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The Politics of Debt Repudiation

Pouring the Red Ink Down the Sink

by MIKE WHITNEY

The US consumer’s decade-long spending spree has ended, but there’s still an ocean of red ink left to mop up. And with housing prices falling and unemployment tipping 9 per cent, it will take longer to clear the family balance sheet than many had anticipated.

Traditionally, the government has helped to ease the pain of deleveraging by providing fiscal stimulus to boost economic activity and lower the real cost of debt. But Capital Hill is now in the grips of deficit hawks who frown on such Keynesian remedies, so households and consumers will have to fend for themselves and pay-down debts as best as they can or default when repayment is no longer possible . That’s bad news for the economy that depends on consumers for 71 percent of GDP. Without a healthy consumer, the economy will face years of sluggishness and stagnation.

U.S. household debt as a share of annual disposable income is currently 115 percent, down from the peak of 135 percent in 2008. But, while consumers are making headway in paring down their debts, there’s still a lot of work to do. Economists believe that the figure will eventually return to its historic range of 75 percent, which means slower growth for years to come unless someone else makes up the difference in spending.

But what sector is big enough to make up for the loss in consumer spending? Business? Government?

Business spending is still significantly below pre-crisis levels of investment. Naturally, businesses aren’t going hire more workers and produce more products if demand is weak. And, demand is bound to stay weak if there’s no rebound in consumption.  But how can the consumer rebound when he’s buried under a mountain of debt and making every effort to increase his savings? Surely, if wages were growing, then it would be easier to pay down debts while increasing spending at the same time. But wages aren’t growing, in fact, they are falling in inflation-adjusted terms. So personal consumption–which typically leads the way out of recession–will continue to disappoint. This is from an article by Stephen Roach titled “One Number Says it All”:

“There are two distinct phases to this period of unprecedented US consumer weakness. From the first quarter of 2008 through the second period of 2009, consumer demand fell for six consecutive quarters at a 2.2 per cent annual rate. Not surprisingly, the contraction was most acute during the depths of the Great Crisis, when consumption plunged at a 4.5 per cent rate in the third and fourth quarters of 2008.

As the US economy bottomed out in mid-2009, consumers entered a second phase – a very subdued recovery. Annualized real consumption growth over the subsequent eight-quarter period from the third quarter of 2009 through the second quarter of 2011 averaged 2.1 per cent. That is the most anemic consumer recovery on record – fully 1.5 percentage points slower than the 12-year pre-crisis trend of 3.6 per cent that prevailed between 1996 and 2007.

These figures are a good deal weaker than originally stated. As part of the annual reworking of the US National Income and Product Accounts that was released in July 2011, Commerce Department statisticians slashed their earlier estimates of consumer spending. The 14-quarter growth trend from early 2008 to mid-2011 was cut from 0.5 per cent to 0.2 per cent; the bulk of the downward revision was concentrated in the first six quarters of this period – for which the estimate of the annualized consumption decline was doubled, from 1.1 per cent to 2.2 per cent.

I have been tracking these so-called benchmark revisions for about 40 years. This is, by far, one of the most significant I have ever seen. We all knew it was tough for the American consumer – but this revision portrays the crisis-induced cutbacks and subsequent anemic recovery in a much dimmer light.” (“One Number Says it All”, Stephen S. Roach, Project Syndicate)

Roach’s timeline is key to understanding what’s going on. He says: “the subsequent eight-quarter period from the third quarter of 2009 through the second quarter of 2011 averaged 2.1 per cent.” The period that Roach calls a “very subdued recovery” coincides with the implementation of the $787 billion fiscal stimulus (ARRA).

Absent the Obama administration’s fiscal intervention, there would have been no recovery. This is worth considering in view of the fact that households continue to pay-down debts and will do so for the forseeable future. If the government doesn’t provide additional stimulus, then the economy will slip back into negative territory. And that’s precisely what’s happening now. Here’s an excerpt from an article by John P. Hussman, Ph.D, Hussman Funds who connects the dots drawing from recent data:

“It is now urgent for investors to recognize that the set of economic evidence we observe reflects a unique signature of recessions comprising deterioration in financial and economic measures that is always and only observed during or immediately prior to U.S. recessions. These include a widening of credit spreads on corporate debt versus 6 months prior, the S&P 500 below its level of 6 months prior, the Treasury yield curve flatter than 2.5 per cent…, year-over-year GDP growth below 2 per cent, ISM Purchasing Managers Index below 54, year-over-year growth in total nonfarm payrolls below 1 per cent, as well as important corroborating indicators such as plunging consumer confidence. There are certainly a great number of opinions about the prospect of recession, but the evidence we observe at present has 100 per cent sensitivity (these conditions have always been observed during or just prior to each U.S. recession) and 100 per cent specificity (the only time we observe the full set of these conditions is during or just prior to U.S. recessions). This doesn’t mean that the U.S. economy cannot possibly avoid a recession, but to expect that outcome relies on the hope that “this time is different.” (“A Reprieve from Misguided Recklessness”, John P. Hussman, Ph.D, Hussman Funds)

Policy should be based on more than hope. It should be grounded in a firm grasp of macroeconomics and a commitment to the common good.

Keep in mind, that during the peak bubble years of 2000 to 2007 households nearly doubled their “outstanding debt to $13.8 trillion” and “personal consumption grew by 44 per cent from $6.9 trillion to $9.9 trillion”. Also, from 2003 to the third quarter 2008 US households extracted $2.3 trillion of equity from their homes in the form of home equity loans and cash-out refinancings” (figures from “Will US Consumer Debt Cripple the Recovery”, McKinsey Global Institute)

$2.3 trillion! Think about that. That’s nearly $500 billion that was being pumped into the economy every year, which is more than Obama’s $787 stimulus distributed over a two-year period. That’s why unemployment stayed low while housing prices ballooned, because loose lending standards and easy money inflated the biggest credit bubble of all time. But now the trend has reversed itself and debt-deflation dynamics are in play forcing consumers to cut spending, increase saving, and pay down their debts. Only the federal government has the ability and the wherewithal to support the flagging economy while the process continues. The government must boost its spending, increase the deficits, and assist in the deleveraging process. This is from an article by economist Laura Tyson titled “Recovering from a Balance-Sheet Recession”:

“In other recoveries during the last 50 years, public-sector employment increased. This time it is falling: during the last year the private sector added 1.8 million jobs while the public sector cut 550,000.

What should policy makers do to combat the large and lingering job losses that result from a financial crisis and balance-sheet recession? Mr. Koo, whose book on Japan’s experience should be required reading for members of Congress, showed that when the private sector is curtailing spending, fiscal stimulus to increase growth and reduce unemployment is the most effective way to reduce the private-sector debt overhang choking private spending.

When the Japanese government tried fiscal consolidation to slow the growth of government debt in response to International Monetary Fund advice in 1997, the results were economic contraction and an increase in the government deficit. In contrast, when the Japanese government increased government spending, the pace of recovery strengthened and the deficit as a share of gross domestic product declined….” (“Recovering from a Balance-Sheet Recession”, Laura D’Andrea Tyson, New York Times)

Did you catch that? When the Japanese government tried to decrease the deficits by slashing spending, they increased the deficits. This is the lesson that every country in the EU –which has applied the ECB-IMF austerity measures—has learned. Cutting spending when the economy is weak is bad policy and bad economics. Struggling economies must growth their way out off of recession by spending liberally and putting people back to work, thus adding to government revenues. Here’s Tyson again explaining why this is so:

“The market understands that the most important driver of the fiscal deficit in the short to medium run is weak tax revenues, reflecting slow growth and high unemployment, and that additional fiscal measures to put people back to work are the most effective way to reduce the deficit.

“Every one percentage point of growth adds about $2.5 trillion in government revenue. An extra percentage point of growth over the next five years would do more to reduce the deficit during that period than any of the spending cuts currently under discussion. And faster growth would make it easier for the private sector to reduce its debt burden….Under these conditions, slow growth leads to a higher debt ratio, not vice versa…” (“Recovering from a Balance-Sheet Recession”, Laura D’Andrea Tyson, New York Times)

So, how do we speed up the deleveraging process so the economy can get back on track?

First, the government must be committed to long-term “sustained” fiscal stimulus until the share of household debt to disposable income returns to normal. Second, there should be a restructuring of household and personal debts “including”,– as economist Carmen Reinhart says– “debt forgiveness for low-income Americans”….

“Until we deal head-on with the fact that some of those debts are not ever going to be repaid, we will continue to have this shadow over growth”, Reinhart told Bloomberg News last weekend.

Debt repudiation, principle write-downs on underwater mortgages and amnesty on delinquent student loans should all be added to the mix of stimulants to future growth.

Finally–along with federally-funded government jobs programs (a revised WPA, etc)–Congress needs to address the chronic supply-demand imbalance that has emerged from Labor’s dwindling share in corporate profits. The imbalance has now reached historic levels which has widened gross inequality and threatens to keep the economy in a semi-permanent state of Depression. Here’s a quick summary from Barry Ritholtz’s “The Big Picture”:

“Labor share averaged 64.3 percent from 1947 to 2000. Labor share has declined over the past decade, falling to its lowest point in the third quarter of 2010, 57.8 percent. The change in labor share from one period to the next has become a major factor contributing to the compensation–productivity gap in the nonfarm business sector….

While Labor Share has recently plummeted to all-time lows since record keeping began, Median Household Income has stagnated for the past 12 years. In the last recession (2001), incomes had only begun to decline…. One decade later, Labor Share has collapsed, incomes have gone nowhere, and credit availability… has all but vanished except for the most creditworthy…” (“The Heart of the Matter”, The Big Picture)

Not only is labor getting a smaller and smaller piece of the pie, but, also, financial engineering–spurred-on by low interest rates and deregulation–has given rise to consecutive credit bubbles which have transferred a larger share of pension and retirement fund-wealth to Wall Street speculators. So, working people are not just getting screwed on their labor, the government and central bank are actually helping to facilitate the pilfering of their savings.

At the same time, corporate profits have continued to skyrocket. As the Wall Street Journal’s Kelly Evans notes, “Since the recession ended in mid-2009, U.S. corporate profits have jumped by about 43 per cent to a record $1.45 trillion as of the first quarter, after taxes, inventory and accounting adjustments, according to the Commerce Department.” (“More Liquidity Only Douses Growth Sparks”, Wall Street Journal)

So, despite sky-high unemployment, household deleveraging, historic inequality and slow growth; profits keep rising. Is there any doubt about whose interests are being served.

The only way out of the mess that workers find themselves in, is through politics. And–on that score–FDR said it best:

“We cannot allow our economic life to be controlled by that small group of men whose chief outlook upon the social welfare is tinctured by the fact that they can make huge profits from the lending of money and the marketing of securities–an outlook which deserves the adjectives ‘selfish’ and ‘opportunist.’” –Franklin Delano Roosevelt, “FDR Explains the Crisis: Why it feels like 1932″, Pam Martens, CounterPunch.

Mike Whitney lives in Washington state. He can be reached at fergiewhitney@msn.net