Monday, June 14, 2010

Household Deleveraging

American households have shut up shop and stopped spending. After a couple of decades of borrow and spend, they need to get their balance sheets in order. This creates a problem for business that produce consumption goods. This falling demand is a serious issue for the businesses produce consumer goods, but fortunately many of them in a China.

In a free economy, this falling demand would not be a problem. When households stop spending, interest rates usually fall. If households are saving more, banks can offer lower interest rates and still get the funding they need. If households stop borrowing, banks have to lower interest rates to attract borrowers. Increasing supply and falling demand both push interest rates down.

When interest rates fall, numerous investments projects, which previously could not make a reasonable return, suddenly become viable. The result is increasing demand for investment goods. Some businesses will respond to that demand by shifting resources from the production of consumer goods to the production of investment goods. This adjustment may take a couple of quarters, but by shifting the mix of production away from consumption to investment, the slack in the economy is quickly taken up. More important, the resulting build up of capital goods tends to make the economy even more productive in the future.

In a free economy, if demand for consumption falls, production shifts to investment goods. When household start consuming again, the extra capital makes the economy more productive, so the demand for extra goods is easily met. There is no need to have a demand driven recession.

Unfortunately, America is not a free economy and interest rates are fixed by the Fed. Although households are saving more, the Fed has left interest rates unchanged, so the signal that declining interest rates should give to businesses has not gone through. Worse still, the Fed held interest too low during much of the decade. This sent the wrong signal to businesses, and may investment projects were undertaken that would not have been viable, if interest rates had been at an appropriate level.

Artificially low interest rates cause households to borrow too much and business to produce too many investment goods. Households are reducing demand for consumer goods to get out of debt. Businesses should be able to switch to producing investment goods, but there is already a glut of capital goods, due to past overproduction in response to artificially low interest rates.

The leaves the productive sector in a bind. Demand for investment goods and demand for consumer goods, which should balance each other, are both declining. This leaves the government to fill the gap by increasing its purchases of investment goods.

Unfortunately, the government does not have any money, so it has to borrow to spend. This works in the short term, if a nation is willing to mortgage its future, but in the long-term, this increase in government debt adds to huge debt hanging over the country.

This debt and demand imbalance will prevent the economy from launching into economic growth, but it will not cause it to fall off the cliff, for quite a while. A double dip does not seem very likely, but nor is it likely to be a vee. The American economy could trundle along at a bit above mediocrity for quite some time.


jg said...

"...The American economy could trundle along at a bit above mediocrity for quite some time..."

You could be right. I made my nest egg by short selling the stock market 18 months before the Oct./Nov. '08 crash. But, no way did I foresee The Fed doubling its balance sheet; I thought 'the game' was up once The Fed had bought $900B of government securities.

Yes, you are right, it took 500 years for Rome to fall.

But, the Soviet Union -- of similar vintage to our Federal Reserve system, and of similar unsustainability -- fell overnight.

Our Chinese creditors are taking action to protect themselves, by slowly exchanging some of their 'reserve assets' for real assets. Two months ago, the Chinese asked for ironclad guarantees against debasement of their 'reserve assets.' They did not receive such guarantee. The Chinese are watching things closely, and they will find U.S. developments this fall -- whether it is tumbling tax revenue or another round of 'quantitative easing' in an effort to prevent such -- to be truly disconcerting. Thereafter, I presume they will begin faster liquidation of their 'reserve assets.'

I think we are at 1918 in the timeline of Germany's 1919-'23 hyperinflation episode.

Blessed Economist said...

You could be right about 1918 in the German experience. Just remember that hyperinflation did not destroy the German economy. It opened the way for a Caesar, but the economy continued to be strong for much longer. Twenty years later, Germany was able to take on all comers in a world war. They were strong enough to go five rounds against several of the strongest contenders all at once, before their economy finally collapsed.

Hyperinflation will not destroy the American economic and political power. America loves war, but it has the sense to only fight against rats and mice. As long it does not take on serious contenders, it could go on much longer than the Germans did, despite hyperinflation.