The Consumer-Dependent Economy
John Mauldin's Outside the Box

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This week's letter comes to us from Dr. A. Gary Shilling, president of A. Gary Shilling & Co., Inc. Gary is a long time friend and one of my favorite economic analysts.

Gary takes a look at what he has termed the consumer-dependent economy. The consumer has increasingly become a larger factor in driving our economy with the help of debt and loose monetary policy. Savings, GDP, housing, debt, and bankruptcy trends are pieced together to create a bleak picture of the baby boom retirement years. You will find this very interesting food for thought in this week's Outside the Box.

- John Mauldin

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The Consumer-Dependent Economy

The dependence of the U.S. economy on consumer spending is nothing new. At nearly 71% of GDP, consumer outlays are not only up significantly from earlier years, but also much higher than in most other major countries (Charts 1 and 2).

Very Important Now

Nevertheless, the role of American consumers in promoting economic growth in the U.S. and, indeed, in many export driven foreign countries will be especially significant in coming quarters. The effects of the previous huge federal tax cuts and rebates are over. Indeed, with the revival in the stock market and economic growth in the last several years, the effective tax rate is creeping up after having been slashed by tax cuts. At the same time, the leap in federal spending for homeland security and military action in Afghanistan and Iraq is over, so federal spending's share of GDP has leveled.

Meanwhile, the stimulative effects of earlier Fed credit ease have been reversed (Chart 3), so the salutary effect of declining short-term rates on housing activity has been reversed. Sure, housing remains strong because 30-year mortgage rates have actually fallen in step with Treasury bond yields. And with housing in a full-blown bubble and aided by very accommodative lenders, rising ARM rates, many of which actually don't adjust up for years, don't bother house buyers.

Impotent Fed?

So, thus far the Fed action has had little effect on housing or other economic activity. Indeed, the Fed itself describes its interest rate-raising campaign not as tightening but as removing accommodation that was introduced to counteract the negative effects of the stock market collapse and 9/11, and returning to what the central bank regards as neutral credit policy. As in the initial stages of some previous Fed credit tightening campaigns, stock investors seem to be regarding the credit authorities as toothless tigers.

Nevertheless, three realities are clear. First, tighter credit is simply not stimulative to the economy and in fact is constrictive, one way or the other, sooner or later. Two, history says that the Fed will tighten until something happens, and that something almost always is a recession. Third, with Treasury bond yields falling, the Fed will probably need to invert the yield curve (Chart 4) to get short rates where it wants them. This will be very rough on banks and other financial institutions that rely on a positive spread between the long rates at which they lend and lower short-term borrowing rates. Note that, in the post-World War II era, the Fed has precipitated recessions without inverting the yield curve, but when it does invert, a recession is almost assured.

No Capital Spending Rescue

Elsewhere in the economy, capacity utilization here and even more so abroad remains so low and business caution so subdued that a capital spending boom big enough to lead the economy is unlikely. This is true even if capital spending continues to grow at around 10% annual rates.

U.S. consumer spending strength has been reflected in rising imports while sluggish exports follow from subdued economic activity in Europe and the zeal in Asia to export, not import. This negative and growing trade gap is, of course, a drag on the U.S. economy. Sure, the leap in crude oil prices has been propelling imports since 55% of American petroleum usage comes from abroad. Still, even without high energy prices and even without slower growth abroad than in the U.S., the trade gap would continue to rise.

With consumer spending growth about 1/2% faster than after-tax income on average for over 20 years--and that's what the decline in the saving rate tells us (Chart 5)--American imports grow 2.9% for every 1% rise in GDP. In contrast, this propensity to import is much lower in other major countries. So, if all grew at the same rate, U.S. exports would grow faster than American exports--the imports of other lands--and the U.S. trade gap would widen.

It's Up To The Consumer

By process of elimination, then, the economic ball will need to be carried by consumers in the quarters ahead. Will they have the income to do the job? Personal Income grew 6.7% in the 12 months ending May 2005, or 4.3% after subtracting the 2.4% year over-year rise in the Personal Consumption Expenditure deflator. That's a healthy clip, and is much greater than the first or second quarter annual rate rises in GDP (Chart 6). But is it sustainable?

The 7.2% year-over-year growth in total compensation and 7.0% rise in wages and salaries might suggest so, but these numbers hide some important details. The financial services industry did well last year, and bonuses and commissions were robust in the fourth quarter.

But, much of the bonuses and commissions go to high-income people who tend to be big savers--if anyone is saving these days. Meanwhile, lower-income people who depend on weekly paychecks have seen their real weekly pay continue to decline (Chart 7). Note that 80% of Americans have hourly jobs. Part of the reason for the weakness in real wages is that U.S. employment is shifting from high-paid areas like manufacturing to low-pay areas such as leisure and hospitality.

Furthermore, much of income growth for Americans comes from working more hours. A recent study found that in the 1970-2002 years, annual hours per capita rose 20%. In contrast, other major countries have seen declines in hours worked due to rising unemployment, earlier retirement and declining labor force participation by younger people.

The net result has been a recent leap in the share of income going to the top 20% of Americans while the other four quintiles' shares keep slipping (Chart 8). Indeed, a recent survey found that the number of U.S. households with a net worth of $1 million or more, excluding their residences, jumped 21% last year.

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No Let-Up

Pressure on wages will probably continue. The explosion in profits in recent years (Chart 9) is unlikely to continue as most of the low-hanging fruit of restructuring has been picked, and the rebound from the corporate trouble of the early 2000s is over for the vast majority of companies. Meanwhile, global competitive pressures remain intense. A move from the first quarter's 7.9% toward the long run 5% mean for profits' share of GDP seems likely, especially since in the long run, profits actually grow slower than the overall economy or corporate sales.

In this climate, business is likely to press labor costs harder, much as it did in 2002-2003 when hiring was curtailed and the resulting robust productivity growth flowed to corporate earnings. One reason employers are keeping a tight grip on wages and employment levels is the rapid rises in medical and other fringe costs.


Dividend income is benefiting from the pressure on companies to pay more to shareholders. The maximum 15% tax rate helps as does less certain capital appreciation and, in a post-Enron/Arthur Andersen world, the assurance of credible accounting that meaningful dividend payments bring.

Still, much of the leap in dividends in the last year was due to the gigantic $30 billion Microsoft payment in late 2004. Also, big overall dividend jumps will be difficult even though the current dividend yield, 1.7%, is well below the previous 3% floor (Chart 10).

In the post-World War II era, the payout ratio, the percentage of after-tax profits paid as dividends, has only been at 60% or higher in recessions when earnings fall faster than dividends. Yet with the current 19.3 P/E on the S&P 500 index, a 3% dividend yield, the floor of yesteryear, calls for almost a 60% payout ratio as the average.

Where To Get The Money

It appears, then, that personal income growth in the quarters ahead will not be sufficient to provide the money consumers need to sustain rapid economic growth. But that won't necessarily deter them. They can fuel their spending the old fashioned way--by increasing borrowing and reducing saving. In pursuing these tried and true techniques, however, consumers do face some new challenges.

One is the recent, tighter bankruptcy law. Earlier bankruptcy laws made filing a routine occurrence for many, almost a financial planning tool. The attitude seemed to be, I'll borrow to the hilt to eat, drink and be merry and if my ship comes in and I'm rolling dough, I'll repay my debts. If not, or if unexpected problems arise, I'll file for bankruptcy and get a clean start, as increasing numbers have in recent years (Chart 11).

Eager lenders have sanctioned this approach, in effect. Credit card issuers slice and dice their prospect lists, calculate the expected default rates and set their interest and fee charges accordingly. Losses to deadbeats are just a planned cost of doing business.

In 2004, 1.6 million Americans filed for bankruptcy compared with 780,000 a decade earlier. And in so doing, they wiped out over $40 billion in debt. Over 70% of filings were under Chapter 7 of the bankruptcy code, which erases credit card, medical and many other debts after certain assets such as savings, houses and cars are liquidated to satisfy creditors. But since filers usually had few assets, most simply used Chapter 7 to wipe out debts, and life went on. In 2003, those filers turned over only $1.5 billion in assets to benefit creditors.

Chapter 13 allowed filers to keep their houses and cars, but required them to follow a court-approved debt repayment plan. In 2003, those debtors paid $4.2 billion to creditors.

The New Law

The new bankruptcy law makes bankruptcy much less desirable. Now, filers with incomes above their state's median and with the ability to repay some debts can't use Chapter 7, but must file under Chapter 13. They must undergo credit counseling at their expense six months before filing. They must repay in full auto loans within 30 months of filing and they can't file for Chapter 13 more than once every two years.

Meanwhile, not only debts but debt service, the monthly payment of interest and principal, continues to leap and, in relation to DPI (after-tax income), is much above the mid-1980s peak (Chart 12). Interest rates are much lower now, but the principal owed has exploded. Lending to consumers continues to be a growth business. To get in on the consumer lending opportunities as well as take deposits and handle customer transactions, auto manufacturers including Volkswagen, GM and BMW as well as retailers like Nordstrom, Sears, Federated, Target and Wal-Mart are getting into Internet and in-store banks, often structured as "industrial loan companies."

What Is Saving?

Back in the late 1990s, many argued that the saving rate as structured by the National Income and Product Accounts was irrelevant. It defines saving as what is left from Personal Income, after income taxes, that is not spent on currently-produced items--durable goods like cars and appliances, nondurables like food and clothing and services such as recreation and travel. The critics back then noted the exclusion of capital gains, which were plentiful at the height of the dot com bubble.

Sure, many consumers considered those capital gains as saving. They felt wealthier and spent lavishly even if those gains weren't cashed in. That spending, of course, fueled the economic boom that accompanied the stock bonanza. Economists call this the "real wealth effect." But with the collapse in tech stocks, those capital gains disappeared and so did the criticism of the saving rate definition.

But with the recent leap in house prices (Chart 13), the idea that capital gains are saving is back. Some note that even though capital gains are not included in income as defined by the NIPA, the taxes on them are included in the income taxes that are subtracted from income to ultimately arrive at saving. So, they contend, even the NIPA definition understates saving.

This effect is really small, however. Even in 2000, a huge year for capital gains, removing capital gains taxes would have only increased the saving rate by 1.7 percentage points to 3.0%, still well below the 12% level of the early 1980s. Furthermore, the critics fail to note that the increase in mortgage borrowing, not subtracted from income in the saving calculation, has leaped as house prices, purchases and financial leverage and home equity borrowing have all skyrocketed (Chart 14).

Regardless of how personal saving is defined, unless house prices leap forever, or the stock bubble revives, most Americans' assets are totally inadequate to support them in retirement. And, the almost nonexistent saving from current income--actually zero in June--means that those net assets are being augmented year by year at trivial rates. A recent study of Federal Reserve data found that the households headed by baby boomers had median financial assets of $50,700. With a 5% annual withdrawal rate, that would generate only $2,535 annual retirement income. And financial needs are growing as retirement years expand along with life expectancies.

Not Nearly Enough

Another recent study found that personal savings will provide only 10% to 20% of retirement income, and when pensions and Social Security are included, the total retirement income will be just 59% of median current income for working Americans. Reflecting low saving rates, only 10% of eligible workers in 2003 and 13% in 2004 made the extra contributions to their 401(k)s that Congress allowed in 2001 for people 50 and older, even though 80% of 401(k) plans allow them. Those over 50 could have socked away an extra $3,000 of pre-tax income last year in addition to the basic $13,000 limit.

Apart from saving out of personal income, investment gains are unlikely to provide comfortable retirements for many. It's a question of when, not if, the housing bubble collapses, in my view. Also, in the mild deflation I foresee, stock returns will average 4% to 5%, assuming 3% dividend yields, a far cry from the 20%-plus in the 1995-1999 era. After Treasury bonds rally with the advent of deflation, 3% yields will prevail.

Meanwhile, Social Security benefits will probably become less generous, given the impending financial strains on the system caused by postwar baby retirements and the low birth rates of those who followed them. And defined benefit pension funds are being frozen, terminated, converted to less generous cash balance plans, cut out for younger workers and turned over to the government's Pension Benefit Guaranty Corp., leaving many employees to rely principally on 401(k)s that depend on investment results.

Resistant to Saving

So, Americans will need to finance much more of their retirements the traditional way--by saving more of their disposable personal income, but the average American is fighting saving at any level tooth and nail. Only about 70% participate in their company 401(k) plans and thereby take advantage of company contributions, even though 64% of employers in 2004 said 401(k)s are their primary retirement plan, up from 55% in 2003. Lower paid employees are especially absent from participation, with 40% for those making less than $20,000 and 60% for those earnings $20,000 to $40,000, while 90% of employees earnings $100,000 or more participate. Furthermore, almost 40% of those who left their jobs and had small or medium sized defined contribution plans didn't roll them into IRAs last year, but instead cashed out.

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My Golden House

Despite these financial strains, Americans have yet to run up their saving rate and run down their debt and debt service levels. Instead, the housing bubble apparently has convinced many that their house (or houses since increasing numbers own more than one) is a huge piggy bank that allows them to borrow more and save less--and thereby generates all that money that will be needed to sustain rapid consumer spending and overall economic growth in coming quarters.

So, if my analysis is correct, the key to consumer spending and overall economic growth is the housing bubble. When it breaks, so will the economy as construction nosedives and consumers shift to a massive saving spree and debt repayment, and a serious recession or worse unfolds. Miserly consumers also will slash imports, to the detriment of the many nations that rely on Americans to buy their excess goods and services. With the Chinese economy cooling and headed for recession, aided by the small revaluation in the yuan, a global recession will result. Furthermore, a serious break in U.S. house prices could destroy so much net worth and so disillusion Americans that the good deflation of excess supply I foresee may instead become the bad deflation of deficient demand.

When will the all-important housing bubble break? Ah, that's the $64 trillion question. It looks like it's in the blow-off stage that is typical of the end of a speculation. Still, speculations tend to last longer and go to greater extremes than imaginable. I'm watching closely for signs of a bursting in the housing bubble, and suggest you do too.


I hope you enjoyed the insights of A. Gary Shilling. You can find out more about his company at

Your following the consumer-dependent economy analyst,

John F. Mauldin


John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

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Posted 08-15-2005 2:19 AM by John Mauldin