Economics: Present Fundamentals Portend Future Crisis
If you’ve been listening to president Trump recently, you’d probably believe that we are living in an unprecedented economic wonderland. Throughout his term, the President has expressed his views by claiming, “In many ways this is the greatest economy in the history of America”, and, “Our economy is setting records on virtually every front.” However, when Trump was a candidate, he said that “the economy [was] very sick” and called it a “giant bubble.” What change has occurred over the past two years that has caused him to change his view? The answer is nothing at all. The current economy is, in reality, the very same economy that Obama left us with. And that economic reality is about to become a devastatingly shocking one.
President Trump is particularly eager to cite the employment rate, GDP growth, and the stock market (not anymore!) as evidence of “the strongest economy we’ve ever had.” Unemployment numbers certainly appear strong, with the lowest unemployment rate of the Trump presidency being 3.9%. However, we need to also look at exactly what types of jobs are being created - not just how many. For many people in this country, the jobs that they are employed in are the same low paying, high turnover, service sector jobs that have plagued the U.S. for decades now. In addition, the methodology of what constitutes “employment” has been altered, which distorts the numbers. A better statistic to watch for employment trends is the U6 unemployment number. The U6 number, which includes workers that have been disenchanted for a period of less than a year or have chosen to take on part-time jobs, is 7.60%. Although these numbers are more realistic than the headline numbers, they are ignored by the administration and economists because of their revelation - that something is wrong. In terms of the low unemployment number being evidence of a strong economy, it is, in fact, the exact opposite. Recessions always begin when unemployment rates are low, and end when the rate is high.
GDP growth has also been cited as strong, but it is really nothing out of the ordinary, limping along at an annualized average of 2.9% for the Trump presidency. The Obama presidency garnered a 2.1% average. Let’s take a closer look at that number. In 2017, federal government spending was approximately 17% of GDP. 68% of GDP was consumer spending, while only 17% was business investment, and -3% of GDP was net exports. In the perverse consumption based economy that we have today, higher asset prices are instrumental in engendering growth. As homeowners see their net worth go up due to increases in the stock and real estate markets, they loosen their budgets. This so-called “wealth effect” has driven the economy post-crisis. As interest rates rise, we can expect an inverse of this wealth effect. As homeowners see their real estate and stock portfolios lose value, they will spend less money. The decline of consumer credit will affect many industries that have become bloated recently and is thereby increasingly affecting the economy at large. Expect retail and the housing industry, two key sectors of the economy that are heavily reliant on consumption and low interest rates, to be hit the hardest. Clearly, the economy is relying on spending to stay afloat. What happens when higher interest rates cause that consumption to disappear? Recession is the answer. To make matters worse, the price of the excess consumption at both the government and consumer level has been mounting national and personal debt, which will eventually have to be serviced. Ultimately, this profligate country will have to pay the piper.
The problems in the U.S. economy are varied and wide-ranging. Principal among these factors is that the U.S. is no longer the productive engine of the world. This simple yet often misunderstood fact is represented by the trade deficit, or the difference between a country’s imports and exports. In 2017, there was an annualized trade deficit of approximately 566 billion dollars, and the deficit for 2018 is projected to be even larger than that. The trade deficits will become a major problem later on in time as the debt that was used to finance them must be repaid. They cannot continue indefinitely. Eventually, the economies that have warehoused our trade deficits in the form of dollar income that has been recycled into U.S. debt and equity markets will demand real products from the same country that has failed to provide them. Eventually, those countries and their people, in the form of their dollars, will find those real products in America, resulting in price inflation. Another distinct yet related problem is the overleveraging of the American economy. Due to an appetite for consumption fueled by low interest rates and the strength and worldwide acceptance of the U.S. dollar, Americans have taken on trillions of debt. Not only is the national debt a staggering 22 trillion, but corporate debt, consumer debt, and student loan debt are all at all-time record highs, amounting to an unprecedented total debt upwards of 70 trillion. As interest rates move higher, we can not only expect a wave of defaults on existing floating rate debt, but also a sharp decline in the growth of new credit, resulting in a broader decline in economic growth due to lower consumption and investment levels. The interest payments on floating rate debt will become increasingly burdensome, including the national debt, which is growing at the fastest rate in history.
An increasing amount of recent evidence suggests an economic downturn. The stock market has declined a maximum of over 20% in the most recent decline, and currently rests at -15% from the peak. All of the gains of 2018 have been wiped out, with the stock market -8% for the year. The stock market often serves as a forward-looking economic indicator, but the reality is that the economy and stock market are more closely joined now than they ever have been in history. The low interest rate policy that has been followed since 2009 has over-inflated asset prices, as housing and stock prices are inversely correlated to interest rates. Not only do lower interest rates result in an increase in debt-based consumption, in addition, the higher dollar value of collateral encourages consumers to go further into debt. The higher levels of debt that consumers have been able to attain are in part due to their consistently rising asset collateral (in the form of rapidly appreciating stock portfolios and property values.) The stock market was also supported by Quantitative Easing (QE), where the Federal Reserve purchased troubled assets from banks, thereby crediting banks with money that had previously not existed (otherwise known as creating money). This injection of liquidity, which was performed at an average of 42 billion dollars a month, was instrumental in restoring confidence in the stock market and possibly the largest contributing factor to rising equity prices. QE ended in 2015, and 2016 was consequently a volatile and poor year for the market. The only reason the stock market was able to make new highs was the euphoric sugar high that resulted from the 2016 presidential election, and the policies that Donald Trump was perceived to be in favor of. However, this short-term uptrend in the stock market has already been reversed. As the stock market further declines, investors will be reminded that the Federal Reserve has, in fact, reversed the QE policy and is now selling 40 billion to 50 billion dollars of assets. If QE caused asset prices to rise, this new balance sheet rollover will cause asset prices to fall, thereby triggering a slowdown in U.S. consumption, which has been the linchpin of the economy for the past ten years. Consequently, as people pull in their horns and spend less, they will be faced with debt that will need to be serviced with lower incomes, or no incomes at all due to job losses. However, this scenario of temporary deflation is not likely to last. As the U.S. economy slows, international investors may look for alternative places to park their money. As the demand for treasuries (government debt) tanks, the supply will explode because of increased government outlays. As an increasing amount of Americans qualify for welfare and unemployment benefits due to losing their jobs, government spending will increase, even faster than it is now. Increased government spending will also come in the form of stimulus, and since tax revenues decline in recessions, the deficits will increasingly need to be financed in the capital markets, which will cause two fatal problems. Initially, the first of these is the “crowding out” effect, by which global credit markets are flooded with American debt, and to the extent that demand for this debt increases to meet the increase in supply, other markets such as the stock market and real estate markets will suffer credit outflows, which will be detrimental to those asset prices, and as mentioned above, thereby harmful to the economy. The second issue is the foreign exchange related consequences that will result from a rapid increase in government debt. As the deficit reaches a “critical mass,” for the lack of a better term, demand for government bonds will not be able to keep pace with the increasing supply, and the Federal Reserve will have to soak up the excess debt. Essentially, this means that the government will be borrowing much of its money from its own central bank, i.e. “printing money”. This is always a negative sign for a nation’s currency, as it signals that there is not enough real demand in the capital markets to finance a nation’s spending. Due to the fact that the United States’ skeletons will have come out of the closets, currency traders will short the dollar on international exchange, leading to a situation in which the dollar falls through its floor of support, leading to massive, large scale inflation. As foreigners begin to incur losses on their stock and bond holdings in the U.S., they will sell their investments, leading to a downward spiral across nearly all asset classes. The dollars that will be gained from the proceeds of these asset sales will function as a financial hot potato, flooding back to where they came from and being directly re-injected into the U.S. economy. If foreigners won’t be buying financial assets, they’re going to be buying real consumer assets, such as cars, houses, and other properties within the U.S. The flood of dollars that was created carelessly during the good times will come back to haunt the very same politicians that spent them, as the influx causes consumer prices to explode to the upside. As the economy worsens, an increasing amount of pressure will be placed on politicians to do something. Fearing for their offices, and of someone who can out-promise them, the congressmen and women along with the president will be forced to meet these demands. The trillions of dollars in stimulus that will result from this public backlash will seal the coffin on the dollar, and act as kerosene on the inflation fire.
As the housing markets and stock markets decline, the Federal Reserve is likely to respond by cutting interest rates and bringing back Quantitative Easing. Previously, both of these policies combined with massive deficit spending assisted in breathing life back into the shattered housing and stock markets. This time, these policies will be used to a level commensurate to the crisis: extreme. The excess liquidity in the banking system combined with massive deficit spending resulting from a political crisis will result in a dangerous inflationary death spiral. As the economy collapses, unemployment soars, and inflation rips out of control, the U.S. will face a new reality: stagflation. In the Recession of 2008-2009, Americans had the benefit of the increased value of the dollar. If a person did not lose their job during the last recession, the increased value of their real wages was a boon. In this next cycle, regardless if citizens lose or keep their jobs, the relief of a higher dollar will not be there to help them. This time, the Federal Reserve will be stuck between a rock and a hard place. If they raise interest rates to combat inflation, they will collapse the economy and cause unemployment. If they lower interest rates, inflation will explode to the upside. As more and more desperate Americans blame the crisis on Republican leadership, they will increasingly turn to increased government spending to solve their problems. This time, government intervention and inflation will destroy the economy and private sector to the point of tragedy. Meanwhile, inflation will rage out of control, destroying the purchasing power of savings, harming the middle class and poor the most. Once the U.S. reaches this stage, it will have some serious choices to make. Will we continue down the path of big government, debt, and reckless spending? Or will we turn the page on a new chapter of our country, reject the present and future circumstances, and rise like a phoenix from the ashes?
