The Big Elephantine Squeeze

The obvious is sometimes so much so that nobody [wants to] pay attention. The media finally sounds the big bugle about the elephant that's been smelling up the room all this time. None of it is rocket science, just [personal] finance 101 that the "punditry" routinely chose to glaze over on the tube and [less so] in print: flat wages + high debt + high market/GDP growth = ?

And it doesn’t help that “pundits” - chatterboxes or slick-talking snake oil salespeople are just as descriptive - play musical chairs knowing that growth can grind to a halt when credit’s overstretched to breakpoint. Yet they fear crying wolf given how vested they are in folks buying into the dogma of everlasting stock market growth - while they divest - business cycles be damned.

Newsweek's "A Widening Credit Squeeze" (August 9th, 2007) aptly frames the issue:

…A credit-card squeeze carries real risks for the U.S. economy overall. “The shift from home-equity borrowing to credit cards is quite costly,” says Smith. Not only are mortgage interest rates about half that of credit-card interest rates, but the interest paid on credit cards isn’t tax-deductible. Smith believes that already-strapped households with little or no savings to rely on will be faced with increased financial obligations that will eventually lead to slower growth in consumer spending. And with consumer spending accounting for about 72 percent of gross domestic product, any slowdown could have a big impact.

Americans are so tapped out financially that they may not be able to stop using plastic no matter how high rates get, says Christian Weller, an economist and senior fellow at the Center for American Progess. “I think credit-card usage could still go up even if rates go up,” says Weller. “The credit market right now is like a balloon that’s being squeezed on the mortgage side and expanding on the credit cards side,” he says. Weller says he’s concerned that credit-card debt has risen dramatically over the past few months, even as growth in consumer spending has slowed. This, he says, is a sign that credit-card borrowing is being used to close a widening household budget gap—that cards are being used to fund housing, transportation and medical care. “I believe what we’re seeing is that consumers are borrowing out of necessity—we’re not talking about a flat-screen TV or iPods here.”

This chart shows how consumer spending has slowed even though credit card use has risen. According to some economists, this may indicate that consumers are increasingly using cards for basic living expenses, rather than luxury items.

Source: Moody's Economy.com, Inc.

For customers who need access to credit but get knocked out of the prime credit-card market due to tightening standards, the only alternative to meet their expenses may be the subprime credit- card market, says Ellen Cannon, assistant managing editor at the financial research group Bankrate.com. And that could put them even deeper into trouble, she says. “What happens with the subprimes is that they’ll give you a $200 credit limit and then they charge you $59 initiation fee and an annual fee of $45. So by signing up, you can be $150 in the hole and your interest rate is 32 percent. It’s highway robbery.”

How long will it take Americans to dig themselves out of their credit hole? Years. “Debt will increase and consumption will weaken in the next year,” says Smith. “But there will come a point when people will either have maxed out their credit or they’ll see their credit rating starting to suffer, and that’s when many of them will decide to get their household balance sheets back in order—probably by sometime in early 2009.” Smith warns, however, that reversing a borrowing trend is “a slow process.” And that’s something anyone who’s ever tried to pay down a big credit-card bill knows firsthand.

I’ve blogged for a while about the overextended American, including a month ago, “It’s the Balance of the Paycheck, Stupid”. That was a response to a posting about the “irrelevance of trade deficit figures”, a oft-popular sentiment during peaks of a financial bubble.

In fact, our growth has run too long on the inferior grade economic fuel that is debt financing, mirroring the Japanese bubble. That bubble was followed by more than a decade of spiraling deflation and economic stagnation that the Japanese are just beginning to recover from.

Now China’s finance ministry’s bold threat recently to withdraw their $1.33 trillion dollar reserves from US treasuries and debt markets if forced to devalue their yuan is doubly potent. (UK's Telegraph - August 10, 2007 - "China threatens 'nuclear option' of dollar sales")

As history tends repeating, a lame-duck administration is acting its part as a modern day Hoover, waiting for the economic fallout to widen before being forced to resort to a last-ditch effort to do something. Even then, it’d be mostly cosmetic laced with rosy sound-bite oratory – doubly impotent & intellectually hallow – as is the low expectations of these past 7 years.

And the non-stop touting of tax cuts as panacea for much of this country's financial maladies, big and small, is a rather sorry linchpin for American economic policy. It also sets a shoddy example and excuse for Americans to heed, akin to deciding to cash the always-plentiful "free-for-now" check-as-cash offers that credit card companies shovel out.

While attractive politically, tax cuts are botched economics when they dig an even bigger financial hole using 100% debt-financing as is the case when a country is in a deep red trillion-dollars+ deficit and chooses to starve itself of tax revenue by refusing to maintain tax rates as is or raise them as needed (like "no voodoo economics" Bush 41 did) and goes about writing a giant nationalized IOU check that in the fine print inevitably also echoes "free-for-now, ballooning-interest-later". All the while, benefits of this tax cut accrue mostly to the wealthy who often reinvest most of that unneeded upside overseas in emerging markets, in order to maximize returns.

And this sums up at root the flaw of the Laffer-inspired "supply-side" economics, in a nutshell*.

Which also means that, bottom line, some serious green and gravy is due Asia and the rest of the world, which they will cash in the not-too-distant future at a time of their choosing, not ours.

* Not-so-nutshell, from Wikipedia:

Estimates of the effectiveness of the Laffer curve

In 2005, the Congressional Budget Office released a paper called "Analyzing the Economic and Budgetary Effects of a 10 Percent Cut in Income Tax Rates" [2] that casts doubt on the idea that tax cuts ultimately improve the government's fiscal situation.

Unlike earlier research, the CBO paper estimates the budgetary impact of possible macroeconomic effects of tax policies, i.e., it attempts to account for how reductions in individual income tax rates might affect the overall future growth of the economy, and therefore influence future government tax revenues; and ultimately, impact deficits or surpluses. The paper's author forecasts the effects using various assumptions (e.g., people's foresight, the mobility of capital, and the ways in which the federal government might make up for a lower percentage revenue).

Even in the paper's most generous estimated growth scenario, only 28% of the projected lower tax revenue would be recouped over a 10-year period after a 10% across-the-board reduction in all individual income tax rates.

The paper points out that these projected shortfalls in revenue would have to be made up by federal borrowing: the paper estimates that the federal government would pay an extra $200 billion in interest over the decade covered by his analysis.

To support these calculations, the paper assumes that the 10% reduction in individual tax rates would only result in a 1% increase in gross national product, a figure some economists consider too low for current marginal tax rates in the United States. [3][4]

The paper appears to focus on Federal government revenue only and does not look at the total public sector revenue (i.e., it does not include increases in local and state government revenue).