Credit Crunch and Asset Deflation Recession

At least when sports, spin on primary results or celebrity news does not interfere, we are a nation debating the presence, absence, severity and personal impact of economic weakness.
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As you sit down to read this, several debates rage. In financial markets and boardrooms decisions are made and assets repositioned based on opinion regarding the presence or absence of recession. If we are in or headed to recession, how deep and how long will it be? Around kitchen tables, water coolers, church parking lots and bars, the risks to homes, jobs, and making ends meet dominate discussion. At least when sports, spin on primary results or celebrity news does not interfere, we are a nation debating the presence, absence, severity and personal impact of economic weakness. To this debate I would like to add my voice.

The significant group arguing for no or minor coming weakness tends to focus on the relatively specialized areas of trouble. These include, the automotive sector, housing, financial and credit markets. Overall employment and economic growth data -- while far from strong -- are not yet definitely recessionary. Personal earnings numbers have not radically turned down and neither has employment. I will disclose my position now, as I have been writing this position since November. I believe that our post 2001 economic boom was uniquely and imprudently based on consumer credit and asset inflation. Equities rebounded and performed well- particularly outside the US -- since 2003. American home prices surged. All of this was based on consumer credit. Employment and personal earnings growth was weak across the last few years. Thus, it would not be shocking to see less profound earnings and employment downturn as recession begins. If you boom on house price inflation and consumer credit, you bust when they bust. They are busting now.

How bad is the housing scene? There was a 53% increase in the value of American homes as assets from 2002-2007. The price of all homes increased from $14 trillion to $21 trillion. These are paper gains that rise and fall. Now they are falling and likely will decline by at least 15%, or over $3trillion, before the end of 2009. Across the same period there was a 73% or $4.4trillion increase in home mortgage debt. This isn't going away. In fact, thanks to teaser intro rates and balloon options mortgages, it will rise. Consumer credit borrowing increased by $492billion or 25%. We borrowed so much and so fast against our inflating homes that the average American went from owning 56% of their home in 2002 to owning 50% in 2007. As prices fall and debt levels remain the same, this percentage will fall further. Very soon the Average American family will own less than the half the value of their home!

From 2002-2007 there was a 55% -- $16 trillion -- increase in financial asset prices, from $29trillion to $45trillion. The prices of financial assets tend to be sensitive to corporate profits and credit conditions. Over the last 4-5 years corporate profits have risen sharply and are at 77 year highs as a percentage of national income. Corporate profit performance has been the mirror image of employee compensation. It has outperformed averages and surged to all time highs. Low interest rates and financial innovation allowed greater profitability and opportunity to corporations, particular those engaged in the booming credit and housing markets. Our recent economic performance was the offspring of financial innovation, low interest rates, massive consumer borrowing and asset price inflation. All is running in reverse now. The mechanics of the boom have become the engine of the bust.

This was not your father's expansion. It was not based on excellent overall economic growth. It was not based on salary and wage growth. There was only a 31%, $2.4trillion, in disposable income over the last 6 years. Consumer debt increased by $2.4 trillion more than disposable personal income from 2002-2007. Housing and financial price inflation ran at many times the rate of income growth. Debt growth fueled consumer borrowing. A financial asset and housing boom based on easy money and financial innovation created a national economy dependent on assets and home price increases and further credit access. We are now faced with declining housing prices, falling asset prices and squeamish lenders fearful of overly indebted consumers. This is why I believe we are already in a recession or near recession. The near term future will be defined by significant economic weakness.

We don't see particular weakness in jobs and earnings because the recent recovery 2003-2007 was spectacularly weak in terms of job and income growth. The average wage and salary annual percentage gain across 55 years of expansions ran at about 3.8%. Our recent expansion has seen only 1.9% growth in wages and salaries. This is half the average annual wage and salary growth. That is how we reached the dubious low water mark for wages and salaries as a percentage of national income in 2006. In 2006 only 51.6% of national income went to wages and salaries, this is the lowest percentage since 1929 when data collection began. We will have to wait to see weakness in the already limping areas of employment and earnings. I don't see how this bodes well for the near term future or acts to dispute our recessionary trajectory?

We are in the early to middle stages of asset price deflation and credit limitation. This is where we found growth and it will be where we find pain in the coming year. More important than the general forecast is the specific policy lesson that our inorganic and unusual recovery offers. It is unsafe, inequitable and fragile to build and base economic performance on asset price inflation and debt. This economic arrangement produces redistribution of wealth from debtors to creditors and creates a very delicate and poorly shared expansion. Sadly, the weakness that comes from the end of the boom falls heavily on the shoulders of those who gained little from the expansion. It must be with this in mind that we make policy and rebuild.

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