One of our brokers in India called us the other day, excitedly exclaiming, “Bernanke is going to buy a further $1.2 trillion (Rs60.6 trillion) of assets, time for us to start buying too!” While we didn’t say it to him in these many words, our response should have been, “Son, neither have we seen a recession like this, and nor have you!” Sure, the markets are gung-ho about the US treasury’s toxic asset plan to take legacy assets off bank balance sheets. Be it the Federal Reserve’s money printing or the US government’s repeated attempts to prop up the financial system, we contend the excitement is premature—far too premature.
To elaborate on why we say this, consider the following: a common Indian family puts away in saving a significant portion of its monthly pay cheque, and assets such as real estate, gold or, until recently, even stocks, were meant to be stashed away— not touched but passed on from generation to generation. Contrast this with the typical American household that has not only spent its entire pay cheque, but also dipped into its assets to prop up spending. In the Indian context, it would not even seem conceivable to do this, especially with real estate assets, but, in the US, as home prices were going up, the home owner effectively owned a larger part of his house—his equity—and borrowed further against this equity to spend. Of course, that just added to the household indebtedness and it’s this debt that’s being shed now.
To illustrate the above, consider this—personal spending in the US in 2005, the year the housing market peaked, was about $8.7 trillion, a growth of about $500 billion over the previous year. Nominal GDP (gross domestic product) growth in the same year was about $700 billion. At the same time, this cashing out of rising home prices, or mortgage equity withdrawal as it was popularly called, was almost $1.3 trillion; even if just half of this amount was spent by the consumer, nominal GDP growth in the US would have been zero, leading to negative real growth or a recession in the 2003-2005 time period itself.
Such a “balance sheet” recession has never been seen before—the US has seen severe consumer recessions in the past, but the savings rate dropping to zero and this “asset consumptiveness” are reasonably new phenomena. Meanwhile, the net worth of US households has decreased some 18% from its inflated peak in the third quarter of 2007—the biggest such decline since the Federal Reserve started releasing this data some 50 years ago. What’s even more telling is that household asset prices have dropped far less than the 18% net worth drop—so households are not being able to pare their debt burden in pace with the asset price decline, which shouldn’t be surprising. Consider the US consumer’s conundrum—jobs are being shed, wages are not keeping pace with inflation and asset prices are going down. Despite this, in 2008, consumers managed to find an additional $300 billion over 2007 to spend; our simple contention is this—one just cannot get away so easily in a once-in-a-lifetime recession.
We do not believe the US consumer is headed to the 8-10% savings rate of the 1980s, the newer generation is programmed to spend. However, the consumer has his hands tied with respect to assets and wages. Wages not growing at the pace of inflation, too, isn’t as big a problem as the gargantuan per capita assets that the US population has gathered and the debt to support those assets.
If in the best of times the consumer couldn’t rely on his pay cheque to support his spending habits, but had to borrow against his assets which were going up in price, what chance do we have of spending continuing when asset appreciation can no longer be relied upon?
To put this situation into perspective, mull over this statistic—current US wages are about 2.5 times what they were in 1980; by contrast, net worth at its peak was about 7.5 times of 1980s levels. Unfortunately, this isn’t just a US problem. Japan, the second largest economy, is less than 8% of global GDP, the US consumer himself is more than twice that size.
The catch phrase made popular by the Nobel Prize-winning economist, Paul Krugman, “This isn’t your father’s recession, but your grand father’s recession”, rings rather true.
Rajeshree Varangaonkar and Bharat Indurkar have day jobs with US-based hedge funds. They write every other Thursday.
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