "Real disposable income" (income after taxes) is a much better measurement and shows strong increases over the same period. Plus, the "real" means inflation; and housing has been one of the biggest parts of inflation over the last decade but that inflation doesn't apply to homeowners who don't see their mortgages go up when the value of their asset (house) went up. Often times, homeowners have even been able to refinance at lower rates freeing up money or have been able to take out home equity loans when the value of that asset increased, so they've benefitted from housing inflation and shouldn't be penalized for it in the inflation and real wage statistics.

[KillTheMessenger]

Dugan, stop the GOP spin tank shilling. It's getting lame.

Refinancing is still not a source of income. It's just another stay of the execution for many who have no savings but the value of their home and even most of that is borrowed money, anyway. For those who thought they can spend now and cash out later the current housing crisis is just as much of a trap as for those who bought in too late for too much.

You are trying to pretend that one can improve an economy by constant borrowing. Well, the truth is, one can't. One can only play a Ponzi scheme where some people borrow to go broke and other people cash in the borrowed money and make a living, for a while.

Please look at the definition of Ponzi scheme and compare with current events:

http://en.wikipedia.org/wiki/Ponzi_scheme

And even that is not a correct description of what has been happening here because much of the money we are talking about ended up building palaces in Saudi Arabia and cities for millions of people in China. So even the winners of our world economy chain letter didn't keep most of the profits but those went to the people who had a real business (natural resources and industrial production) going.