Monday, June 28, 2004

Econometrics point to rough sledding in our future

"The equity bubble of the late 1990s was a transforming event in many ways for the US economy. But there is one lasting implication that stands out above all - an important transition in the character of the American growth dynamic. The income-driven impetus of yesteryear has increasingly given way to asset-driven wealth effects. For consumers, businesses, policymakers, and investors, the asset economy turns many of the old macro rules inside out. In the end, it could well pose the most profound challenge of all to sustainable recovery in the United States.

The genesis of the asset economy can be traced back to the late 1980s. Prior to that period, there was little change in the role of assets as a driver of US economic activity. Over the 1952 to 1985 time span, the ratio of household sector assets to GDP fluctuated in a fairly tight range centered around 3.75. But then, as the all-powerful secular bull markets in stocks and bonds took hold, that ratio started to drift upward. In the latter half of the 1980s and the first half of the 1990s, it moved up to around 4.25. And then, courtesy of the Great Equity Bubble, it took off. Over the 1994 to 2003 period, household sector assets expanded by 84% - more than 50% faster than the growth of nominal GDP over the same interval. As a result, the ratio of US household sector assets to GDP pierced the 5.25 threshold in 1999. While the asset base was then pruned in the post-bubble carnage that was to follow, by the end of 2003, household sector assets still stood at 4.9 times US GDP, well in excess of earlier norms. "

...and 4.9% of a hugely expanded 11 trillion GDP, by the way...

"The emergence of the asset economy over the past decade is traceable to two developments - the equity bubble of the late 1990s and the sharp appreciation of property in the early 2000s. Over the 1994-99 period, equity holdings rose from about 19% of total household assets to about 35%. For most of the long sweep of modern economic history, the home had been the American family's most important asset. As the equity bubble expanded, there was an extraordinary role reversal. In both 1998 and 1999, the equity share exceeded the property share of total household sector assets for the first time ever. In the post-bubble shakeout that was to follow, there was a reversion back toward earlier norms. However, while the equity share of total household sector assets fell back to 24% by the end of 2003, it was still double the average from the mid-seventies though the 1980s. Meanwhile, the tangible property share of consumer assets had risen back to about 37% at the end of 2003, near the upper end of historical experience.

It didn't take long for the American consumer to uncover the miracle of the Roaring Nineties. The "wealth effect" - the ability to monetize asset inflation and convert it into consumer purchasing power - quickly became the rage. The macro role of wealth effects is very much dependent on context. In a vigorous income generation climate, wealth effects are the "icing on the cake" - in effect, allowing households to indulge in excess spending or build saving for the future. In an income-constrained environment, the wealth effect takes on a very different role; it can plug the gap brought about by a shortfall in income generation, thereby enabling consumers to defend the lifestyles they had grown accustomed to. Both roles have come into play in recent years.

In the asset economy, there are critical distinctions between the wealth effects of equities and property. The equity wealth effect is largely a "mark-to-market" translation of the household sector's success (or failures) as investors; as such, it reflects the monetization of both realized capital gains as well as the psychological boost imparted by recent and expected appreciation. The "feel good" element of this latter effect cannot be minimized in a frothy stock market climate. It has the potential to convert the excesses of the asset bubble into the excesses of the consumer spending climate. The property wealth effect is a very different animal. The monetization of wealth from tangible assets takes two forms - realizing the gain by selling property or extracting the gain through mortgage refinancing. In recent years, the "refi" bonanza has been on the ascendancy in allowing the American consumer to capture the benefits of the property wealth effect.

Largely for those reasons, economists have found that the impacts of the property wealth effect are well in excess of the impetus provided by the equity wealth effect. Whereas econometric studies demonstrate that consumers spend about 3-4 cents of every dollar's worth of equity appreciation, the spending propensity out of property appreciation is closer to 7 cents on the dollar (see Karl Case, John Quigley, and Robert Shiller, "Comparing Wealth Effects: The Stock Market versus the Housing Market," NBER Working Paper, October 2001). This differential wealth effect is very important for the asset economy in one other way - it underscores the critical role of debt as the means by which asset appreciation can be converted into purchasing power. In property markets, equity extraction and debt go hand in hand. The property wealth effect is a far more debt-intensive phenomenon than the equity wealth effect.

This "leverage factor" shows up dramatically in the recent debt binge of the American consumer. While there has been a clear secular upturn in the household sector's appetite for debt over the past 50 years, the increases in leverage in the past seven years have dwarfed earlier trends. By the end of 2003, total household sector debt had hit 85% of GDP, up fully 15 percentage points from pre-bubble readings of 70% prevailing as recently as 1995. This development, of course, is widely depicted as the "rational" response to two developments - record low interest rates and rapid house-price appreciation.

Yet the evidence raises some serious warning signs about the potential ramifications of this debt binge. Although market interest rates had fallen to 40-year lows, debt service burdens remained near the upper end of historical experience, according to the Federal Reserve. It is also common to believe that rational consumers have locked in fixed rate debt in funding their wealth effects - in effect, securing a guaranteed insulation from any back-up in interest rates. The recent shift to adjustable-rate rate mortgages draws this assertion into serious question; the ARMs portion of the dollar value of new mortgage origination exceeded 50% in May 2004, well in excess of the 20% share prevailing in early 2003.

Stepping back from the data flow, it is important to appreciate the consequences of the asset economy. A more chilling picture emerges. Courtesy of the Great Bubble of the late 1990s, the American consumer discovered the sheer ecstasy of converting asset holdings into spending power. Households learned to spend beyond their means - as those means are defined by growth in disposable personal income. Yet when the equity bubble popped, the consumer never skipped a beat. There was a seamless transition to another asset class -property. And the joys of asset-driven consumption continued unabated. Income-based consumption had, in effect, become pass?, and American households went on an unprecedented debt binge. No one seemed to care that the personal saving rate had fallen from 5.7% in the pre-bubble days of early 1995 to 1.0% in late 2001 (and now stands at just 2.3%). In the asset economy, who needs to save out of his or her paychecks? Who needs to worry about debt? Asset markets, goes the argument, had emerged as a new and presumably permanent source of saving for the American consumer.

The role of the wealth effect took on added importance in the current economic recovery. With jobs and real wages under extraordinary pressure, there has been an unprecedented shortfall in the cyclical rebound in this key wages and salaries component of personal income. As job growth has picked up in recent months, that gap has started to close. But through April 2004, real wages and salaries had still risen less than 3% from levels prevailing at the recession trough in November 2001; that's far short of the nearly 10% gains that had occurred in the first 29 months of the preceding six cyclical recoveries. This translates into a shortfall of $280 billion in "missing" real personal income. In such an income-short recovery, there is an added urgency to draw on the wealth effects as a supplemental support to spending. In the asset economy, the idea of cutting back on discretionary consumption - a classic pattern of the American business cycle - had also become pass?.

America's policymakers have joined in celebrating the miracles of the asset economy. The Federal Reserve has taken the lead in this regard, providing the rock-bottom interest rates that have taken asset markets into uncharted territory. But the Great Enabler has now created the ultimate moral hazard: overly-indebted consumers and overly-exposed financial institutions, both of which are exceedingly vulnerable to a long overdue normalization of monetary policy. The fiscal authorities have also been seduced by the siren song of the asset economy. Income-short consumers have drawn ample support from open-ended tax cutting and the massive government budget deficits such initiatives have spawned.

That takes us to one of the greatest pitfalls of the asset economy - ever-widening twin deficits. Increasingly, asset-based saving has come to be viewed as a substitute for the income-based impetus to consumer demand. This has resulted in an unprecedented shortfall of domestic saving: America's net national saving rate - the combined saving of households, businesses, and the government sector (net of depreciation) - fell to a record low of about 2% of GDP in 2003. Lacking in domestic saving, the US has had to import surplus saving from abroad and run massive current account and trade deficits to attract that capital. The record current account deficit of about $580 billion just reported for 1Q04 — 5.1% of GDP — is a grim reminder of how serious these deficits are. Such twin deficits are part and parcel of the asset economy. That also underscores the important role that foreign investors - especially foreign central banks - have played in funding the excesses of a saving-short, asset-long US economy. The world is hooked on America's asset economy as never before.

In the asset economy, the rules of traditional macro have been rewritten. Income-based metrics that have long been used to scale deficits, debt, and saving are depicted as irrelevant. Instead, the balancing act is now evaluated relative to asset-determined wealth. I must confess to being just as suspicious of this new paradigm as I was of another such scheme back in the late 1990s. As the bursting of the equity bubble should forever remind us, there is no guarantee of permanence to asset values and the wealth effects they spawn. That's even more the case when assets are artificially inflated by unsustainably low interest rates. Saving-short, overly-indebted, and more reliant on foreign lending than ever before, the United States has pushed the limits of its asset dependency.

That takes us to the weakest link in this daisy chain - the striking juxtaposition between the imbalances of the income-based US economy and the purported soundness of the asset-based alternative. In a rush to abandon the old and embrace the new, America has pushed the concept of income-based imbalances into uncharted territory. This could not have happened, in my view, were it not for the high-octane fuel of extraordinary stimulus of monetary and fiscal policies. As those policies are now normalized, the asset economy should be subjected to its toughest test.

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