With consensus on growth, the public and private sectors concentrated on the expansion of demand. The public sector used some overt policies such as tax cuts, distorted accounting rules for calculating profits such as accelerated depreciation, deductibility of interest, etc. But the main focus has been on expansion of debt. From 1960 to 2000, nonfinancial debt as a percent of nominal GDP rose from 137.3 to 185.6, for an annual increase in debt of $440 billion, which augmented demand along with income growth.

Until the 1970s, the developed economies still had currencies with some tie to gold, which inhibited the growth of debt and money, but since then they have had fiat currencies and the change has been striking. Few remember that the extension of consumer credit was once tightly controlled by the federal government. The fear then was that excess credit would increase demand so much that rapid inflation would result. Today, we use every enticement to induce people to buy on credit, even if their credit card debt is already "atrocious", to quote a popular commercial. If their credit card limit has been reached, they are urged to cash in whatever home equity may exist. And, in the case of automobile purchases, they are paid a "cash rebate" for incurring the obligation to pay for a new vehicle. The old time bankers must shudder in disbelief!

We have already cited the disparity between the growth of debt and the growth of income on a national level but even more strikingly on a household level and on a business level. These divergences sustained the economic boom by spurring demand. But they are also unsustainable. Like the current automobile rebates and zero financing, they spur current consumption at the cost of reduced future consumption. Since debt servicing must be paid from income, a point must be reached when debt levels can no longer grow, and thus the basis for the boom is undermined. Logically, this should result in a protracted period of reduced consumption and little or no economic growth.

A Perspective

The postwar period should be viewed as a single historical episode. The first two decades of the period were marked by reconstruction in Europe and industrial expansion in America, stimulated by pent-up demand and reconstruction needs. When these trends played out, the developed nations turned to a fiat money system, credit expansion, and trade promotion to maintain growth. Since 1960, the U.S. M-3 money supply has grown twenty-five fold whereas real GDP has grown only four fold.

The aim of public and private policy has been to promote consumption by making it easier to buy things. This has been accomplished by consistently lowering the requirements for borrowing. Banks were encouraged to expand credit by a series of reductions in reserves required to be maintained against their own deposits by the Federal Reserve Bank. As a result, the "money multiplier" phenomenon enabled bank deposits (which are a product of lending) to grow nineteen-fold from 1960 to 2001 whereas bank reserves grew only four-fold. Reserves as a ratio of deposits fell from 4.9 percent to 1.0 percent. Nonfinancial debt has grown almost seven times more than real output.

The key point about this credit growth is that it augments demand. In the economists' dream world, the income generated by production will be sufficient to clear the market "at some price level". In practice, this does not happen, and additional demand must be created. This is the function of debt: every increase in debt augments the demand derived from income, while a decrease would subtract from demand. Interestingly, however, this stimulant seems to be diminishing. Debt growth peaked in the mid '80s when it equaled about 25 percent of national income. Today it is only half that percent.

The obverse of debt growth is money creation, and this money creation resulted in a considerable shift in wealth concentration. From 1960 to 2000, the share of income received by the lower three fifths of the population fell from 34.5 percent to 29.8 percent. At the same time the share going to the top fifth rose from 42.0 to 47.3 percent. This shift exacerbated the problem of maintaining consumption from income alone and also the problem of expanding capital investment. The top fifth has little incentive to increase their consumption; therefore, they have an ever-increasing pool of money available for investment. But the opportunities for profitable investment are shrinking, particularly since the collapse of the technology bubble. As a result, we now have a frantic search for every possible speculative gain: day traders, currency traders, arbitrageurs, futures, etc. Long-term investment today means a period of months rather than years. The result has been a great increase in stock market volatility but not much change in direction. Profiting from these short-term price changes is now considered "investing".

Thus we have arrived at the heart of the current predicament: a crisis in capital accumulation. Through credit and monetary stimulation we have driven the economy steadily upward to the point where the stimulants lose their effectiveness.

The statistical evidence for this interpretation is pretty compelling. First, short-term interest rates (which are determined by market forces, not the Fed.) are the lowest since 1955. Factoring inflation in, they are really negative. Second, the earnings-price ratio of the S&P stock index, at around 3.0 is the lowest since the Great Depression. The dividend-price ratio is below 1.5, negative after inflation. Third, since 1994, the M-3 money supply has grown substantially faster than nonfinancial debt. The explanation for this divergence is that more and more money has been deposited into money market mutual funds and money market deposit accounts. These are low-yielding but safe investments which investors prefer to other choices. It is somewhat analogous to putting their money under the mattress. Fourth, the remarkable surge in borrowing by government sponsored enterprises, federally related mortgage pools, and asset backed securities. These represent an "investment" in the debt of others.

The Japanese experience is of particular interest in this context. Prior to the nineties, the Japanese economy was the most successful in the world. Following WW2, the Japanese transformed their islands with new factories and modern infrastructure. Their products succeeded in markets throughout the world. A small island nation became the world's greatest creditor.

But limits were reached. Japanese manufacturers found it more profitable to build new factories abroad. New infrastructure was pushed to the point of "building bridges to nowhere" and "paving river bottoms". Stock and property values rose to the stratosphere. These bubbles burst in the early nineties after the Nikkei stock index had reached 39,000; today it is around 10,000. GDP growth in 2001 was -1.9 percent, and over the past three years it has averaged less than one percent. Unemployment has risen from virtually zero to five percent, and the Japanese export surplus has declined to under $100 billion for the first time in many years.

Obviously, Japan does not suffer from any shortage of capital, human resources, or technological excellence. But it does suffer from opportunities to use these resources profitably. It is not unrealistic to suggest that the Japanese have reach their limits to growth.

One further aspect of the Japanese experience should be kept in mind. The Nikkei peaked in 1989 whereas GDP did not decline until 1991. This suggests the financial collapse gradually undermined the productive sectors of the economy resulting in a stagnation of demand that led to the present malaise. Our own experience to date shows similarities to that of the Japanese. We used every stratagem available to the public and private sectors to expand demand. But these stimulants have limits. Tax stimulants for one sector result in higher taxes for some other sector. Low interest rates help borrowers but undermine college endowments, pension funds, insurance companies, retirement accounts, etc. Credit cannot be extended to the bankrupt. And, importantly, property values cannot continue to rise if personal income lags or falls. In 2001 we had repeated reductions in interest rates, tax rebates, and tax rate reductions. But they had little apparent effect in stimulating the economy. Apparently we have run out of stimulants.

Developments over the remainder of the year should clarify our outlook. The implications could be profound.

The similarities across major economies is sometimes striking. In 2001, GDP growth plunged in all five economies while in the first half of 2002 each except Britain made a mild recovery. Industrial production (latest 12 months) did not mirror this performance as it fell in the first half in all five economies except Canada which experienced a slight rise. Canada was also the only country to experience an increase in retail sales. Sales growth in Germany and Japan has now been negative for two and one half years.

Despite sluggish demand, consumer prices continued to rise except in Japan which has now experienced several years of deflation. Unemployment rates rose except in Britain where the rate was unchanged.

Short term interest rates show the same similarity as GDP growth: they have fallen consistently in all five economies over the past two and one half years. Japan has a zero interest policy while the U.S. rate after inflation is now zero also. This decline can only be interpreted as evidence of a lack of opportunity to employ capital profitably - there is already too much of everything in relation to demand. This prospect is reflected in the major stock indices which declined further in the first half. The U.S. index has since fallen below the 8000 level.

Canada, Germany, and Japan show large current account balances while Britain and the U.S. show large deficits, reflecting similar imbalances in trade, which the existing world trading system seems unable to correct.

Exchange rates were little changed during the period, with some further strengthening of the U.S. dollar.

Real GDP slowed to 1.1 percent in the second quarter after rising 5.0 percent in the first. The pace of personal consumption fell in the second quarter along with gross investment (which, however, was still positive), net exports, and government consumption expenditures. Industrial production trended upward during the first half, led by durables and utilities. Automobile output was strong, but business equipment was flat. Capacity utilization trended upward, while manufacturers' new orders remained below 2001's level.

New construction remained the economy's bright spot with another strong gain. Commercial and industrial construction fell, but the decline was offset by strong residential activity. Inventories of unsold homes, however, rose through the period.

Real gross investment fell slightly in the first half with definite weakness in the nonresidential sector. Business sales were virtually unchanged in the period while inventories did not fall any further. Retail sales and inventories rose moderately. Real personal income rose after dipping in the fourth quarter.

Employment growth is essentially stalled with weakness in manufacturing and little change in services and government.

Many commentators look only at consumption when assessing the state of the economy. But the reality is that consumption is driven by the financial sector. Developments in this sector, therefore, are of primary importance. National income growth slowed markedly in 2001, and this lowered rate picked up a little in the first half of 2002. Compensation of employees increased along with corporate profits. Interestingly, interest income also rose despite very low rates due to "faster accumulation of interest-bearing securities". (mortgage backs and asset backs)

Per capita personal income was boosted by tax cuts and larger disbursements by the federal government for social security and salary costs. Average real weekly earnings also rose aided by an increase in (overtime) hours worked and moderate price inflation.

Gross saving declined moderately in the first half despite increases in both personal and business saving. The decline was due to the now evaporated federal surplus. Federal saving was negative in both quarters.

Commodity prices rose a little but are well below the 1995 benchmark. Food prices are being propelled upward by drought conditions in the U.S. and elsewhere. Producer prices weakened slightly; crude materials was the poorest performer.

After almost two years of decline, corporate profits rose in the first two quarters, with increases in both the financial and nonfinancial sectors.

Interest rates continued to fall to multi-year lows through September, with the 10 year Treasury below 4 percent and home mortgage yields around 6 percent. Investors apparently continue to seek safety.

M-3 money supply grew rapidly in 2001 as savings deposits and money market mutual fund balances soared. The pace slowed substantially in the first half with declines in small time deposits (CDs) and retail money market mutual funds. Do these changes reflect a flight to safety from the stock market?

The federal government incurred deficits in both quarters of 2002; the second quarter level was $185.l billion. Commercial bank credit rose at about the same (lowered) rate as in 2001. The increase was mostly in securities and real estate. Commercial and industrial loans actually declined, another indication of economic weakness.

Consumer credit rose $45.5 billion in the first half, below the $106.9 billion in 2001. Nonfinancial credit market debt grew 6.3 percent while household debt increased 91 percent (8.6 in 2001), and business debt slowed to 2.4 percent (6.1 in 2001).

The trade imbalance worsened considerably in the first half of 2002 - $15.5 billion over the same period in 2001. The balance on goods fell $8.3 bn while the (positive) balance on services fell $7.2 billion. The volume of both exports and imports tended to fall. If sustained, the first half imbalance will be a new record. In July, estimates of the U.S. international investment position were revised to include new source data. The negative position for prior years was reduced.

Despite a large downward revision for 2000, the net position for 2001 was more negative than the original estimate for 2000.

With direct investment valued at current cost, the net investment position in 2001 was -$1,948.l billion compared with a (revised) -$1,350.8 billion in 2000. Financial outflows from the U.S. were almost offset by valuation changes, whereas financial inflows offset valuation changes by $601.5 billion. In two years, the deficit rose from -$784.1 billion to -$1,948.1 billion!

At current cost, direct investment rose $124.1 billion as net inflows exceeded valuation declines. Foreign holdings of Treasury securities were up slightly, but holdings of corporate and agency bonds rose strongly due to record purchases of $288.1 billion. Foreign holdings of U.S. stocks declined as purchases of $119.5 billion were more than offset by market depreciation of $203.1 billion. Over the past two years, the S&P 500 stock index declined by 23 percent. The increase in U.S. currency was due primarily to demand from Argentina, which experienced a collapse of its own currency.

Copyright © Andrew Caughey, 2002

The Pulse of Capitalism is published quarterly. Comments may be sent to Pulse Publication, P.O. Box 140, Gibsonia, PA 15044. Telephone: (724) 443-2396
Material may be reprinted with acknowledgement of the source. Economic statistics are revised routinely and may, therefore, differ from one report to another.

Published October 2002