The Precarious Position of the US Consumer

Each time retail sales in the US increase and beat the Street’s estimates by a small amount, Wall Street cheers and pushes the market higher. However, I seriously question the use of retail sales in the US as a measure of economic strength, for two principal reasons. In my opinion, retail sales that are not accompanied by a rise in industrial production are highly questionable as an indicator for the domestic economy. They are a far better indicator for the strength of the Chinese economy, because rising US retail sales are leading to a widening of the US trade deficit with China, which is increasingly supplying the US market with consumer goods. Consider the following. The US housing industry is booming. However, US production of appliances is flat to moderately down compared to a year ago. Or take the home furnishings industry, which should be a prime beneficiary of strong home-building activity. However, furniture imports into the US have jumped 71% since 1999 and now comprise between 40% and 50% of all sales. According to an economist who has studied how US industries have been affected by rising imports, half a million workers lost their jobs in the furniture industry between 1979 and 1999. This is in stark contrast to China, which has become one of the world’s largest manufacturers and exporters of furniture, claiming 10% of the global market share. In the first seven months of this year, furniture exports - principally to the US - rose 35% to more than US$3 billion.

Perhaps Fed governor Ben S. Bernanke should consider this point when advocating an ultra-easy monetary policy. He recently pronounced before the National Economists’ Club in Washington that:

The US government has a technology, called a printing press that allows it to produce as many US dollars as it wishes at essentially no cost. By increasing the number of US dollars in circulation, or even by credibly threatening to do so, the US government can also reduce the value of a dollar in terms of goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

As I have just shown, the government can generate temporarily higher “spending” though not necessarily higher production in the US, but overseas! If we look at the increase in US retail sales over the last three years and compare it to the increase in the US trade deficit, we note that practically all additional retail sales originated from the import of additional overseas products. Therefore, Mr. Bernanke’s US printing press seems to have an extremely limited effect in stimulating domestic economic activity, while being very effective in stimulating foreign direct investments and industrial production in China and, increasingly, Vietnam. I hope that the leaders of the Asian exporting countries appreciate this fact and sent Mr. Bernanke a large Christmas card - naturally, one made in China.

A similar situation to the US furniture industry is evident in its auto industry. While overall car sales are robust (although down from the torrid sales pace in July and August), sales of the three domestic producers are currently lower than they were in the 1990 recession, while sales of imported cars and light trucks are at a record. (Ford announced recently that it will boost its purchases of auto parts in China to as much as US$1 billion annually starting in mid-2003.) In fact, while the goods-producing sector lost 332,000 jobs in the last eight months, the service-producing sector has added 506,000 jobs over the same period. (Mortgage brokers were up 47,000, health services employment was up 178,000, education up 92,000, and government up 158,000.) In the meantime, the number of manufacturing jobs is back to the 1961 level.

However, rising import penetration aside, there is another reason to be skeptical about the durability of strong US consumption growth. For one thing, it should be obvious that there is at present no pent-up demand in the US, as consumers have not yet retrenched and rebuilt their liquidity, as was the case in previous recessions. In addition, until recently, US consumption was boosted above the trend-line by a decline in the savings rate. In the absence of strong stock market gains in the near future, it is likely that the savings rate will increase somewhat in the next 12 to 18 months and, therefore, contain consumption growth.

Finally, and this seems to me to be the crux of the matter, the consumer has become highly leveraged and his consumption may finally succumb to his debt load. Now, I am aware that many analysts and strategists will dismiss this concern, arguing that the consumer has been highly leveraged for a long time and has so far continued to spend and will therefore continue to spend in the future. To my mind, this line of argument is reminiscent of US strategists who, in the spring of 2000, predicted that the stock market would continue to rise, based on the fact that it had been going up for 18 years in a row. The facts are simply as follows (figures courtesy of Doug Noland): In 1946, as a percentage of National Income, total personal sector liabilities were 31%, non-farm mortgages 13%, and consumer credit 5%. At the end of 2001, however, total personal sector liabilities were 133% of National Income, non-farm mortgages 70%, and consumer credit 21%. Non-farm corporate liabilities stood at 44% of National Income in 1946, compared to 101% at the end of 2001, total mortgage debt was 23% compared to 93%, security credit 3% versus 10%, state and local government debt 7% versus 17%, and total credit market debt 192% versus 359%. In addition, in 1946 the personal savings rate stood at 9%, compared to around 2% now. Moreover, since the beginning of 1998, total (non-financial and financial) credit growth has surged $9.7 trillion, or 62%, to $30.4 trillion. By category, Total Household Borrowings jumped 64% to $8.2 trillion, while Total Business Borrowings increased 64% to $7.1 trillion. Since the beginning of 1998, Financial Sector Credit market borrowings have more than doubled to surpass $10 trillion. For the third quarter, Total Household debt expanded at an annual pace of 9.6%, the strongest rate of growth since the 1980s. The Household sector added debt at a record annualized rate of $724 billion. For comparison, 1998 was the first year that Households increased their debt-load by more than $400 billion. Year-to-date, Corporate sector borrowings have expanded at less than 1%, the weakest performance since 1992. These lending figures illustrate a qualitative maladjusted flow of credit. And while the corporate debt market is hardly growing at present, it required heroic 12.8% Household Mortgage Credit growth to produce GDP growth. During the third quarter, Total Mortgage Credit expanded by $235 billion - a stunning annualized pace of $941 billion (12.4%) to $8.2 trillion. This was 20% above the previous quarterly lending record set during last year’s second quarter, and we are now on track for a record $826 billion of Total Mortgage lending for 2002. For the 10-year period 1988-97, Total Mortgage Credit expanded by an average $222 billion annually. The system now accomplishes as much in three months. Noteworthy is the fact that Total Mortgage Credit growth accounted for 88% of Total Non-federal Borrowings during the third quarter (versus 1990’s average of 51%). This one ratio provides a striking example of a maladjusted qualitative distribution of the money stream, which usually becomes a factor of instability for the entire economy at some point.

I hope the reader will understand that the current mortgage financing boom and consumer credit explosion is simply not sustainable in the long run and that, at some point, credit expansion in the consumer and mortgage sector will slow down, as it has in the last two years in the corporate sector. The consequences of such a slowdown will obviously be that consumer spending will have to slow down very considerably, which will inevitably hurt the economy, but hopefully will redress some of the external imbalances. So, whereas economists who point out that the consumer is in great shape may be correct now, sometime in the future the consumer may wake up with a terrific “debt hangover”, which will force him to retrench.

In this respect, some additional observations might be in order. In the third quarter of this year, household net worth fell 4.5% from the second quarter to US$38 trillion, according to the Federal Reserve. The ratio of net worth to disposable personal income sank to a seven-year low of 4.9 in the third quarter from 5.2% in the second quarter and 6.3% at the end of 1999. The drop in net worth resulted from shrinking assets and rising debt. Assets fell 3.4% to US$47 trillion (mostly stock market related), while liabilities rose to US$8.5 trillion, mostly as a result of the increase in mortgage debt described above. So, whereas in the late 1990s the equity bull market enabled households to boost spending and reduce savings, the recent bear market is leading to reduced spending and a rise in savings. It is also in this context, and in order to boost the currently under-funded pension funds, which will become a drag on future corporate earnings, that we must understand the US administration’s desperate efforts to boost the stock market a tout prix - even at the expense of creating other sets of problems such as the consumer and mortgage credit bubble we described above, a weaker dollar, and higher inflation rates for commodity prices, which will in turn depress bond prices.

In recent reports I have repeatedly drawn the readers’ attention to the rise in housing and commodity prices over the last 12 months. The purpose was to show that, although we are in a deflationary environment for manufactured goods, principally because of the rising supply of “cheap” consumer goods from China, a shift has taken place in the last two years from inflation of equities (or a bull market for equities) to inflation of hard assets such as residential real estate and commodities. But whereas it would appear that housing inflation in the UK and the US is nearing an end, commodity prices appear to have completed a multi-year base and are poised for further gains. It is worth noting that despite weak global economic conditions and weak stock markets around the world, the CRB Commodity Futures Index has risen by more than 24% over the last 12 months. Also, as I have pointed previously, commodity prices have been in a bear market for more than 20 years and, in the age of capitalism, have never been as low as just recently. Therefore, once fundamentals improve, prices could run away on the upside. However, what do we mean by “once fundamentals improve”? For one, if synchronized growth around the world should materialize (a scenario about which we have serious reservations, but which is nevertheless a possibility for the short to medium term given central bankers’ propensity to print money), then obviously the demand for all commodities should improve and drive prices higher. But more importantly, with people like Mr. Bernanke at the Fed, and actually even being a serious candidate for future chairman of the Federal Reserve Board, depreciation of the dollar and a rise in commodity prices is almost guaranteed - particularly if the economy weakens. In fact, Bernanke’s statements didn’t go unnoticed by the believers in sound money (gold), who subsequently pushed gold prices through an important resistance level. Therefore, if easy monetary policies bring about higher commodity prices, interest rates, which usually move in tandem with commodity prices will rise and bring an end to the current unsustainable mortgage-refinancing boom. And once the consumer can no longer borrow against his house in order to sustain his spending habits, consumption and along with it the economy are likely to collapse. As a result, I would look at selling US equities during the present rallying phase, and avoid the US dollar and US treasury bonds. In my opinion, the Euro, gold and Asian emerging markets will continue to outperform US equities, as they have already done so over the last 18 months.

I don't like these analyses. I think they are misleading, and to some degree misleading on purpose. I say that because it is hard to believe that some of the people writing them are not more sophisticated than this article would suggest. I have to conclude that the real mission here is political.

On the subject of imports:

Suppose we have a vertically-integrated firm which manufactures its own products and sells them at retail through its own stores. To hear this author tell it, all of the value in this firm is added at the first step -- in the manufacturing phase -- and the entire rest of the company does nothing to produce the firm's results. The engineering department, the QA department, the marketing department, the sales department, all do nothing to contribute to customer satisfaction. By the lights of this author's analysis, the only position in this company that adds value or deserves a return -- or should be accompanied by any capital investment -- is that of assembly-line worker.

That is what the author is saying when the claim is made that "retail sales that are not accompanied by a rise in industrial production are highly questionable as an indicator for the domestic economy. They are a far better indicator for the strength of the Chinese economy." That is saying that the only component of all this economic activity that imparts "strength" is that of manufacturing -- in particular the labor component of manufacturing, for that is what has moved to China -- and that all else is noise.

But that's bunk. If we go back and examine our hypothetical vertically integrated company, we would find that a little less than half of the sales dollar was going into manufacturing. The other half was being spent on all those other things: R&D, sales and marketing, administration, plus hopefully something left over to call a profit on all the assets employed in doing all this stuff.

Manufacturing itself would in turn be split into materials, labor, and burden, where "burden" is the depreciation on the building and the equipment, the electric bill, and all the other stuff that has to go on before an assembly-line worker can do anything.

The key to understanding what's really going on here is to note that the "labor" component of manufacturing has been declining as a percentage of manufacturing cost for a long time. That has nothing to do with the Chinese. That has to do with new materials, automation, a whole bunch of things that have the effect of reducing the skill level needed by whatever humans are left in the manufacturing process. Fifty years ago, a company like NCR had huge facilities in which highly skilled machinists and carpenters made every individual screw and fitting that went into the company's products. A cash register of the era had hundreds of moving parts -- gears, springs, sprockets, etc. -- that all had be machined to high tolerances for the thing to even work. And all of that was done on machines no more complex than the lathe with the machinist standing there operating it.

That job -- running that simple lathe -- is the so-called "high-paid manufacturing job" that these political squealers pretend we are losing to China. But we're not. Those jobs were gone anyway. Today the entire working guts of a cash register is a single printed-circuit card that has almost zero human labor component in its cost. The whole thing is assembled by auto-insertion machines, soldered by a wave-solder machine, and the "manufacturing job" associated with this consists of taking the board off the insertion machine and putting it on the conveyor belt going into the soldering machine. There's no skilled machinist, there's just this boring thing to do that anyone who can breathe in and out can accomplish.

When I was a kid, Zenith used to run ads on television showing how every component in a Zenith television was hand-soldered. This was supposed to connote reliability and dependability. I was one of those kids who used to take things apart, so I know that if you turned the chassis of a television set over in those days, what you saw under there was hundreds of components that had been installed, one by one, by a human being with a long-nose pliers and a soldering iron. There were probably a dozen labor-hours in a television set, and all of it fairly highly skilled. If even one of several hundred leads was soldered to the wrong pin, you would literally have smoke coming out when you plugged it in.

Today we hear that no television sets at all are made in the United States, and the implication is that what has been lost -- to the Mexicans, or the Chinese -- is a dozen highly-skilled labor hours per television. But that isn't true. The whole "guts" of a TV is a half-dozen chips on one printed circuit card. There's no soldering. There's slap-it-in-the-box and snap-the-connector. Poof -- another TV chassis done in .2 labor hours by a person who doesn't even have to know how to read.

Huge swaths of what used to be skilled manufacturing have turned into this kind of brainless "machine-tending" that requires little to no skill. The jobs are not going to be highly paid no matter what we do. They amount to burger-flipping in a factory setting. But to hear these politicians tell it, these are "high paid manufacturing jobs" while the guy at McDonald's is just a burger flipper. But in fact both jobs are equally brainless and will ultimately end up being paid the same, because supply-and-demand will make that happen. If anybody can do it, everybody will apply, and the wages will drop.

The consequence of all this transition is that "labor" shrinks as a component of manufacturing cost. The capital-equipment portion thus becomes larger, and the return on manufacturing is more to capital than to labor. What the Chinese are getting out of this deal is not "strength," but the smallest and still shrinking component of value added. Even were we -- by political means -- to pull these jobs back into the United States, we would find that we still do not have any "high paid manufacturing jobs," we just have more burger-flipping jobs that take place in factories. That is not the future we should want.

The more global thing that is happening is that the value of "replicatable stuff in general" is dropping, relative to services and other kinds of (non mass-produced) things, as manufacturing becomes a less highly-skilled activity and as manufacturing technology continues to improve. We don't see much in the way of "watch repair" anymore. That's because watches are so cheap to produce on an automated assembly line that it is cheaper to throw a broken one away than to engage a human for even a half-hour to fix it. What kind of "highly paid job" could there be in watch manufacturing if it doesn't even pay to fix one, let alone build one from scratch using human labor?

There is probably some philosophical, science-fictiony thing to discuss about what humans do, exactly, when robots take over all the work. So far machines have all but eliminated skilled humans from most volume manufacturing processes, and right now the machines that power the Internet are going to work on a whole bunch of account-maintenance and customer support jobs... so the marketing and sales departments aren't safe from robots, either. Computers have also wiped out a lot of what used to be called "middle management," which was a reasonably highly-paid occupation twenty years ago.

Left untended, this problem will turn into political Marxism, because what's happening is that the returns on economic activity are increasingly going to capital, and the portion going to labor is dropping. It is an immutable fact of human existence that not everyone is destined to become a nuclear physicist... so that is not a way out. We do have to find something for people with average abilities to do, or they will be trashing the place with torches and pitchforks... or voting in people who will implement socialism.

The tactic of blaming "foreigners" for society's woes has a long and proud history, so it's no surprise that we see some people proposing that as a solution. My own view is that we could put a lot of effort into listening to these people and following their advice, only to discover that we have re-claimed a bunch of burger-flipping-equivalents that really aren't the answer to the problem, because they can't command much of a salary no matter what we do. We could make McDonald's pay the people behind the counter $35 an hour, too, but that isn't going to make their hamburgers worth the $18 they would then have to charge for them.

There is a separate issue concerning what are highly skilled positions, right now mostly engineering and computer programming. The out-sourcing of huge software projects to outfits in Russia and India is a new kind of threat to our economic well-being, because there is little to no skill differential, so there is no place to hide from guys who are willing to work for ten dollars a day. Today we're hearing about this in high tech, but the same thing could -- and will -- happen with architecture, civil engineering... almost anything where the work product can be transferred over a distance at reasonable cost. This is a different phenomenon, and there probably is no real escape from this. These jobs are not going to be taken over any time soon by machines, but the leveling of salaries across international boundaries is probably an unstoppable phenomenon. This is not good for people in the U.S. Anyone who says he knows how to fix it is lying.

Even when we're done adjusting to that, though, we're still going to have the problem of what to do with the tens of millions of people who do not have the stuff between the ears to become physicians and rocket scientists. A Luddite binge of smashing the machines so these folks can all go back to making things with human-operated lathes for $35 an hour is not a 21st century solution. But right now, I don't think anyone knows what that solution is. Blaming "foreigners" is for sure a red herring. The real gotcha here is how to distribute the proceeds of machine labor. The socialists have an answer for this, and it sounds seductive. If we don't want socialism, and all the crap that comes with it -- usually tyranny -- we had better start now to think up how to solve this problem in a private property environment. Foreigners have nothing to do with it. This is "on us" to solve.

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