A Tale Of Two Recessions

Macro-economists know that there are two types of recessions: the common economic decline variety which happens due to excess inventory accumulation within the normal business cycle and the Category 5 storm which results from consumers going on strike and sharply curtailing spending (let's call it "Katrina"). Therefore, here is a question to consider: can the US still have mild, inventory-induced recessions, or are we now destined to have mostly Katrinas, even if they only happen rarely?

Let's analyse the common recession first.

I believe that the inventory accumulation/liquidation cycle for consumer merchandise no longer plays the same role in the US economy as it once did, for two reasons:

a) "Just in time" (JIT) delivery has become the norm everywhere and has progressed to the point where a major retailer can place an order with a manufacturer in China and be confident that his outlets will receive the goods on specific days and times, ready to be sold to the consumer exactly as ordered. It is all arranged by the huge companies that have integrated container ship liner operations with local logistics (eg AP Moeller, Maersk, MSC). This means that much less inventory is now being maintained by merchants vs. final sales and that consumer behavior signals get transmitted to the factory floor much faster than ever before.

There is very little slack left in the manufacturing-shipping-distribution-retailing network. In other words, a merchant seeing his sales going down can and will instantly cut back on his orders to avoid a big inventory accumulation. The level of retailing/logistics technology has reached the point where most of this work is actually done automatically as a cashier swipes a product's bar code at the point of sale.

We can see the result as a steady downward progression in the Inventory to Sales Ratio in the chart below (click to enlarge).



b) The de-industrialization of the US economy has reduced its sensitivity to manufacturing activity and employment, i.e. there are fewer jobs that get affected by the inventory adjustment process. Instead, workers in foreign factories will get affected - and faster than ever before, given how little slack there is within the JIT network.

The two factors taken together mean that inventory imbalances are less likely to be the proximate cause of US recessions. In other words, it is unlikely that we will be getting many "common" type recessions in the future - at least in the US.

However, the US economy is now structured in such a way that it is more vulnerable to "Category 5" type recessions, caused by personal consumption declines. These are the reasons:

Personal consumption now accounts for 71% of GDP, the highest percentage ever (see chart below).

At the same time, such consumption has become more dependent on borrowing. We saw in previous posts how household debt increased much faster than incomes and we know that the saving rate is negative. All this means that unless incomes start rising much faster, personal consumption will be limited by the ability of households to borrow backed by the value of their assets, i.e. the wealth effect I discussed two days ago.

In addition, the ability to boost personal spending through tax cuts has been essentially eliminated after the repeated tax cuts of the current Bush administration and the parlous state of government finances (e.g. war spending).

In other words, the economy is now highly vulnerable to fluctuations in asset prices - mainly real estate, because this is the type of asset most commonly held by the average American (by contrast, 85% of all financial assets are held by a mere 10% of the population). In the past real estate values rose in a steady and measured pace with no overall extremes. All this changed starting as far back as 1992 and peaked in the 2005-06 bubble; the situation is now reversing rapidly, with housing prices falling in absolute terms for the first time since the Great Depression. The effect on household net worth for the vast majority of Americans is going to be severe. Rises is stock prices may create a false, or mirage sense of prosperity but this cannot last in the face of a 100 mph headwind caused by falling house prices. Remember - the vast majority of Americans own no stocks whatsoever, directly or indirectly.... but they do own homes, with mortgages attached.

There is no question whatsoever in my mind that the current situation will have a direct negative effect on personal consumption. We are seeing this happening already, as most retailers started to announce very meager sales increases on a month to month basis, significantly below the pace of inflation. The fact that personal consumption hasn't collapsed is probably due to what I call "wealth inertia": the vaguely delusional belief that "our house is still worth X", maintained because of so many prior years of increases. I am afraid that unless incomes start rising fast the economy may soon be hit by the next stage in the asset price cycle, which is none other than the "poverty effect".

If this were to happen - and we will know soon, as the most crucial period of Christmas sales starts to ramp up in a month - consumers will curtail spending in absolute terms, will seek to cut debt and replenish savings. This is the Katrina of recessions - a Category 5.

Final word... there is only one way out. Corporations need to immediately raise cash salaries and wages to boost confidence and maintain spending. Yes, this will cause an immediate hit to profits, but corporate earnings are already so elevated that the pace of LBO's, buybacks and special cash distributions is at an all time high. Better a bit of profit medicine than Katrina..