Over lunch yesterday with a friend we discussed the direction of the American economy. I am naturally bearish and he is naturally bullish. So this lead to an interesting lunch. He asked me to articulate my thoughts and here they are:
I believe that the American economy faces heavy headwinds and that “business as usual” is just not on the cards. Moreover, the American economy’s make up, imposes some real limits to future growth.
Over the past two decades, personal consumption as a percentage of GDP has trended upwards. Looking back to the 80s and 90s personal consumption hovered around 60%. In 2010 it reached 70% – it is much higher in the U.S. than in the rest of the OECD. Secondly, more than half of all adult Americans have FICO score of less than 600, prohibiting them from obtaining a mortgage. Third, in some of America’s largest cities 8% of all homes are in default, where the home owners are channeling all expenditure away from mortgage payment to consumption.
What does this mean?
First, there is little scope for personal consumption to rise organically since it is already such a large percentage of GDP. Second, over the next two years many Americans that today “consume” their mortgage payments will begin to pay rent – reducing their ability to consume. The housing overhang will last for another 24 to 36 months, and it is unclear how it will clear since so many Americans are no longer credit worthy. Between 2002 and 2007 Americans have accessed their “home ATM” to meet their standard of living expectations. While 8% of mortgages are in foreclosure, about 25% are “underwater” where the value of the outstanding mortgage either equal or exceeds the value of the home. The home ATM source of disposable income for consumption has disappeared for good. Therefore, business as usual for the consumer is just not on the cards
The other part of the equation is government spending, which is set to fall. Federal, State and local governments account for about 25% of total GDP; whereas the Federal government is only now beginning to look at expenditure reduction, state and local governments have already facing to large budget deficits, and they are cutting. BTW state governments account for about 2/3rd of all government expenses. It is also important to note that several state have resorted to increase in taxes, further reducing disposable income.
Finally, and despite what the GOP is preaching, there is no way to balance the Federal budget without some revenue generation strategies. The GOP may oppose increase in income tax, but the reality is that sales taxes are almost certain to be needed to bridge the gap, moreover, it is a more ”egalitarian” form of taxation. This will further reducing available income for consumption. Yes Americans are inventive, but it remains that a federal government that has a deficit equal to 10% of the GDP will have to take action soon, rather than later.
I am reluctant to get into the argument for growth in the private sector, but one aspect resonate across many sectors, while net profits continue to improve top line revenues remain sluggish. American corporations have become master at the art of cutting costs, but there’s a limit to this strategy (although Q1/2011 performance has been spectacular). Most American companies have indicated a reluctance to increase employment, until they see an upward sign in sales activities.
For all these reasons, headwinds for the American economy remain heavy. Moreover, one crisis (either in America or elsewhere) could cause systemic tension to explode.