The Dire Position of the US Economy

Yes, cheer up everyone, the 'Great Recession' has come to an end. Or so says the New York Times, in yet another positive article:

Even as evidence mounts that the Great Recession has finally released its chokehold on the American economy, experts worry that the recovery may be weak, stymied by consumers’ reluctance to spend.

Here we go again. The 'mounting evidence' that all is well in the world after all. The problem is that, having told us that all is well, the article goes on to say the following:

Given that consumer spending has in recent years accounted for 70 percent of the nation’s economic activity, a marginal shrinking could significantly depress demand for goods and services, discouraging businesses from hiring more workers.

Millions of Americans spent years tapping credit cards, stock portfolios and once-rising home values to spend in excess of their incomes and now lack the wherewithal to carry on. Those who still have the means feel pressure to conserve, fearful about layoffs, the stock market and real estate prices.

So what of the recovery? With consumers quite reasonably digging in their heels and refusing to spend, and consumer spending having been 70% of economic activity, where exactly is the recovery coming from? The basic contradiction between the opening of the article and the content is completely lost on this author. He even highlights one of the artificial props to the so-called recovery, writing:

In recent weeks, spending has risen slightly because of exuberant car buying, fueled by the cash-for-clunkers program. On Friday, the Commerce Department said spending rose 0.2 percent in July from the previous month. But most economists see this activity as short-lived, pointing out that incomes did not rise.

If this is a recovery, then I would really like to see how they might define a bad economic situation. As such, a brief review of some of the highlights of the US economy....

Let's start with the banking system. It is all tickety boo, is it not? The first problem is that, at the commanding heights of banking, there are the zombie banks with portfolios filled with toxic waste. Whilst the world appears to be sunny, this is largely down to the accounting fiddle of FASB 157 (Financial Accounting Standards Board), in which the standard of Mark-to-Market standard 'fair value' of assets was watered down. What this means in plain English is that the valuation of assets has been moved from being what they can actually be sold for in the open market, to what they might be able to make if the world was a wonderful place again.

The excuse for this change to the rules was that there was no market for the assets, due to a collapse in banking liquidity...but even at the time of the change, there was a massive pool of liquidity 'out there', for example in sovereign wealth funds (who are estimated to have over $US 3trillion in assets). If the toxic waste on the bank balance sheets were of any value, then there were plenty of potential buyers out there, so there has always been a market for these assets in principle. The problem is that they are junk, and the change to the accounting rules has simply hidden this.

As if this were not bad enough, the meltdown of retail mortgages is now going into the new phase, which is the rise of prime mortgage defaults:

The percentage of loans on which foreclosure actions were started was 1.36 percent, down from 1.37 percent in the first quarter, driven by the decline in subprime loans. New foreclosures on prime loans increased to 1.01 percent from 0.94 percent, while subprime loans dropped to 4.13 percent from 4.65 percent, Brinkmann said.

The delinquency rate for prime loans rose to 6.41 percent from 6.06 percent, and the share of prime loans in foreclosure increased to 3 percent from 2.49 percent.

To add to the misery to come, we have this from the Economist magazine (the chart referred to shows the growth in resets):

Just as worrying is the possible recurrence of “payment shock” as interest rates on adjustable-rate mortgages reset higher. Resets on subprime loans have mostly taken place, but the worst is yet to come for some other loans, especially the “Alt-A” category between prime and subprime and a nasty type of mortgage called an “option ARM” (see chart 3). The impact may be muted, but only if the Fed can keep short-term rates very low for the next couple of years—or if the borrowers can refinance as the reset approaches.

As a final addition to the nasty state of retail mortgages, there are new problems being stored up for the future, with Ginnie Mae racking up new dodgy loans:

This extraordinary resilience reflects the widespread political lust in America for subsidising housing. Anyone who doubts this should look at Ginnie Mae, another fully state-owned agency which guarantees and bundles mortgages, usually of below-average quality, that are insured by the government. Fannie and Freddie are now being conservative about writing new business, but Ginnie is enjoying its own bull market, issuing guarantees at a furious rate. It is expected to have a trillion dollars outstanding by next year. “We are seeing a gravitation of the subprime universe from Fannie and Freddie to Ginnie”, says Mr Setia. It will be a miracle if taxpayers get their money back from Fannie and Freddie. Worse, there is a chance the disaster will be repeated.

What this means is that there is an ongoing attempt to reflate, or at least stabilise the housing market, and the US taxpayer will be on the hook for the fallout. Without such irresponsible lending, the crisis in the housing market would no doubt be even worse, but the future liabilities are undoubtedly racking up.

Then there is the commercial real estate meltdown that is finally arriving. I have spoken about this in the past, but it has taken longer than expected:

Defaults of multifamily and commercial real estate loans from banks climbed to their highest rate since at least 2003, as lenders gave up hope of being repaid in full, according to a report by research firm Real Estate Econometrics.

The default rate of bank loans for shopping centers, office buildings, warehouses and hotels rose to 2.88 percent in the second quarter, up 0.63 percentage points from the prior quarter, according to the report released on Monday.

The default rate for apartment buildings rose 0.68 percentage points in the second quarter to 3.13 percent.

The results of these ongoing crises is an endless stream of bank failures, with many more to come yet. The Federal Deposit Insurance Corporation's (FDIC) latest report makes ugly reading, and there is widespread speculation that the solvent banks will shortly be tapped for huge sums of money to fund the depositor insurance for the failing banks.

Bove said the FDIC will likely levy special assessments against banks in the fourth quarter of this year and second quarter of 2010.

He said these assessments could total $11 billion in 2010, on top of the same amount of regular assessments. "FDIC premiums could be 25 percent of the industry's pretax income," he wrote.

It appears that all is not so tickety boo in the world of finance. In fact, the crisis is just being buried away. We then have the problems of rising unemployment, which is further feeding into the downwards spiral of the US economy. Whilst there have been a few slightly positive signs of late, the trend is still firmly downwards:

The government announced that the jobless rate had fallen one-tenth of a point to 9.4 percent in July on narrowing job losses but analysts say the rate could soar to about 10 percent by year end even with an improving economy.

Perhaps the most worrying aspect is that there is no expectation of recovery in jobs in manufacturing. This from the President of the Atlanta Federal Reserve:

'Unfortunately, time may not return manufacturing employment to pre-recession levels,' he added. Between 1965 and 2000, manufacturing employment generally fluctuated between 16.5 and 19.5 mln jobs. But in the first years of this decade, the number of manufacturing jobs have fallen to just over 14 million and have continued to drift downward, Lockhart said. 'The harsh financial constraints of this recession appear to have accelerated this secular decline.'

The picture already looks pretty bleak, but the real unemployment rate is considered by many to be far higher than the headline figures suggest, according to the Economic Policy Institute:

The real unemployment rate nationally is nearly 17 percent, instead of the official 9.4 percent, when discouraged workers and part-timers who want full-time employment are factored in. Other workers have seen their hours cut or been forced to take furloughs.

Meanwhile, the number of Americans out of a job for six months or more is at a 70-year high.

The result is a huge labor glut at a time when net job gains are scarce or nonexistent. Observers celebrated when the national economy lost only 247,000 jobs in July. (Washington state even added 4,000 new jobs in July.) The U.S. number would be a catastrophe in most circumstances, but was better than the more than 700,000 lost in January. Yet the American economy must add 127,000 jobs a month just to keep up with natural population growth.

At this stage I will halt with the state of the real economy. For each harbinger of recovery touted by the media, there is a mass of data that suggests the real depth of the underlying problems. Furthermore, even where there are upticks, what we are viewing is the artificial life support being provided by the government, such as the 'cash for clunkers', the absurd lending of Ginnie Mae, or the so-called federal stimulus. That this comes at huge future cost is simply forgotten by the cheerleaders for the view that the economic crisis is at an end.

Perhaps the surest indication of the scale of the underlying problem can be found in how those outside of the US view the state of the economy. The chart below shows net capital inflows into the US, and that there is now the start of a dramatic outflow of capital.



It seems that overseas investors are not too impressed with the recovery, or the prospects for the US economy. It is no wonder really that they are reacting this way, with fiscal deficits climbing to shocking levels, monetization of government debt through money printing by the federal reserve, and an economy still in free fall. The overseas creditors can clearly see that there is no sustainability in the US economy.

The bottom line is this. Trying to borrow yourself out of a recession caused by too much borrowing is just plain silly. It would be laughable, were it not such a tragedy. The actions of the US government are attempts to turn back time. They are trying to support an economy that was always unsupportable. Consuming more than you produce is just unsustainable, and no matter how many economists line up to tell you otherwise, it is the underlying reality that must be addressed.

Perhaps the most shocking part is that the borrowing binge is not even managing to support the economy. All of the costly measures are still not enough to brake the US economy from a downward spiral. This begs the question as to how bad the US economy really is. I am guessing, and it is no more than a guess, that the answer might start becoming apparent towards the end of the year. At some point, the great unwinding must take place, and then it is time to reach for your hard hats. The ride has only just started, and it is going to get very bumpy.