As Americans cut back on imported LCD TVs and Starbucks coffee, the U.S. consumer slowdown will undermine the world economy.
This consumer slump in the U.S. will affect business investments overseas, including factories that are springing up in China and elsewhere to feed American demand.
The rule for a prudent individual is simple: Don't spend more than you make. For a long time, the U.S. economy obeyed that rule. As far back as the 1960s, personal spending, adjusted for inflation, has basically tracked the overall growth of the economy, as measured by gross domestic product (GNP).
That pattern changed in the 1990s. As of the third quarter of 2007, the 10-year growth rate for consumption was 3.6%, vs. GNP growth for the same period of 2.9%. This difference represents an enormous gap. If consumer spending had tracked the overall economy over the past decade as it has in the past, Americans today would be spending about $600 billion less a year. The extra spending has amounted to a total of about $3 trillion since 2001. The question now is how much of that extra $3 trillion we will have to give back.
Non-self-liquidating credit is a loan that is not tied to production and tends to stay in the system. When financial institutions lend for consumer purchases such as expensive cars, boats or homes, or for speculations such as the purchase of stock certificates, no production effort is tied to the loan. Interest payments on such loans stress some other source of income. Such lending is almost always counter-productive; it adds costs to the economy, not value. The result is the subtle deterioration in the quality of spending choices due to the shift of buying power from people who have demonstrated a superior ability to invest or produce (creditors) to those who have demonstrated primarily as superior ability to consume (debtors). Near the end of a major expansion, few creditors expect default, which is why they lend freely to weak borrowers. Deflation involves a substantial amount of involuntary debt liquidation because almost no one expects deflation before it starts.
When the social mood trend changes from optimism to pessimism, creditors, debtors, producers and consumers change their primary orientation from expansion to conservation. As debtors and potential debtors become more conservative, they borrow less or not at all. As producers become more conservative, they reduce expansion plans. As consumers become more conservative, they save more and spend less. A downward "spiral" begins, feeding on pessimism just as the previous boom fed on optimism.
The resulting cascade of debt liquidation is a deflationary crash. A deflationary crash is characterized in part by a persistent, sustained, deep, general decline in people's desire and ability to lend and borrow. A depression is characterized in part by a persistent, sustained, deep, general decline in production. Since a decline in production reduces debtors' means to repay and service debt, a depression supports deflation.
As asset prices fall, people lose wealth, which reduces their ability to offer credit, service debt and support production. For prices of assets to fall, it takes only one seller and one buyer who agree that the former value of an asset was too high. If no other bids are competing with that buyer's, then the value of the asset falls, and it falls for everyone who owns it.
The past 10 years will go down as one of the greatest consumer-lending sprees ever. Adjusted for inflation, consumer debt--including mortgages--rose an average 7.5% per year since 1997, far faster than the 4.2% rate of the previous 10 years. If Americans had kept borrowing at their pre-1997 pace, they would have had about $3 trillion less in debt. "Going forward, we're not going to see this credit-driven growth," says Alistair Milne, a professor and banking expert at City University in London. "Banks are saying, 'we have to be more careful here.'"
Sources: BusinessWeek, February 4, 2008 and Conquer the Crash by Robert R. Prechter Jr.
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