The Turn of the Cycle?

The U.S. economy declined significantly during the third and fourth quarters of 2000. GDP growth in the second half averaged 1.7 percent as compared with 5.2 percent in the first half. At the same time the technology sector of the stock markets experienced a drastic decline from its highs. The NASDAQ index fell from 4803 in March to 2657 in January 2001, a decline of 45 percent.

These developments raise the possibility that we are at a historical turning point marking the end of the great postwar boom that dominated the second half of the 20th century. If this is the case, it is not too early to begin investigating the basic factors responsible for the long economic expansion that brought unprecedented prosperity to the American people. This endeavor will no doubt lead in many direction and to many false trails, but nevertheless it must be done. We cannot really go forward until we have identified the factors that led us to where we are today.

As this is written, the most prominent feature of the downturn is a pronounced decline in consumer and business demand for durable goods, particularly demand for information processing equipment and software. This slowdown has undermined the irrational enthusiasm for stocks of technology companies which had risen to absurd valuations. This market bubble has now burst, with the NASDAQ down, as noted above, 45 percent from its high. The slowdown in demand, however, must be rooted in more tangible factors than the self-delusion of stock market speculators, and it is this aspect we will address.

A slowdown in demand can be produced by simple saturation of the market - consumers simply do not need more of a certain good and reduce their purchases of it. This condition, however, has prevailed for some time, but consumers have still been enticed to keep on buying. The suddenness and breadth of the slowdown suggest that something more than satiation is at work.

The Role of Debt

One of the most prominent economic developments of the past two decades has been the great growth of debt. Nonfinancial debt, which includes government, households, and business, rose from $3,957.9 billion in 1980 to $18,344.3 billion in 2000, an increase of 363.5 percent. Thus, three and one-half times more outstanding debt was created in 20 years than in all the years preceding this period. Financial debt, which includes banks, life insurance companies, mortgage companies, finance companies, REIT's, etc, rose even faster - from $578.1 billion in 1980 to $8,430.8 billion in 2000, an increase of 1,358.4 percent. An increase in nonfinancial debt results in one form or another in an increase in the demand for goods and services: over the two decades, $14,386.4 billion, an average of $719.3 billion per year. The problem with this dynamic is that it must not stop: if debt ceases to grow, the economic stimulant is removed. Moreover, because of inflation the dollar amount of the increase in debt must continue to grow just to maintain the same amount of stimulant.

Source of data: Flow of Funds, FRB; NIPA Tables, Bureau of Economic Analysis

As the chart shows, debt and nominal GDP accelerated moderately until 1980 when they turned up sharply. It may be significant that debt consistently grew faster than GDP. In 1980 debt was 141.6 percent of GDP, but by 2000 it was 184.1 percent of GDP If the upward momentum of GDP depends on an even faster upward momentum in debt, the relationship is not sustainable, since debt obligations must be serviced and paid off out of GDP derived income.

For a period from 1980 to 1986, federal debt grew faster than non-federal, and again from 1990 to 1994 it grew faster; from that date to the present, non-federal debt growth exceeded federal, which actually became negative in 1998-99-00. Total nonfinancial debt, nevertheless, rose 6.9 percent in 1998 and again in 1999. This result was due to an increase of 9.6 percent in non-fedeeral debt in 1998 and 9.5 percent in 1999. These increases helped lay the foundation for the strong GDP growth of the past two years, but they also created new problems.

As this chart shows, household debt rose from $1,404.0 billion in 1980 to $7,169.1 billion in 2000, or 410.6 percent. Disposable personal income was also rising rapidly, but debt as a percent of d.p.i. still increased from 69.5 percent in 1980 to 102.6 percent in 2000. During that same period, personal saving as a percent of disposable personal income fell from 10.2 percent to -0.1 percent. This decline in saving augmented the rise in debt in raising the level of consumption. Here, again, we have a dynamic that cannot be sustained.

Much of the increase in consumer spending is ascribed to the "wealth effect". The Economist (12/9/00) comments:

"In the five years to 1999, rising share prices boosted the wealth of American households by $10 trillion. These gains encouraged households to save less out of their current income, pushing the personal saving rate into negative territory for the first time since the 1950s. This happened at the same time as business investment soared. As a result the private sector is running a record financial deficit (the difference between the saving of households and firms and their investment) of about 6 percent of GDP. Over the previous four decades net saving has never before turned negative for more than a year.

"----If share prices fall further, the reverse wealth effect on consumer spending could be bigger than in the past. Households will be starting with negative saving, giving them no cushion to fall back on, and they have never before had so much of their wealth tied up in shares."

Business Week (1/22/01, p 30) amplifies the effects of this situation as follows:

"Even if the market recovers, (James) Paulsen (of Wells Capital Management) thinks consumption may stay restrained. The reason: The economy in the 90s experienced its longest big-ticket spending spree ever, bringing outlays on durable goods and structures to a postwar high. 'Households are flush with new homes, furniture, cars, and computers.' he says, 'and many businesses are over invested. Demand is saturated for a while no matter what the Fed does.'"

This view is echoed by the Long Island Business News (1/12/01):

"Americans generally have been responsible in handling of money, balancing improved lifestyles with their ability to earn and save. But several signs suggest overconfidence have grown in recent years.

"While incomes rose, expectation often grew faster. You can read it in the growing size of houses, in the more elaborate vacations, in the 17 million car sales per year, in casino operations and in luxury oddities.

"The 'wealth effect' was and still is, a factor in such behavior. And the destruction of the wealth effect could be compared to pulling the rug out from under millions of Americans."

Business debt, like household debt, grew steeply from 1980 to 2000, fourfold in 20 years. But unlike household debt, business debt as a percent of income (measured as profits before tax with inventory valuation adjustment) did not change significantly. The level of debt in relation to income has been considerably higher, however, and serious questions need to be considered. One is raised by Newsweek (1/22/01):

"Since 1995 a growing share of business investment has been financed by high-risk capital from venture capitalists and new sales of stock. In 1995 these sources provided $86 billion, estimates Morgan Guaranty Trust Co. By the first half of 2000, the amount had increased to $350 billion (at an annual rate). Investors were enticed by soaring prices for technology stocks. Now falling prices for tech stocks -- and the dot-com bankruptcies--are drying up this source of funds. Inevitably, business investment will suffer."

Another concern is pointed out by the Economist (1/21/01):

"There is always a tension between the owners of a firm and its creditors. Owners want to earn the best returns; creditors want their loans repaid with something extra to compensate for the risk of default. Until the 1990s, most companies put the interests of bondholders first. Having a top-notch credit rating was an article of faith. Since then, corporate America has been downgraded, both intentionally and unintentionally, to the detriment of bondholders. Few companies now boast a top-notch credit rating. In recent years the exuberance of shareholders has been matched only by the pessimism of their bond counterparts."

The Economist reviews several reasons why companies have favored debt over equity in recent years. One is a financial theory that debt is cheaper than equity, primarily because it receives different tax treatment than equity (interest is deductible but dividends are not.)

"The second reason why companies preferred debt is because it had become easier to raise. Competition among suppliers of credit had increased hugely. Banks used to be the kings of corporate finance; in recent years they have become the handmaidens. In the early 1970s banks had three-quarters of the lending market in America; now they have less than half. Capital markets have ballooned: think, for example, of the development of the junk-bond and asset-backed market in the 1980s.

"Until recently , this increased competition meant that companies both big and small had unparalleled access to credit. Over the past 20 years, mutual funds, banks and other lenders have been trying to discover how low down the credit spectrum they can go, and how finely priced their lending can be.

"So in recent years companies have been buying back their own shares in huge quantities. American firms, for example, have bought back a net $2.7 trillion worth in the past five years. Many of these purchases are financed not with retained profits but with debt, thus increasing firms' leverage and reducing their credit worthiness. By last November, Moody's, a big credit-rating firm, had downgraded 36 companies during 2000 for buying back their shares--the same as the combined total for the previous three years.

"The urge to borrow has been exacerbated by the growing habit of handing out stock options as incentives to senior employees. These are supposed to align the interests of a firm's managers and its shareholders, but in reality they do no such thing. Holders of options--unlike shareholders--have every reason to bet the firm, because they share in any upside but not in most of any downside. If things go wrong, they simply refrain from exercising their options.

"Bond investors were the first to spot that all was not well. Banks have taken much longer; indeed, in the past two years, they have been filling the gap left by choosier bond investors. Only now that their bad loans have started to mount have they reigned in their lending. Suddenly credit is no longer so cheap and plentiful; instead, America is seeing the first signs of a credit crunch. This does not bode well for the country's stockmarkets, which have already come off their highs."

The Year 2000

At the beginning of 2000 and even at the end, there was almost universal optimism that the economy would continue to boom at the rate with which it started the year. Then, out of the blue, things changed. Business Week (1/29/01), describes it as follows:

"During all of 1999 companies were churning out goods at an increasingly rapid rate in an effort to catch up with the even stronger growth in demand. By the middle of 2000, however, sales were slowing sharply, and by yearend, the pace of stockpiling was far ahead of demand."

The question then arises of what caused the sudden slowdown. We have already noted the mounting debt loads taken on by households and business. We have also noted the evaporation of the wealth effect following the collapse of the technology stocks (and stagnation of other established stocks). The following data shed additional light on the onset of the downturn: