Benson's Economic & Market Trends

At the beginning of 2003, the level of debt that American’s owed as an absolute amount, and as a ratio of income, was already approaching levels never seen before. Debt can be handled in a number of ways: 1) earn enough money to pay it off; 2) default; 3) borrow even more; or, 4) pray for inflation so you can earn more dollars (but really pay back less). Where are we now?

Last year, personal income increased about 2%. Individual debt increased about 10%. Personal debt for autos, credit cards, etc., topped $2 Trillion - up about $120 Billion despite massive debt consolidation and mortgage refinancing. Mortgage debt rose about $800 Billion, and total individual debt rose over $925 Billion, while wages and salaries rose only $190 Billion. Retirees and savers saw their interest income shrink, as interest paid on savings dropped by $30 Billion. Indeed, given the Fed’s low interest rate policies, it doesn’t pay to save.

In December, the savings rate dropped to a new low of 1.5% and in the 3rd quarter of 2003, the only reason financial assets were acquired is because they were bought with borrowed money. The low savings rate is even more astounding when you consider the increase in Disposable Personal Income of around $200 Billion from the tax cut. The economy needs $500 Billion in government stimulus from tax cuts and increased spending just to keep employment from falling and to help consumers roll over their credit cards for another month.

The savings rate is actually materially overstated. Personal Income, according to the Bureau of Economic Analysis, includes a few hundred billion dollars in “imputed income” for owning your own home and receiving value for other “non-cash services”. Imputed income is significantly greater than the 1.5% savings rate! Unfortunately, debt can only be repaid with actual cash flow. In January, Personal Income rose at about a 2% annual rate and very few jobs were created. Consumers are spending every last penny to live, and many are “tapped out”.

What is perfectly clear from simple arithmetic is that without a sudden increase in the number of jobs and the wages they pay, individual debt can not be serviced by personal income. Worse yet, not only are people not saving, but their financial reserves are not in real cash. The only thing keeping the “national ponzi scheme” going is the illusion of wealth created by the Federal Reserve’s low interest rates and liquidity that has allowed stock market valuations and housing prices to artificially inflate.

The market value of homes in 2003 rose about $1 Trillion and stock market values rose about $1.5 Trillion. The rising asset prices look like they balance rising debt on household balance sheets. Tragically, the increase in asset prices will vanish the day that interest rates rise, but the debts will still remain. Indeed, not only will the debt remain, but the cost of servicing it will go up dramatically. As interest rates rise, wages and salaries must increase or massive debt defaults will follow.

Income and job growth are so low that we have certainly passed “The Point of No Return”. There cannot be an easy resolution to the debt bubble and resolution will only come when a crisis forces change. Perhaps, for this election year, crisis can be postponed by continuing to facilitate an increase in borrowing so that debts can be rolled over, but increased. By 2005, the ultimate outcome to resolve the debt problem looks like it will be a combination of inflation, rising interest rates and debt default.

The reason we do not believe that job and income growth will save the day for the American worker is we have never before seen in history such increases in government spending, tax cuts, federal budget deficits, consumer spending and borrowing, with so little job growth. The massive fiscal and monetary stimulus has mostly been spent. There will be some nice tax refunds this spring, and that’s it! The peak of mortgage refinancing is already past. Construction spending is at a peak and the percentage of people who own their homes is at a record 69%. Mortgage underwriting shows that 5% of homebuyers in 2003 really couldn’t afford to buy a home, and another 5% could lose their home if one spouse becomes unemployed.

While the industrial sector is recovering, employment in the manufacturing sector has not increased since the start of the recession - there has been job loss in manufacturing for the past 42 months in a row. The United States has been in an economic recovery for over a year and a half and continues to lose manufacturing jobs every month! This is unprecedented!

Capacity utilization in the US remains about 76%, while massive new investments in production capacity are being made in Asia. The drop in the dollar has primarily affected trade with Europe, and Europe isn’t stealing our jobs. As long as Asia buys our dollar debt and continues to hold their currencies down against the dollar, job growth will happen there, but not here. Even when China and the rest of Asia “finally float” their currencies, few jobs will come back to America. In the United States, we only produce 45% of the manufactured goods we consume and much of that production is in electricity, petroleum refining, chemicals etc., that are capital intensive, with few workers required. Critically, many of the workers listed as employed in manufacturing are not engaged in manufacturing at all but in design, marketing, and distribution. Even if the Chinese currency doubled in value, the labor cost for a worker in China would still only be a fraction of the cost for an American in America. The sad fact remains that Personal Income growth will not happen because of job growth. Personal Income remains under pressure as higher “valued added” manufacturing jobs are exchanged for lower paying part-time and service jobs. America is losing manufacturing jobs paying $45,000 - $60,000 a year so it needs three new service jobs paying $15,000 - $20,000 a year just to replace the one manufacturing job that was lost.

So, where are Americans and their mountain of debt headed? If the days of borrowing more - courtesy of both the Federal Reserve and Asia’s Central Banks - are winding down later this year when Asia revalues its currency, it looks like there will only be two ways out: increased inflation and debt default. Both are likely. When those Chinese goods at Wal-Mart go up 30% in price, Americans will see inflation. The Fed will accommodate most of the inflation, but there will be a rise in interest rates. Inflation, if allowed and encouraged, will save the wage earner so he can continue to service his consumer debts. Rising interest rates will smash into housing prices like a tornado in Kansas. Homeowners who have a 30-year fixed rate mortgage will come out in the end, if they don’t have to sell their home for at least 10 years. Anyone who wants to sell their home will see some “asset deflation”, and financial institutions will experience substantial “debt default”. The Federal Reserve will “print money like crazy” to fight asset deflation and encourage inflation. Sometime before or after the Presidential election, the financial markets will be interesting, but painful to many.

Richard Benson, SFGroup, is a widely published author on securitization and specialty finance, and a sought after speaker at financing conferences on raising equity for mid-market companies.

Prior to founding the Specialty Finance Group in 1989, Mr. Benson acted as a trading desk economist for Chase Manhattan Bank in the early 1980's and started in the securitization business in 1983 at Bear Stearns, and helped build the early securitization businesses at Citibank and E.F. Hutton.

Mr. Benson graduated from the University of Wisconsin in 1970 in the Honors Program in Math, and did his doctoral work in Economics at Harvard University. Mr. Benson is a member of the Harvard Club of New York and Palm Beach.

The Specialty Finance Group, LLC is a Florida Limited Liability Company and is registered with the NASD/SIPC as a Broker/Dealer.