US debt trends threaten economy

In an election year, the deficit that most people are focusing on is that of the federal budget. Dean Baker, co-director of the Center for Economic and Policy Research, reminds us that household debt and foreign debt have also been rising, with potentially serious implications for the long-term health of the US economy.

In a paper titled "Dangerous Trends: The Growth of Debt in the U.S. Economy" dated 7 September, he says that "the current paths of household and foreign debt are unsustainable trends... If current borrowing patterns even persist through the next presidential administration, both forms of debt would reach implausibly high levels. The inevitable adjustment process to a sustainable growth path will involve higher inflation and a drop in living standards, and almost certainly another recession."

Such views are not new. Many economists have been warning of the threat posed to the economy by these debt burdens since the 1990s, and continued to warn about them as the debt levels kept growing over the last few years.

For example, on 10 September, Stephen Roach, chief economist at Morgan Stanley, wrote in the Global Economic Forum:

[T]he jury is still out on...the months ahead when the US economy is finally taken off the special life support measures that have been so critical to this recovery. For America, that will be the ultimate moment of truth -- when the economy then comes face-to-face with the lingering imbalances of subpar income generation, sharply reduced saving, an ever-widening current-account imbalances, and a record overhang of household indebtedness.

In his paper, Baker provides a wealth of data showing how much the household debt and foreign debt have risen over the past few years, and how he thinks they will continue to grow and adversely impact the US economy.

Some of Baker's projections, though, may be a little alarmist. For example, he projects the growth path of household debt and shows that the ratio of household debt to disposable income will rise to 152.0% by the end of 2009 based on current trend. That would be far above historical norms. Realistically, though, current growth rates are not likely to be maintained for that many years.

Baker makes a similar projection for foreign debt, showing that at the current growth rate, the net indebtedness of the United States will exceed $7 trillion and the net foreign debt will be almost half the size of the economy by the end of the next presidential administration in 2009.

In my opinion, the problem is that even at current or slightly higher levels, these debts can pose a threat to the US and world economies.

With regards to the household debt, higher interest rates, which Baker also mentions, will by itself aggravate debt service burdens of households. With interest rates currently at historically low levels, the probability of significantly higher interest rates going forward is high.

With the foreign debt, the most likely manifestation of reversion to the mean is through a fall in the US dollar. Baker thinks that this can happen if foreigners stop buying US assets. He thinks that a fall in the US dollar would cause higher import prices and higher inflation, leading in turn to higher interest rates, "especially if the Federal Reserve Board deliberately raises rates in order to contain inflation".

In my opinion, inflation resulting from higher import prices may not cause the Federal Reserve to raise interest rates. It would be suicidal for the US economy for it to do so, and the Federal Reserve knows it.

Nevertheless, interest rates -- particularly the long rates which the Federal Reserve does not directly control -- may rise anyway simply because of the withdrawal of foreign buying of US debt. In other words, long-term rates may rise not because of the Federal Reserve but in spite of it.

And the probability of foreigners sharply curtailing their purchase of US financial assets is far from remote. Clearly, foreign investors can see that the US current account deficit continues to grow, threatening the long-term value of the US dollar. The current account deficit rose to a record US$166.2 billion in the second quarter, which is equivalent to 5.7 percent of GDP, up from 5.1 percent in the first quarter.

And there is little indication that this deficit is likely to reverse soon on its own. In July, the trade deficit was US$50.1 billion, the second largest in history, the highest being the deficit of US$55 billion just a month earlier.

So the debt trends are dangerous indeed, even minus the most alarming projections. Having said that, remember that the trends had been considered unsustainable even back in the 1990s. Yet, they have persisted till today.

Having outlasted the stock market bubble of the 1990s, who can say exactly how long these trends will ultimately last.

Still no clear indication on world economy

After surging in the first quarter of this year, the world economy moderated in the second quarter. July and August economic data announced so far have been mixed, and there is still no clear indication whether the world economy will re-accelerate or continue to slump further.

In the United States, durable goods orders were up 1.7 percent in July, accelerating from a 1.1 percent gain in June. However, excluding transportation, orders were up only 0.1 percent. Confirming the slowdown is a fall in the Institute of Supply Management's index of national manufacturing activity to 59.0 in August from 62.0 in July.

The Institute for Supply Management's index of non-manufacturing activity also fell in August to 58.2, the lowest level of the year, from 64.8 in July.

Data on housing were mixed. New home sales slid to a 1.134 million annual rate in July, the slowest rate since December. However, construction spending hit a record high in July, rising 0.4 percent. But as a possible sign of things to come, new applications for home loans fell for the past two weeks.

Consumer spending in the US did rise in July by 0.8 percent, reversing a 0.2 percent fall in June. However, personal income rose only 0.1 percent. A fall in the Conference Board's consumer confidence index to 98.2 in August from 105.7 in July does not bode well for consumer spending.

Sustained consumer spending requires job growth. The US economy added 144,000 workers in August, the Labor Department said on Friday. On the same day, the Labor Department announced that job growth had been revised up to 73,000 in July and 96,000 in June. However, these monthly figures are hardly enough to keep up with the growth in the labour force in the long term, although the August unemployment rate did fall to 5.4 percent -- the lowest since October 2001 -- from 5.5 percent in July.

Not surprisingly, Asia has been affected by the slowdown in the US, with the effect exacerbated by the deliberate effort of the Chinese government to cool down its economy, a major engine of growth for many other Asian economies.

In Japan, industrial output in July was unchanged from June. Japan's jobless rate rose to a worse-than-expected 4.9 percent in July. Spending by Japanese households headed by salaried workers rose a lower-than-expected 2.9 percent in July from a year earlier. In a sign that deflationary conditions persisted in Japan, core consumer prices in July fell 0.1 percent from June.

And it is not just Japan. In South Korea, industrial production for July was 0.1 percent lower than the previous month. Similarly in Taiwan, industrial production growth slowed to 9.5 percent year-on-year in July, from 16 percent in June and 16.3 percent in May.

Singapore appears to be an exception to the general trend, showing some signs of an acceleration from a slowdown. On a seasonally adjusted basis, industrial production rose 2.9 percent in July, reversing a 3.5 percent decline in June. And the purchasing managers' index compiled by the Singapore Institute of Purchasing and Materials Management rose to 55 in August from 53.5 in the previous month.

Europe also appears to be seeing steady growth. The European Central Bank on Friday announced a slightly higher GDP growth rate for both this year and next year. The mid-point of the forecast ranges are 1.8 percent for 2004 and 2.3 percent for 2005.

Not that Europe's economic indicators are uniformly optimistic. Reuters actually reported that its purchasing managers' index for August for the Eurozone fell to 53.9 from 54.7, while the British PMI slid to 53.1 from 56.0.

The stock markets have not given much of a clue on the global economy's direction either. Most markets have recovered from lows earlier in the year, but are still either down from the beginning of the year or only slightly higher.

Exceptions are the stock markets in Australia, Singapore and the Philippines. Australia's All Ordinaries Index hit an all-time high of 3594.7 on 2 September. The Singapore Straits Times Index and the Philippines PSE Composite Index closed at 1940.86 and 1627.96 on 2 September and 3 September respectively, levels not seen in the respective markets since February 2001.

A similar performance may be in store in the US stock market. Mark Hulbert at CBS.MarketWatch.com reported on 3 September that three Dow Theory newsletters he monitors have indicated that the stock market's near-term direction is up.

The three newsletters are Dow Theory Forecasts, edited by Richard Moroney, TheDowTheory.com, edited by Jack Schannep, and Dow Theory Letters, edited by Richard Russell. All three are currently bullish, the last turning so being Russell.

Hulbert wrote: "Moroney and Schannep...believed that it was bullish during August when, despite the Dow Industrials closing at a new 2004 low, the Dow Transports' remained well above its low for the year." Russell, however, waited until both the Dow Industrials and Dow Transports had rallied past their recent peaks last Thursday.

So despite the lack of clear economic indicators, there is still hope for a rally in the stock market over the next few months, which might be a signal that an improvement in economic growth is in the offing.