Consumer Goods vs. Factors of Production

The recent consumption business cycle in the US  can be easily quantified.

The chart below shows the development of private consumption, private investment, and government expenses in the US since 1947:

consumption-investment-government-expenses-in-us
Click on image to enlarge.

The output of a country, its GDP, is approximated by adding those three components up and adding exports and deducting imports. The logic being that if someone consumed something, then someone must of course have produced it. Items exported are not consumed inside the country and thus not captured, hence they are added. Items imported are reflected in the components above, but they are produced outside the country, hence they are deducted.

Consumption expenses give us an idea of how many consumer goods are produced in the country, investment expenses give us an idea how many factors of production are being turned out (duly accounting for exports and imports).

It is completely safe to assume that government expenses can be equated to consumption. It is true that the government spends a fraction of its money on investments such as roads and other infrastructure. However, this fraction is almost negligible when compared to consumptive expenses on goods that are used up immediately and don’t aid in any production processes, such as military products and health care.

The chart below shows the development of the percentage of consumer goods production in relation to the total output, GDP from the Great Depression through now:

us-consumption-as-percentage-of-gdp-1929-2008
Click on image to enlarge.

As can be seen above, the percentage of goods produced for consumption by the productive factors in the US has historically oscillated between 79% and 98% since 1929. The average has been 86.27%.

Another way to look at it is to only look at private consumption only:

us-personal-consumption-as-percentage-of-gdp-1929-2008
Click on image to enlarge.

It reveals a severe drop in personal consumption during World War 2 which was more than replaced with government consumption.

Where can we go from here? It is safe to assume that production of public and private consumer goods will at least fall back to the average of roughly 86%, but maybe even drop to around 80%, given the fact that corrections usually seem to overshoot that average and given the severity of the current correction.

A good indicator of when a true recovery is near will be when investment expenses stop to fall and begin to bottom or even rise again. Meanwhile, the production of consumer goods may continue to drop while employment in businesses that produce factors of production should begin to absorb the released resources at some point.

Businesses that produce this capacity may be attractive at that point. This includes in particular companies from the mining and drilling industries, such as the canadian energy trusts (examples: PVX, PDS, PWE, AAV). New AND old energy sources are likely to be explored and expanded. Alternative energy businesses, such as wind or solar energy may be worth looking into for people who understand the technological challenges that they are exposed to. Basic commodities should do well. Gold and silver should continue to act well so long as people consolidate their finances and demand cash to pay off their debt.

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Delevaraging, Contraction, Imploding Consumer Credit & Increased Saving – The Long Term Outlook

Asia Times Online makes some good observations in Easy bets with other folks’ cash:

Why then are investors persisting with this course of action that adds risks? Many theories have been propounded, but a clear framing of the future outlook would help to understand the sheer “courage” that is involved in buying such assets now. To make things easier, I have used a modified decision tree wherein the basic trend has been used as the title, with financial market consequences being highlighted below each such possible trend. Such an approach is provided below:

1. Green Shoots of economic recovery are for real (hahahahahaha, but let’s take these bubble-spewers at face value for now; or else read “Truth is too hard to handle”).

a. This could only be due to the US and European consumer spending money on borrowed time; yet again
b. Over the short-term that would argue for buying risky assets such as stocks and high-yield bonds and going short US Treasuries;
c. Inflation will rise inevitably, so buy physical commodities including gold;
d. Go short anything near the government bond curve including US Treasuries and German Bunds, among others.

2. We are into a Great Depression

a. The monetization of the debt cycle would have failed for this outcome to percolate to the masses in Europe and the US;
b. Financial institutions in Group of Eight leading industrialized countries cannot raise any capital from the public;
c. Forget about stocks, high-yield bonds that will fall in price dramatically just as soon you buy them for your retirement account;
d. Buy some government bonds, but only of countries that can service their future debt obligations (that is, avoid the likes of the US and pretty much all of Europe);
e. You will need to have some stuff that has real economic value rather than the worthless IOUs issued by G-8 governments, so buy some gold;
f. This might also be a good cue to buy some weapons and ammunition.

3. We will have a Y-shaped recovery (see How about a Y-shaped recovery, Asia Times Online, February 23, 2008.)

a. The US and Europe are toast, but emerging markets will do well;
b. Financial institutions in G-8 countries cannot raise any capital from the public;
c. Buy emerging market equities and bonds, sell everything else;
d. As most emerging market currencies are quite funky and don’t really fit into your wallets, you will need some gold for your travels.

My comment: I am of the opinion that #2 is the correct assessment of the current situation and that we have a long period of debt consolidation, consumer abstention, and wealth deflation before us. We are repeating the playbook from the Great Depression. Gold and silver should continue to hold the line. Government bonds should do fine throughout this period, see Time for Treasurys. Shorting commercial property ETFs in addition to that is a decent addition to any portfolio.

What the average reader thinks for himself is one thing; what he is being told by the financial media at large (and G-8 financial media in particular) is altogether a different matter. Whilst I would normally lean towards the school of an incipient economic recovery after a couple of years of any economic bust, a number of factors conspire to deny any such notion in my mind at the moment:

1. This is very much a crisis caused by excess leverage in the US (and, less so, in Europe). Until the leverage is washed out, there is no chance of any economic recovery;
2. Governments have engaged in widespread monetization of such leverage, rather than addressing the core event itself. This has the effect of actually making the future even more uncertain. For example, General Motors or Chrysler as private companies would have entered bankruptcy many months ago; but thanks to government intervention now re-emerge as worker-owned companies that couldn’t possibly get bank financing down the road (due to the destruction of creditors’ rights by the Obama administration). Ergo, this is money wasted by the government at great cost to the average US taxpayer: not exactly the recipe for an economic recovery;
3. Then there is the question of bank funding. Most analysts point to a funding gap of around US$20 trillion for the G-8 banking system by 2011, made worse by the reduced velocity of money (that is, a lower money multiplier). This problem has not been addressed, and most likely will not be; unless banks can pledge more useless collateral with their central banks and in effect get “free” funding;
4. Export-driven markets are toast, be it China or Germany or Japan. All these countries will have to reinvest in their domestic markets: some to fruitful results (China) but others to no avail (Japan). Whatever they do, it is clear what they will NOT do – that is, they will not buy more US sovereign and state-guaranteed debt;
5. Many of the weaker emerging market countries are facing funding pressures; particularly those in Eastern Europe. The resulting increase in defaults promises to fell the rest of the European banking system that hasn’t already fallen victim to the US financial collapse. This will also divert more resources from the International Monetary Fund and so on, to the expense of the G-8;
6. Increased strategic risks: think Pakistan’s ongoing fights with the Taliban, Iran’s nuclear weapons program, Russia’s anger with the North Atlantic Treaty Organization over Georgia as just a few examples of what could go wrong in the very, very near future.Based on all this, it is clear to me that the only people who could possibly believe that risky assets such as high-yield bonds and common stocks are a good buy are either the people who currently own them (and therefore will post profits when they rise in price) or those that need to get out of their positions (that is, sell their bond positions or raise new equity).

In most cases, the answer is “both of the above”, namely US and European banks who are loading up on some securities to cause artificial shortages that in turn help to raise prices of the rest of their books. These institutions have the benefit of knowing that a good trade gets them out of jail, but bad trades only result in more government assistance being lavished on them.

They aren’t playing with their own money, but rather with yours. When you are only ever going to lose other people’s money, the rules change and an entirely different “game” takes hold. That is what you are seeing now; until the final blows of economic data help to chase these fake rallies out of the market. When that happens, the biggest losers will be the people who own these risky assets like high-yield corporate bonds in the US (or Europe) and stocks of banks across G-8.

My comment: I marked the most important point in the passage above in bold. There is no end in sight for the current correction of this business cycle so long as the bad debts on balance sheets remain overvalued and uncorrected. For a good estimation of how long this may take, we can take a look at a recent report by the San Francisco Federal Reserve Board, titled U.S. Household Deleveraging and Future Consumption Growth:

How much deleveraging?

Since the start of the U.S. recession in December 2007, household leverage has declined. It currently stands at about 130% of disposable income. How much further will the deleveraging process go? In addition to factors governing the supply and demand for debt, the answer will depend on the future growth trajectory of the U.S. economy. While it’s true that Japanese firms and U.S. households may differ in important ways regarding decisions about paying down debt, the Japanese experience provides a recent example of a significant deleveraging episode that took place in the aftermath of a major real estate bubble and is useful as a benchmark.

The Japanese stock market bubble burst in late 1989, followed soon after by the bursting of the real estate bubble in early 1991. Nearly 20 years later, stock and commercial real estate prices remain more than 70% below their peaks, while residential land prices are more than 40% below their peak.

Figure 3 compares Japan’s nonfinancial corporate sector with the U.S. household sector over 10-year periods before and after the leverage-ratio peaks. In both countries, leverage ratios rose rapidly in the years before the peak.

After Japan’s bubbles burst, private nonfinancial firms undertook a massive deleveraging, reducing their collective debt-to-GDP ratio from 125% in 1991 to 95% in 2001. By reducing spending on investment, the firms changed from being net borrowers to net savers. If U.S. households were to undertake a similar deleveraging, their collective debt-to-income ratio would need to drop to around 100% by year-end 2018, returning to the level that prevailed in 2002.

The report concludes with the following outlook:

Conclusion

More than 20 years ago, economist Hyman Minsky (1986) proposed a “financial instability hypothesis.” He argued that prosperous times can often induce borrowers to accumulate debt beyond their ability to repay out of current income, thus leading to financial crises and severe economic contractions.

Until recently, U.S. households were accumulating debt at a rapid pace, allowing consumption to grow faster than income. An environment of easy credit facilitated this process, fueled further by rising prices of stocks and housing, which provided collateral for even more borrowing. The value of that collateral has since dropped dramatically, leaving many households in a precarious financial position, particularly in light of economic uncertainty that threatens their jobs.

Going forward, it seems probable that many U.S. households will reduce their debt. If accomplished through increased saving, the deleveraging process could result in a substantial and prolonged slowdown in consumer spending relative to pre-recession growth rates. Alternatively, if accomplished through some form of default on existing debt, such as real estate short sales, foreclosures, or bankruptcy, deleveraging could involve significant costs for consumers, including tax liabilities on forgiven debt, legal fees, and lower credit scores. Moreover, this form of deleveraging would simply shift the problem onto banks that hold these loans as assets on their balance sheets. Either way, the process of household deleveraging will not be painless.

My comment: My word exactly. I call it The End of Consumerism:

We need to respond to the reality around us rather than deny it. It is time to cut back and restore sanity and balance. Individuals have realized this and are doing the right thing. The government has not understood this fact at all. It is trying to keep alive failed businesses that should release resources for more demanded projects. It is trying to make up for the “lack of consumption” in the private sector. All these attempts will fail miserably. All they will accomplish is to slow down the corrective phase and turn it into a decade of agony.

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Consumer Credit – March 2009

The total consumer credit volume in the US has dropped to $2.53 trillion, a drop of $27.2 billion from February. It has now fallen from its December 08 peak by $64 billion:

total-consumer-credit-us-may-2009
Click on image to enlarge.

When looking at the chart above one might think that this might as well be just another ditch like the ones that usually followed December.

But one has to realize that the chart above starts at 2001. From 2001 through 2007 the American attitude was consistently biased toward more and more borrowing and more and more spending.

But these attitudes have changed. The end of consumerism is not just a temporary recessionary ditch. It is a fundamental shift in psychology and attitudes that can carry on for a very long time.

When looking at the long term chart of consumer credit, one gets a better picture of where we can go from here, assuming that this consumer cradit bubble that started in 1993 has burst:
total-consumer-credit-us-long-term
Click image to enlarge.

Simply put: I think the roller coaster has reached the top.

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The End of Consumerism

In a free society where individuals are allowed to make choices by themselves so long as they don’t infringe upon their fellow men’s life, health, and property, entrepreneurs use natural resources, transform them and/or combine them with previously produced factors of production, and turn them into either consumer goods or other factors of production. They employ workers in the process who provide the production factor labor.

They exchange consumer goods on the market against money obtained from consumers. They exchange factors of production against money obtained from other entrepreneurs.

Factors of production, once completed at some point in the future, enable entrepreneurs to produce more consumer goods during the same amount of time. But while factors of production are being built, workers and natural resources are being used in processes that don’t turn out any consumer goods. It is thus necessary to only employ workers and resources in the production and maintenance of factors of production to the extent that during this process individuals in society are willing to not consume the full output of their labor, and hence generate savings.

On top of that, it is necessary to maintain the existing stock of productive factors, lest their wear and tear cause a decline in the output of consumer products. Thus a continuous level of savings needs to be maintained by individuals in society.

Interest rates on the market give entrepreneurs an indication of the market participants’ time preference, meaning how much immediate consumption people are willing to forgo in exchange for the prospect of more future consumption. In other words, interest rates give an indication as to how much people are ready to save and thus contribute to the maintenance and new developments of factors of production.

If the the government pursues a policy of business credit expansion, the interest rate indicator is manipulated by force, as opposed to voluntary individual time preferences. The interest rate drops below the level that represents those actual preferences. If mostly consumer loans are pushed, the consumption business cycle ensues:

The Consumption Business Cycle

The central bank and fractional reserve banks create new fiat money and make it available in credit transactions to individuals who intend to use the money for the purposes of consumption. Examples would be car loans and home loans which made the US economy align its productive factors accordingly over the past decades. It is likely, but not necessary that interest rates for such credit instruments will drop initially.

Some individuals may now enter into these new credit transactions and use the new money to consume goods that they wouldn’t have consumed before. But they didn’t do so by reducing their savings, nor did anybody else sacrifice consumption to make this money available. It was created out of nothing. No additional consumer goods have been produced.

The prices for the goods demanded will begin to increase. Entrepreneurs will respond by abandoning the production of some additional factors of production and turn out more consumer goods instead. So long as more credit is channeled into the system, prices will continue to increase while entrepreneurs try to catch up. Fractional reserve banks will begin to earn more interest revenue and expand their operations and resource usage.

Businesses that produce consumer goods will report higher profits, while profits for businesses producing factors of production and basic materials will lag behind. A myriad of consumer goods based businesses will spring up over time. The alignment for immediate consumption vs. more/better future consumption continues so long as individuals continue to be able to pay interest on the credit transactions performed and expect to be able to do so in future.

But as explained above, making interest payments and paying off debt is only possible in the long run if the workforce, as a whole over time, becomes more productive per unit of labor. But the opposite occurs. Productivity per labor unit will be lower than the additional consumer loans appeared to indicate, since in an unhampered system credit can only come out of savings (which means someone somewhere forgoes immediate consumption, making room for more factors of production). After a certain period, the amount of debt and interest payments will become higher than consumers can afford. In addition, due to lower interest rates, a lot of rather risky loans were made to individuals that would not have occurred in the unhampered state. Individuals will begin to default on their interest payments.

They start realizing that they need to consume less and save more in order to not have this happen again. Their demand for additional credit drops sharply. Their demand for money to pay off the debt and/or generate savings rises.

The fractional reserve banks will begin to slow down the creation of additional credit. They begin reporting losses on existing consumer debt.

As excess consumption comes to a halt consumer prices begin to fall, businesses aligned for the production of consumer goods will see declining profits, some will start reporting losses. They realize that they will have to abandon some projects since the demand for consumer goods starts to fall back to sustainable levels that match everyone’s time preference and expectations. The desire to consolidate one’s finances takes priority over everything else.

This is what is currently happening in the United States. The end of consumerism really means the end of capital consumption. It means that people realize that they need to save more and consume less, so as to provide for economic progress and more efficiency in the future, and to restore balance to the economy as a whole. It means that people have understood that too much of the existing capital stock has been consumed and has deteriorated.

This is the causality that the majority of pundits and economics professors that one can hear talk every evening on the news simply don’t understand. All their theories and policies are ignoring this one crucial fact: That Americans are done consuming for the foreseeable future. The end of consumerism isn’t just a temporary ditch. It is here and now and it won’t go a way for a long long time. It is a once in a lifetime occurrence. This is why it is so hard to grasp and to accept. But it is very simple to understand when one approaches it with sane common sense. How many more Starbucks branches do we need in the streets of New York? How many more gas guzzling cars should each family posess? Three, four, ten …? How many more different brands of detergents, shampoos, toothpastes, and consumer electronics products do we really need?

Now, it is important that the reader doesn’t get this wrong. I do not oppose consumption. In fact, the entire material wealth of a person is ultimately determined by how much he can consume. Consumption, present or future, is what all humans ultimately work for. But if, in an environment of government induced credit expansion, people consume more than is sustainable in the long run so long as the music still plays, they need to cut back for a certain period once the music stops playing. If we had never embarked on the disastrous path of credit expansion and government intervention, if all factors of production were allocated as efficiently and effectively as possible, if the government had confined its scope to the protection of each individual’s life, health, and property, we would today be able to consume a lot more than we currently can.

Unfortunately this is not the situation we are in here and now. We do not live in a perfect free world. We need to respond to the reality around us rather than deny it. It is time to cut back and restore sanity and balance. Individuals have realized this and are doing the right thing. The government has not understood this fact at all. It is trying to keep alive failed businesses that should release resources for more demanded projects. It is trying to make up for the “lack of consumption” in the private sector. All these attempts will fail miserably. All they will accomplish is to slow down the corrective phase and turn it into a decade of agony.

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Beer is not Recession Proof

An interesting statistic from FiveThirtyEight.com:

Beer, it seems, is no longer what’s for dinner.

The chart that follows details the quarterly change in alcohol purchased for home consumption, adjusted for inflation and dating all the way back to 1959. We can compare this against the quarterly change in real GDP:

As you can see, there has generally not been much of a relationship between alcohol purchases and changes in GDP — the correlation is essentially zero. Nor have alcohol purchases historically been any kind of lagging or leading indicator.

But something was very, very different in the fourth quarter of 2008. Sales of alcohol for off-premises consumption were down by 9.3 percent from the previous quarter, according to the Commerce Department. This is absolutely unprecedented: the largest previous drop had been just 3.7 percent, between the third and fourth quarters of 1991.

Beer accounts for almost all of the decrease, with revenues off by almost 14 percent. Wine and spirits were much more stable, with sales volumes declining by 1.6 percent and 0.9 percent respectively.

Now, there are several plausible explanations for this. Alcohol sales — but particularly beer — had been on something of a hot streak prior to the 4Q, so perhaps there was some reversion to the mean. Perhaps people are substituting Michelob and Coors for more expensive microbrews like Alpha King and Dogfish Head. (This is unpatriotic, by the way, since all the macrobrews are now owned by foreign-based multinational conglomerates. Stimulate your country — and your tastebuds!).

Perhaps retailers are discounting their prices, or brewers are passing along cost savings to their consumers (there had been a hops shortage for much of 2007-08). All of these are probably factors to some extent or another.

Nevertheless, it’s absolutely startling to see a major consumer staple experience a sales decline like this.

It’s not just beer, either. Sales of jewelry and watches were off by 7.2 percent in the fourth quarter, the third-largest drop ever recorded. Casino gambling receipts are down about 8.5 percent from a year ago, far and away the largest decrease ever over four consecutive quarters.

What’s doing well? The movies. The movies, also historically a recession-proof industry but not a counter-cyclical one, are doing terrifically well. Motion picture theaters increased their revenues by 10.9 percent in the fourth quarter, according to the Commerce Department. But the movies are not typically seen as extravagant. You don’t feel guilty after purchasing a movie ticket; you feel kind of wholesome.

I can’t escape the feeling that there’s something rather Weberian about it all: a manifestation of Calvinist guilt over both the present failures of the economy and its prior excesses. A deliberate effort to deny oneself pleasure.

Conspicuous non-consumption.

This is relevant because it simply shows the sheer magnitude of the changes of consumer behavior in the US. This is not just a little ditch in consumption. It is a seismic shift in consumer philosophy. Frugality is the new credo, all across the nation. This is of course a very healthy (literally and figuratively) development and exactly what is needed to go through the correction phase of the business cycle. The one large stumbling block in the way of this correction is as always the US government whose officials don’t understand the necessity of a corrective phase in the business cycle at all. Their measures ensure that this correction will take painstakingly long.

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