Fears that a bear market will dampen consumer spending and will cause a recession are unfounded. This is not to say that the US economy will not experience a slowdown. But when the recession comes, it will be for a different reason.
There is a widespread misunderstanding of the linkage between the stock market and the real economy that is based upon the belief that higher consumption, prompted by a "wealth effect," has been the driving force behind the US' economic performance. Quite the opposite is true. High consumption is an effect rather than a cause of economic activity.
Another sobering fact is that the "boom" experienced in the US was an unsustainable expansion based upon illusions supported by loose credit policies of the Fed. Now for the real shocker. Alan Greenspan is the source of the problem, so he cannot provide a cure.
For it is not the value of stocks that determines spending. Perceptions of increased wealth as embodied in the much ballyhooed "wealth effect" cannot make an economy grow faster, at least not indefinitely. In order for this to be true, the economy would be more sensitive to changes in stock prices than to interest rates. While the two are clearly related, the valuation of stocks is not the principal driving force in the economy. Nor is consumption.
Credit-fueled expansion
In the first instance, the top 1 percent of equity owners holds about 50 percent of all corporate stock and the top 5 percent owns about 80 percent of all stocks. These groups may account for a disproportionately high percentage of consumption, but perhaps 10 to 15 percent of the total.
At the same time, most of what has been spent by the rest of the population is derived from credit rather than cash purchases. Likewise, the cutbacks seen now are not on spending derived from income but from borrowing in order to spend.
Most of the borrowing was the result of the Fed allowing the banking system to create additional credit by pushing the rate of interest to artificially low levels. In turn, this credit expansion has been fueling consumption and pumping air into a stock market bubble.
So what is now happening to the stock market and what will be the impact on consumption? It turns out that manufacturing is always hit first during recessions. That is why there are so many reports about declining profits by bluechip firms. Many businesses over-expanded their capacities due to the low cost of capital borrowing combined with the illusion that the increases in overall spending were sustainable.
Declines in consumption will come later. Contractions in manufacturing and declines in capital goods industries production do not raise the level of unemployment initially because the demand for labor continues to increase at the consumption end of the production structure.
Another suspect in the process of rising consumption was the assertion that there have been large gains in productivity. During the era when there were believers in a "New Economy" driven by investments in IT, stock market players were constantly dazzled by announcements of record increases in productivity. Yet this is also likely to prove to be proved false. In fact, the reported gains in productivity are also tied to the loose credit policies of the Fed.
Consider that labor productivity is calculated as the change in the ability of workers to produce goods and/or services per hour. Since the valuation of these goods and services is important, the crux of the problem is how to measure the real value of these changes in output by deleting the distortions of inflation.
Measuring change
Dividing total monetary expenditures for goods and services by an average price of those goods is meant to solve the problem of measuring total real output. These adjustments are known as price deflators.
A problem is that this is the rate of exchange between various goods established in a transaction between individuals at a fixed place and at a fixed time. This would be the equivalent of constructing an average of the foreign exchange rates of different currencies. Most people would consider a discussion of average exchange rates to be nonsense. Yet averaging prices used in the exchange of goods and services somehow passes muster.
Yet statisticians attempt to identify a pattern of spending by a "typical" consumer by conducting extensive surveys. In turn, they establish a weighting system to reflect changes in the average price that reflects the purchasing power of money. From these changes in the purchasing power of money, estimates are made for measuring changes in total real output and of labor productivity.
Another problem concerns the fact that the weights are left unchanged over an extended period of time implying that individuals exhibit unchanging preferences. It is hard to draw any conclusion other than the deflators under these conditions have little true meaning.
If the deflator is meaningless, then much of the measured productivity growth arises from the distorted results of monetary spending. This only becomes clear by considering that false monetary signals from loose credit policies encouraged the misallocation of investment.
Although new tangible means and objects of output are created, they are not "real" in the sense that they cannot be supported by the true purchasing power of incomes. It turns out that "labor productivity" in the US rose most rapidly following some of the most aggressive monetary pumping by the Fed. There is nothing new about the US economy or about the nature and prospects for an economic slowdown. Once again, central bankers have taken irresponsible actions that created a classic boom and bust cycle. You may have loved the boom, but you are going to hate the bust.
Christopher Lingle is Global Strategist for eConoLytics.com.
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