SERIOUS MONEY:Advance in US stock prices does not mirror changes in household finances, write CHARLIE FELL.
US STOCK prices have advanced by more than 20 per cent since early March as investors have taken hope from incoming retail and consumer spending data that the worst of the recession has passed. However, the notion that the United States’ beleaguered consumer is setting the stage for economic recovery is wishful thinking.
Massive wealth losses, excessive debt and falling real incomes due to rising unemployment mean that US households face a protracted period of rehabilitation.
The sustained increase in asset prices that accompanied the “great moderation” through the 1980s and 1990s convinced an entire generation of US households that disposable income could be virtually consumed in full and that wealth accumulation could be left to the natural increase in stock prices. The real net worth of households compounded at an annual average rate of more than 5 per cent from 1990 to 2000 and surveys taken at the height of dotcom mania reveal that consumers expected double-digit annual gains in stock prices to persist into the indefinite future.
A change in household behaviour confirmed the increasing exuberance as the savings rate dropped from its long-term average of 8 per cent to just 2 per cent by the end of the decade.
The increase in wealth also convinced consumers that they could accommodate higher levels of debt to accelerate consumption. The increasing impatience to spend saw outstanding debt compound through the 1990s at an average annual rate of 1½ percentage points above economic growth. As a result, the household debt/GDP ratio climbed by roughly 10 percentage points to more than 71 per cent by the decade’s end.
The notion of autonomous wealth creation through ever-increasing stock prices was dealt a severe blow when the technology bubble imploded. Alan Greenspan rode to the “rescue” with aggressive monetary easing and subsequently kept interest rates far too low for far too long. Interest rates sat three percentage points below that prescribed by generally accepted policy rules in 2004 and, all too predictably, irrational exuberance simply shifted from stock prices to the housing market.
Overly accommodative monetary policy contributed not only to rising home prices but also to a plethora of innovations in the mortgage sector that enabled households to indulge their impatience to spend despite stagnant real incomes. The use of mortgage equity withdrawals to boost consumption became the norm and averaged more than 5 per cent of disposable income from 2004 through 2006. At the same time, the need for down payments, income documentation and even timely mortgage payments on new home purchases disappeared.
The treacherous path on which US consumers walked was clear, but illusory wealth gains ensured that the perilous state of household finances remained hidden. The personal savings rate dropped to zero while outstanding household debt increased at a double-digit annual rate from 2000 to 2007 or more than double the rate of economic growth.
The excessive accumulation of debt saw the household credit/GDP ratio jump a staggering 30 percentage points to more than 100 per cent in just seven years, but the extraordinary increase in house prices meant that no noticeable rise in the ratio of debt to assets was detectable.
The asset-based economy has now moved into reverse and it is plain for all to see how unstable the fundamentals underpinning the previous economic expansion truly were. The savage drop in house and financial asset prices through 2008 saw households lose some $7.5 trillion, the largest hit to household net worth since record keeping began in 1952. Net worth has dropped from a peak of 6½ times disposable income at the height of the previous expansion to less than five times today.
Households have lost more than one-third of their home equity or $4.6 trillion since the fourth quarter of 2005. At the end of 2008, homeowners’ equity stood at just 43 per cent of the value of their homes. Almost one in four homeowners could find themselves with negative equity before the housing market hits bottom and roughly 40 per cent of all families with net worth of less than $10,000.
Balance sheet repair has begun and the contraction in household borrowing during the fourth quarter of last year is both dramatic and unprecedented. Outstanding debt dropped at an annualised rate of 2 per cent, bringing the full-year increase down to less than half a percentage point while home mortgages recorded their first ever annual contraction.
The personal savings rate has jumped to 4 per cent, but still remains at roughly half the level that was typical in the 1970s and 1980s. It may not rise much further in the immediate future and, with more than 15 per cent of the labour force either unemployed or underemployed, it is clear that the coffers of America’s beleaguered consumer will remain bare.
The demise the asset-based economy in the US is in full swing as, one by one, the economic fictions that became conventional wisdom have been exposed. Debt cannot increase at a more rapid pace than the economy indefinitely and the same is true of wealth. Indeed, growth theory illustrates that a market economy requires three to four units of capital to produce one unit of output.
The United States’ wealth/ GDP ratio ranged from 3.2 to 3.8 until the 1990s when it soared to almost five. Mean reversion, however, has shaken household beliefs and it is clear that America’s middle classes have no option but to save for their retirement the old-fashioned way.
