In a historical move, US treasury secretary Henry Paulson is asking Congress for $700 billion (Rs32.4 trillion) to buy illiquid mortgage and “other” assets from financial institutions. We explore exactly what sort of footing the American economy was on before these radical measures, and what these measures might mean for the economy going forward.
The initial euphoric response of the US equity market was a bit puzzling given that—1. Plans of such magnitude invariably take time to implement and this will not be an overnight balm. 2. The price discovery of these illiquid assets will itself be a very painful process, this itself will start a whole new wave of write-downs and capital raisings (as we write this piece, Fed chairman Ben Bernanke has suggested that the treasury buy these assets at prices above what they have been written down to; for the moment we’ll pretend this ridiculous suggestion wasn’t made!).
The whole mess was precipitated by the housing market. Home prices are down nationally in the US anywhere between 15% and 20% from the peak; however, with respect to rents, or incomes, residential real estate still looks expensive. Housing inventory (homes up for sale) among new homes is still high at 10.1 months (at least four months higher than what a healthy housing market needs), but not for a want of a response from new construction coming online. New home sales have been chopped to almost one-third of what they were at the peak and are about 50% lower than what some would think is needed in terms of housing creation, given demographics and population growth—a classic no-confidence situation in an asset whose price does not seem to be bottoming. Foreclosed homes are now about 5% of total inventory of homes for sale and a mind-boggling 65% of the new homes up for sale.
At least 90% of second quarter (Q2) US GDP growth came from net exports, and while this is clearly not sustainable, Merrill Lynch economist David Rosenberg makes an interesting argument that more than half the countries the US exports to have already experienced a quarter of negative growth this year. That we are going to slow from current levels is not a secret, but the US is such a consumption-led economy that the health of the consumer is virtually the only gauge for whether we are headed to a recession, or not.
Nominal wage growth has been coming off the boil since early 2007 and as inflation has ticked higher, real wage growth is actually negative. In the meanwhile, the economy has shed more than 600,000 jobs over the last eight months. Incidentally, the US economy has never had eight consecutive months of job losses without entering a recession. Consequently, real consumer spending has stagnated, with real spending on durables declining for six months now. It’s not surprising that with home prices declining and a dismal stock market, the consumer balance sheet is showing weakness too. As of June, the consumer networth (assets less debt) was down almost 4% from December 2007. This metric is sure to look even worse at the end of the third quarter. Nominal spending by consumers has never hung in as well as it has till right now, with networth taking such a big hit. The handout to the consumer earlier this year from the government is definitely an explanation.
While the current measures being talked about will definitely help the credit markets to thaw, we work off the simple premise that the availability of credit has to be distinguished from the demand for credit. While credit will be easier available, consumers are going to be in no shape to demand it. Deleveraging, as we have kept mentioning, is a long drawn-out painful process, and the US financial institutions are actually a few quarters ahead of the consumer in terms of the deleveraging process. Q2 was the first time in 25 years that liabilities on the consumer balance sheet shrunk. At the same time, the liabilities are not going to shrink as fast as the assets, net result being the consumer feels ever so poorer.
Another premise we work off is that companies devote resources—labour, or capital—depending on visible, incremental revenue growth. Since the picture does not look rosy on that front, we do not believe the job market is going to improve soon. America’s labour pool also faces a longer term mismatch of skills with today’s demands, as well as an uninspiring demographic. Let’s also not forget that this had been a “jobless” economic recovery, which was already pointing to the longer-term challenges faced by America’s labour market. Real wage growth is destined only to decline further. All this points to the consumer only tightening her purse strings further, the dismal savings rate, which has already shown an uptick, is bound to increase further. What’s saved is not spent and takes away from GDP growth.
All in all, the treasury’s efforts, though brave, are unlikely to do much for growth over the next several quarters, and an ever weakening consumer will inevitably push the economy into a recession.
Rajeshree Varangaonkar and Bharat Indurkar have day jobs with US-based hedge funds. They will write every other Friday. Send your comments to firstname.lastname@example.org