Today's release of the May jobs report showing that the economy only created 69,000 jobs and that the unemployment rate rose to 8.2% confirms what the equity markets have been hinting at for the past month…that the world economy is starting to slow down, perhaps dramatically. Europe's slow-motion financial crisis is dragging down its economy, which is in turn dragging down Asian export economies, who are cutting their commodity imports and hitting commodity-producing economies like Australia and Brazil in turn.
Once again, the entire world is depending on the profligacy of the United States to keep the global economy afloat. It doesn't have to be this way, and frankly at some point the US should stop putting up with it. I will get to how the world can fix the current state of affairs later, but first, I must pose the question as to whether the US can continue to muscle through a global slowdown given the state of its own economy.
The common complaint among Keynesian-oriented commentators is that we are suffering from insufficient demand. On the surface this would appear to be true. (All GDP figures reported on a nominal basis and sourced from http://www.economy.com.)
- Industrial capacity utilization stands at only 79% as of April 2012, up 67% at the trough of the crisis in 2009 (a record low for the post-war economy), but below what used to be considered a normal level of 81-84%.
- Unemployment stands at 8.3%, above a full employment level of 5% or below. If anything unemployment is being understated due to a large decline in the labor force participation rate and the large number of workers working part-time who would like to work full time.
- Wages and proprietors' income as a percent of GDP is at a near-record low level of abut 52%, down from 57% in the early 2000's and the around 60% that frequently prevailed in the 1960's.
- Personal consumption as a percent of GDP is at a record high of nearly 72%.
- Personal income as a percent of GDP is at a near-record high level of 86%, right around the levels that prevailed in the late 1990's and higher than the levels of the 1960's.
- Personal disposable income as a percent of GDP is at 89%, which is right around the level that has consistently prevailed since the 1960's. Basically the decline in wage income as been continuously offset by rising transfer payments from the government and for health care, and in the past by a large decline in personal tax collections.
- Personal saving as a percent of GDP is at only 3%, below an equilibrium level of 4-6% (although higher than the levels that prevailed at the end of the housing boom).
So basically the government has done a good job of propping up consumer demand with unemployment insurance, transfer payments and tax cuts, just like a good Keynesian should want. Consumers have even kicked in a bit extra by cutting their savings to drive consumer spending to record levels. Consumers, neither rich nor middle class, can be accused of irrationally hoarding cash and holding back our economy.
Another source of demand is private investment.
- Business investment including software, equipment, mines and wells, is running at 7.6% of GDP, firmly in the equilibrium range of 7-9% that has largely prevailed since the early 1970's. It can go higher, but is not irrationally low.
- Real estate investment on the other hand, is at only 4.3% of GDP, far below a more normal range of say 6.5% to 7.5%. Commercial real estate investment is about 1% of GDP below a normal level and residential real estate investment is about 2% below a normal level.
Given the large amount of overbuilding in the 2000's and the slower growth in the working age population now that the baby boomers are starting to retire, there is no way for policy makers to force real estate investment to meaningfully higher levels until consumers' balance sheets are cleaned up and excess inventories have been worked off.
My overall view on real estate has been that investment bottomed in 2011, but that the market would not start clicking until 2013.
- Government expenditures (federal, state and local) are about 19.5% of GDP. (These are direct expenditures and don't include transfer payments.) This figure is about average for the period from 1980 to the present, but lower than the prime Cold War years when the defense budget was far higher as a percent of GDP. The US has room to increase direct government spending, but combined with the massive deficits it is running to support transfer payments, the US government is not being parsimonious.
In addition, how can the US economy be accused of having insufficient demand when…
- The trade deficit is 4% of GDP, meaning we spend 4% more than we produce.
- Our imports are 2% of GDP too high relative to the long term trend of US international trade and our exports are about 2% of GDP too low.
- Running a trade deficit means that our investment is greater than our savings. But, as we established above, our investment is running about 3% of GDP below normal levels. Private saving (business plus consumer) is running at levels slightly higher than normal, so more than the entire trade deficit can be accounted for by a higher-than-normal government deficit.
If demand for investment is outstripping savings, even at abnormally low levels of investment demand, we would expect interest rates, particularly real interest rates to rise. Instead, however, real interest rates are not only negative, but projected to remain negative, on average, over the next 10 years. The cause is of this paradox is that global savings flowing into the US (i.e. the demand for dollar-denominated savings) chronically exceeds the demand for dollar-denominated investment, even during the great business investment boom of the 1990s and the great real estate investment boom of the 2000s.
For the US to bring trade in to line it would either have to cut domestic demand and/or increase exports. Domestic demand can be cut by raising taxes, cutting government spending, and/or raising tariffs to shift demand to domestically-produced goods. Exports can be increased by running an aggressive trade policy that steps up against those countries that are manipulating trade via their capital accounts (more on that later).
The US has geared its economy to a level of demand, for both consumption and investment, that outstrips its ability to produce. In this case demand equals standard of living. The US needs more investment to make its workers more productive, but it is already operating with excess industrial capacity and high unemployment, which circles back to the fact that domestic demand is insufficient to match domestic supply. In other words, international demand is too low relative to international supply more than US demand is too low relative to US supply.
This is not a new observation. China, Germany and the OPEC countries need more consumer demand to sop up excess savings and to increase demand from chronic deficit countries like the US, UK and southern Europe. The US, UK and southern Europe need more investment to maintain or increase their competitiveness versus other countries, but need to fund those investments with more domestic savings.
Here's what needs to happen:
- Germany needs to step up to the plate. Yes, it must be annoying for Germany to have to bail out countries like Greece. Overall, however, Europe has a relatively balanced economy (i.e. a neutral trade deficit), so it has the power to fix its own problems. Germany needs to allow domestic consumption to rise and needs to invest more in southern Europe, which southern European economies need to cut back their state relative to their private economies. Otherwise the other countries are right to protest, as to date Germany has been just looking to cement its advantaged status and protect its own banks.
- The US needs to stand up to currency manipulators. The main culprits here are China and the OPEC countries. If the governments are the ones investing in US securities to keep their currencies fixed and suppress domestic consumer demand, then they are currency manipulators, plain and simple. Letting the dollar weaken won't help, particularly with the OPEC countries, because that just increases the price of oil, making the problem worse. The US should impose capital controls or tariffs on these countries while firming the value of the dollar instead.
- The US needs to cut its petroleum imports. Petroleum accounts for a large portion of our trade deficit. A firmer dollar and a concerted move to domestic natural gas (and electric cars) should do the trick.
- The US needs to increase its savings. It should not be up to the US to support the world economy by running up its debt. The US should implement policies to increase consumer savings, particularly among the middle class.
- The US should increase its infrastructure investment. Such investment should be able to put some construction workers to work while we wait for real estate investment to recover. Plus, its actually needed. This would not be spending money for spending's sake.
- The US should implement policies to encourage domestic investment and exports. Reforming our corporate tax code would be a great place to start.
I realize that many of these solutions sound nationalistic or mercantilistic by themselves. I hope, however, that the facts are pretty clear that most of the demand shortfall that the US faces is due to (i) a shortfall in foreign demand that is a direct result of mercantilistic trade policies, (ii) an excess of domestic demand driven by lower-than-market US interest rates due to excess foreign savings and (iii) a shortfall in real estate development that only time will heal. Outside of using tariffs and capital controls to reduce our trade deficit, the US government doesn't have much further that it can do to stimulate domestic demand without badly distorting the US economy. All of the other actions I recommend are meant to deal with long term structural issues that are also tied to our need to increase the international competitiveness.
Europe has the same internal issue that the US has with China and OPEC, where explicit policies need to be put into place to increase the competitiveness of southern Europe and the UK relative to Germany. These policies need to deal with the short term issue of debts and liquidity, but also with the long term issues of excessive labor regulations, weaker productivity and underinvestment in the tradeable sectors. These improvements will either require a tighter fiscal union or some really enlightened multilateral policy making.
These issues are all fixable, but they arise to remind us that we remain in a Kondriatev Winter, where the economy is consistently weighed down by high debt levels, weak demand and a tendency toward deflation without heroic measures by governments and central banks. Believe it or not, the US has struck the balance pretty well so far. It is now time for Europe to put their house in order before they drag the whole world into stagnation and deflation.