The impact of tax changes is clear in this table. Before 2001 gains in personal income exceeded those in disposable personal income, but since then they have lagged. Personal income gains peaked in 2000 at 8 percent but have since fallen to less than half that rate. Disposable personal income gains also peaked in 2000 but have declined less.

Household debt

Consumption is promoted not only by rising income but also by rising household debt. In recent decades, debt has risen faster than income, often at double digit rates as in the 1980s. During the period we are considering, household debt rose on average 7.5 percent per year from 1993-2001, but increased to 9.7 percent in 2002, 10.6 percent in 2003, and 5.3 percent in first half 2004. This debt represents both consumer credit and home mortgages, but even mortgages (home equity and cash-outs) directly stimulate consumption. Moreover, the divergence between personal income and disposable personal income has an element of debt in it. The divergence is due to tax cuts effective in 2002 and 2003. Since the federalgovernment is in deficit, part of disposable personal income represents debt rather than real income.

The important point is that all debt must be serviced from current income. Low interest rates facilitate this process, but any major rise in interest rates will greatly complicate it. The data in this respect are not reassuring. Household debt as a percent of personal income was 76.l percent in 1993 but 100.8 percent in 2003.

There is a vicious circle involved here. Increasing employment depends on rising consumption. Rising consumption depends on increase in income and debt. But increases in debt(or interest rates) reduce the amount of income available for consumption, which, in turn, limits the growth of employment. The result is something very close to our current economy.

All five economies accelerated GDP growth in the second quarter of 2004 in comparison with the same quarter of 2003, with the largest gain in Germany. Industrial production also accelerated in all five economies, but Japan and Britain still had not surpassed the 1997 base level.

Retail sales growth remained negative in Germany and Japan while growing in the other three countries. It is striking that sales growth is weak in the two largest current account surplus countries but strong in the two largest deficit countries.

Consumer price inflation increased in 2003, and the increase continued through FH 2004 except in Japan where the index remains lower than in 1998. Unemployment edged down except in Germany where it rose .1 percent despite an increase in industrial production. Short term interest rates were mixed and changes were small, rising in the U.S. and Britain but falling in Canada and unchanged in Germany.

There was divergence in the stock indices. Those in Germany, Britain, and the U.S. changed little while those in Canada and Japan moved higher. The U.S. Dow index ended the third quarter lower than the second quarter, not a good sign of future economic activity.

The current account surpluses of Canada, Germany, and Japan continued to increase in the first half while the deficits of Britain and the U.S. continued to increase also. One can only wonder how long this dynamic can go on. The exchange value of the U.S. dollar is a key element in this dynamic. From 2002, the U.S. dollar index fell from 126.75 to 112.54 in January, 2004 before rising to 115.91 in June. The Japanese and other Asian central banks have been strong buyers of U.S. dollars which they then invest in U.S. Treasury securities. These purchases obviously strengthen the dollar, and U.S. authorities obviously welcome the activity. If they did not, they could buy yen and other currencies, thus canceling the effect of Asian actions. Again, one has to wonder how these games can go on.

Real GDP rose 2.8 percent in the second quarter of 2004 after rising 4.5 percent in the first quarter and 3.0 percent for 2003. Personal consumption expenditures and private domestic investment were the primary contributors to the increases.

Industrial production began to rise in November, 2004, and the rise continued through the first half, mainly in manufacturing; mining and utilities were virtually unchanged. The capacity utilization rate gained two points, while manufacturers' new orders have risen strongly since January.

New construction expenditures rose to new highs every month through July; most of the gain was in residential housing, but there were increases in nonresidential construction as well. The vacancy rate for rental housing at 10.4 percent in March was the highest in over a decade.

Gross private domestic investment surpassed its previous peak set in 2000 in the first half of 2004. About half of the gain over 2003 was in non-residential equipment and software, with the other half divided between residential investment and change in private inventories.

Business sales surpassed their 2000 peak in 2003 and continued to rise in the first half of 2004. Retail sales did not decline during the economic downturn, but their rise since March 2004 has been weak. Inventory-sales ratios are low, particularly in manufacturing and trade. Real per capita consumption expenditures continue to rise about $500 per year.

Although many economic indicators have reached and surpassed their pre-downturn peaks, payroll employment through August had yet to do so. Total employment peaked in 2001 at 131,826 thousand and in August was 131,475 thousand. Goods-producing employment was 23,873 thousand in 2001 and in August was 21,942 thousand. Services-producing employment was 107,952 thousand in 2001 and 109,533 thousand in August. Education and health services employment was 15,645 thousand in 2001 and 16,958 thousand in August, accounting for most of the gain in services employment.

From 1994-2000, national income grew 7.3 percent per year; from 2000-2003, it grew 3.4 percent per year, and from 2003-FH 2004(a.r.) it grew 5.2 percent. Corporate profits during the 2003-FH 2004 period grew 14.2 percent, while compensation of employees grew 3.8 percent. National income data is not adjusted for inflation.

Real per capita personal income increased more in FH 2004 (a.r.) than in 2003 but less than in 2002. Real average weekly earning fell in 2003 and declined further in FH 2004.

Gross and net saving increased in the first half due to an increase in private saving in the form of undistributed corporate profits. Net government saving was $-372.9 billion (a.r.) compared with $-367.7 billion in 2003.

Commodity prices continued to rise toward the index base figure of 100 due to surging demand from China and other Asian economies and to rising oil prices. Producer prices fell moderately in 2002 but have risen since then.

Corporate profits (with i.v.a. & c.c.a.) could be called the "star" of the current economic upturn, rising $146.5 billion in 2003 and $145.3 billion (a.r.) in FH 2004. The capital consumption adjustment, which lowers taxes, rose to $237.1 billion in FH 2004 (a.r.) from $160.8 billion in 2003.

The interest rate on 10 year Treasuries rose to 4.73 percent in June but then fell back close to 4.0 percent by the end of September. The interesting thing about this move is that it comes when the Federal Reserve is raising short-term rates. The market seems to be signaling a different message than the Fed. The M-3 money supply continued to grow in the first half; two main sectors were savings deposits and large denomination time deposits. The federal government deficit was slightly larger in the first half (a.r.) than in 2003.

Most of the increase in bank credit was again in real estate loans and leases; commercial and industrial loans and leases again fell. Consumer credit grew faster in the first half than in the preceding twoyears but well below the 1998-2001 level.

Non-financial credit market debt grew 8.4 percent in FH 2004 (a.r.), higher than the average over the past decade. Federal debt grew 11.4 percent while household debt grew 10.4 percent. Financial debt grew 6.9 percent.

The deficit on goods and services increased to an annual rate of $577.8 billion in the first half of 2004. Exports and imports of goods both increased, but the rise in imports was larger. Exports and imports of services rose about the same amount, with a small decline in the surplus. The increases in goods exports and imports were broad-based across industrial supplies and materials, capital goods, and consumer goods, reflecting a pickup in world trade. The services sector increased for the same reason.

At current cost (the basis used throughout this discussion) U.S. owned assets abroad increased $789.2 billion in 2003 of which $283.4 billion was financial outflows and $505.8 billion was valuation adjustments. Foreign-owned assets in the U.S. increased $986.8 billion of which $829.2 billion was financial inflows and $157.7 billion was valuation adjustments. The U.S. net investment position increased -$197.7 billion in 2003 compared with -$344.3 billion in 2002. The value of U.S. owned assets abroad was boosted by appreciation of most foreign currencies against the U.S. dollar.

Foreign direct investment in the U.S. increased $48.8 billion in 2003, mostly due to financial inflows of $39.9 billion, the smallest since 1992. U.S. owned direct investment abroad continued to exceed foreign investment in the U.S. by a substantial amount.

Foreign owned U.S. Treasury securities increased $245.1 billion in 2003 to a total of $1.5 trillion. This increase equaled 67.2 percent of the $364.5 billion federal deficit in 2003. How convenient to have your profligacy financed by foreigners!

U.S. currency held abroad increased $16.6 billion in 2003 after increasing $21.5 billion in 2002.

Foreign holdings of U.S. securities excluding Treasury securities increased $660.2 billion or 21.7 percent in 2003. The major part of this increase was due to price and exchange rate appreciation rather than additional investment. Net foreign purchases of corporate bonds were a record $227.1 billion. In contrast, transactions in U.S. agency bonds (Fannie Mae, etc.) shifted to net sales of $13.4 billion. By region, the United Kingdom remained the largest holder of corporate and agency bonds at 40 percent, while the largest holders of U.S. stocks were the United Kingdom, Canada, and Japan. Net foreign purchases of U.S. stocks declined for the third consecutive year.

Copyright © Andrew Caughey, 2004

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 2004