The Sluggish Economic Recovery

Assessing the economy is always tricky business, but these days it seems all the more so. Every new indicator seems to portray a different vision of current conditions. For instance, week before last, the Federal Reserve's Open Market Committee issued a policy statement in which members complained that the economy's output was sluggish and that household spending was increasing only gradually. The Committee was so concerned that it enacted a policy shift intended to give the economy more support. But reports just a few days later showed upturns for July in both industrial output and in retail sales. At the same time, housing remains stubbornly constrained; construction starts of new houses looked better in July, increasing by 1.7% from June, but May and June numbers were revised lower as more complete information was reported to the Census Bureau, so the new figure for July, 546,000, is actually lower than the original report for June, 549,000.

The stock market mirrors this uncertainty; during trading today, August 23, the Dow Jones Industrial Average (DJIA) surged as much as 101 points from Friday evening's close, then dropped abruptly to a loss of 22 points. Now, at this hour, 3:08PM, it is up 23 points. Several recent days have seen wider swings, and over the last three months, the index has oscillated in a band of nearly 1,500 points. Clearly, investors continue to be unable to sense a trend toward momentum in either direction.

Recessions Correct Excesses
What can we make of this muddled situation? Usually, a recession corrects excesses in business inventories and homebuilding. Stores and manufacturers have generally accumulated too much merchandise and contractors have gotten ahead of demand in homebuilding. The processes of recession curtail manufacturing and construction activity, and after a time, they become better aligned with consumers' ability to buy goods and new homes. In this current case, inventories have gone through that correction. The drop in industrial production (and also in imports of goods) acted to slash inventories back to levels more appropriate for the pace of spending. Then—usually – inventories stop falling and business activity stabilizes and starts to grow again. Some of the subsequent restocking of store shelves and warehouses has indeed begun.

Also, usually, the fall in interest rates that accompanies the recession sets the stage for renewed gains in home construction. This renewal helps push consumer buying of furniture and appliances back up as well. This entire sector is experiencing it differently this time. Interest rates certainly fell, and remain very low. But a burst of renewed lending and buying is not happening – and may not happen for some time ahead.

Consumer Borrowing Excesses Were Really Great
We talked back in the spring about sustainable government budgets, and in some sense, we need to have the same kind of discussion about consumer budgets. Look at these two graphs. The first one shows consumer debt as a percent of consumers' liquid assets. Here we include credit card debt, installment loans, mortgages and some other smaller items. We see that prior to 2000, people's debt never approached their holdings of bank deposits, bonds and other safe financial assets. In general, then, people had ready cash to more than cover their obligations. That changed dramatically during the 1990s and especially the first part of the 2000s. See that at the peak in 2005, people's debt exceeded 125% of their quick, ready cash; for some, this would have been a far higher number.

As if that weren't enough, many people were borrowing on their home equity. The low interest rates made it easy to tap that otherwise inaccessible source of funds; people refinanced their mortgages and borrowed more than their current mortgage amount. With the low interest rates, their payments may easily have been no larger than before and that unlocked money was available for them to spend. In the second graph, we see that from 2003 through 2006 this "home equity withdrawal" supported more than 6% of consumers total spending. Back in the 1990s, by contrast, such liquidation of home equity was never more than an occasional funding source for spending.

Protracted Correction Not Helped by High-Priced Gas
In the subsequent recession, the tables have turned, of course, and part of what the economy is going through at present is the reformation of consumer finances. This process of debt reduction and liquidity rebuilding is holding the economy back right now, but we have to believe that it's a good thing. We're getting liabilities back in line with assets and we're returning equity to our homes. We learned, much to our shock over the last three years, that home prices can fall, bringing us up short when we least expect. We're correcting our behavior, some of the correction forced through foreclosure and other unpleasant disciplines.

We're also experiencing one other burden, the price of gasoline. Energy continues to absorb more than 10% of the measure we have compiled that we call consumer "take-home pay". This share is lower than in 2008, when gas hit $4/gallon, but, at almost $3/gallon, it's well above the 7-8%that prevailed prior to 2005. As we've noted here separately, people are working at cutting energy use, but these costs are still a constraint on our ability to buy other things.

But We're Building a Firmer Foundation for Later Growth
Our graphs here do show that the necessary financial adjustments are occurring, but this is an unusual phenomenon, so it's hard to know how long it will last. Also note that these processes don't lend themselves to formula antidotes, such as "shovel-ready" government stimulus programs. We can guess that more vigorous growth will return to the economy "next year", but that's only a guess. Fortunately for the world's economy, there is growth elsewhere; the so-called "emerging markets" are indeed emerging and demand from them will help everyone recover. And again, what the U.S. is experiencing now is a good thing for the long term; consumers and the economy as a whole will be operating on a much healthier base going forward.