Wednesday, 9 February 2011

An American mystery: the sequel

As a sequel to my previous post I want to delve a bit deeper into the wealth effects of various assets. This was not the main point of the last post but it seems interesting to me, well, I just hope that you feel the same way…

After the markets meltdown in 2008 and the housing market collapse, household assets took a serious hit. Of course this has a fiercely negative effect on private consumption, since the essence of the wealth effect is that when people feel richer they tend to spend more. The inverse is also true and the present situation can attest to that.

source: St. Louis Fed

The main objective of the Fed advocated policies, after the crisis broke out, is to revive wealth effect – induced spending. This is why the US central bank is trying to prop up markets.

Of course, the assets that bring on the larger wealth effect are those that comprise a larger part of the households’ balance sheet. In the case of the US this is real estate and there is an ensuing decline both in the value of real estate assets and and to its share as a % of total. The assets that were buoyed by QE (quantitative easing) were equities, but since their share as a % of total assets is less than half of the one for real estate, the wealth effect should be much smaller.

source: St.Louis Fed
After the equities bubble (or the dotcom bubble if you prefer) burst in 2000, there was a 10% collapse in the value and share of equities as a % of total household assets. This was offset perfectly by the rise in real estate. 

Right now, the problem is that there is no asset that offsets the collapse of house prices. After a bubble bursts it takes many years for the asset involved to see its popularity among retail investors rising, hence the effect of the rise in equities is relatively small. Furthermore, the fact that equities are not that high up in investors preferences, limits the wealth effect in the upper middle and upper class and (as I added at the postscript of my last post) maybe at executives who part of their pay is through stock option schemes and other market based compensation schemes. 

The wealth effect from the rise in house prices was further magnified by the fact that home-equity loans, junior mortgages etc. allowed even homeowners that didn’t sell their house to draw on its rising value. On the other hand equities are infinitely more liquid, so maybe that helps in enlarging the wealth effect there, which means that the after a rise in equity prices will see consumption jump more than with the same rise in house prices.

The rise of Real Personal Consumption Expenditures (RPCE) to levels higher than those seen pre-crisis has got me mystified.

I doubt that just the wealth effect from equities can bring on this rise in RPCE. Then after browsing through data I stumbled upon that:

source: St.Louis Fed

The last three months have seen consumer credit post some small and hesitant increases. Are these some minor blips or is the American consumer following the recipes of the past? If the answer is yes, then that’s exactly what the Fed wanted, to stimulate lending.

Personally, I would like the deleveraging to go on for a while longer, this would go some way in rectifying the excesses of the past and would help the American consumer follow a more sustainable consumption model.

I still believe that a significant part of the population is deleveraging, either through default or through paying off debts, because they have no other choice. Another chunk of the population is maybe now resuming its old habits. If that is so, inequality in the US is rising, something profoundly negative, which further diminishes the sustainability of the current model. When, the next shock hits the US and consumers are forced to deleverage the pain they will have to endure even greater.   
To highlight something positive for the US economy, employment in manufacturing is increasing almost for the first time since 1999. I don’t know if that is sustainable though.

source: St.Louis Fed

source: St.Louis Fed, own calculations

I don’t know if the model of an economy that dependent on consumption is sustainable. The outsourcing of many manufacturing jobs abroad during the past 2-3 decades has been made up from an increase in consumption (partly financed by debt).  I thought the endgame of that would be the current crisis. If the increase in consumer spending is something more than an one-off blip then the Fed succeeded in giving this model a little more time. But every time the strength of the revival is diminished (if my thoughts about rising inequality are correct). You can postpone but you can’t avert the inevitable…

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