I stumbled onto one of Peter Schiff’s radio shows and it was the one where he discusses CNBC chief economic correspondent, Steve Liesman’s call that the American economy needs more consumer debt, which is right in line with the Keynesian theory of spending our way to prosperity. I expect most non-liberal arts degree carrying economists would agree that Steve, once again, out did himself to put economic analysis through a meat grinder and serve it up as a David Burke’s Primehouse 40-day-bone-in ribeye. I’m going to prove that such a theory is simply impossible, and show how it has become that basis of American economics. This is going to get a bit heavy so grab a coffee.
Steve says consumer debt is the bridge between working hard and playing hard. America was built on consumer debt he argues. He claims that debt levels are very low in America which he claims is a sign of a bad economy. Now he also seems to have a hint of understanding that too much debt can cause bubbles and he uses student loans as an example, yet he says that a bit trepidatiously despite the fact that we’re still trying to crawl out of one of the worst credit induced recessions in history. However, despite his caution with student debt he claims the over leverage from the mid 2000’s “has been unwound” and that we are now at the “bottom of the credit cycle”. And that is why, he claims, the American economy needs more consumer debt.
Ok so lot’s of interesting claims there by Mr. Liesman. What I’d like to do here is have a very deep look into the American economic psyche and de-engineer some understanding about GDP, the economy and the American standard of living. To some extent I think we’ll find that Liesman is not all wrong. However, his call for more consumer debt might actually be the worst piece of economic analysis I’ve ever witnessed on national television. But Liesman is just a symptom to the larger problem in our distorted understanding of economics here in America. In any case let’s dig into the matter.
Why don’t we start by having a quick long term look at American consumer debt levels.
And well it becomes pretty obvious that we have in no way de-levered. In fact, growth in consumer debt since the bottom of early 2009 has been extraordinary, adding about $750 billion or 30% more to total outstanding. This is actually an all time high to go along with the nation’s public all time high debt levels. So not sure where Liesman is getting his view of de-leveraging. But let’s do some analysis on consumer debt and see if indeed Americans do need more.
I recently wrote a piece discussing the idea of GDP and indicators, generally. My point is we focus so much on indicators that we lose sight of what they are meant to represent. Most of the indicators that are discussed in the media today point to GDP and if the indicator suggests growth in GDP then we are very happy. However, in my previous article I go on to explain that GDP itself is just an indicator and so GDP growth in and of itself is not the end objective. The objective is that, we the people, are better off and we use GDP as a proxy. But while GDP used to do well to represent improving living standards, we will see why today GDP growth doesn’t always lead to improved living standards and so we must look beyond GDP growth to gauge our real objective.
I recently gave an example to make the point. Consider an economy that has a doubling of the population in one year leading to 5% GDP growth. That growth rate we would consider extremely good in this day and age. However, under that scenario it would mean that the median standard of living had actually declined significantly. Understanding and being cognizant that GDP growth is not our objective is extremely important. When it is overlooked, it can result in incredibly destructive policies that increase GDP but devastate American’s well being. The reality is every part of society from technology to new medicines to new music is to induce a betterment of lives. That is really the whole point of our entire societal system, economics obviously included.
It is important then to understand growth factors of GDP, specifically which factors actually improve standard of living and which simply grow GDP. And so then it is important to understand standard of living. It is somewhat subjective in nature but we must come to some quantitative proxy that we agree reasonably represents standard of living. Now if we remember back to our first economics class the second chart we were shown, after our work/leisure indifference curve, was the following chart (sourced from Wikispaces, classroom).
The chart essentially depicts our ideal level of standard of living. Specifically if you look at the Labour Supply Curve 2, precisely where it meets the L2 dotted line, it depicts the point of our ideal standard of living. So that if you pay me any more I will actually work less beyond that point. Meaning no amount of money will entice me to work more hours because my marginal utility for leisure will trump my marginal utility for any amount of money. But up until that point as long as my wages increase sufficiently I will work more hours meaning I haven’t hit my ideal standard of living and most of us will never reach that ideal conceptual point. And I believe it provides good proof that wage or real income is a very good measure of standard of living in that once we get to a certain point we actually choose to work less implying we are fully satisfied and money then becomes a matter of choice not need.
So how can we determine whether or not American’s level of satisfaction or standard of living in the real world is improving, given the chart above is only a conceptual tool of academia. Well I would suggest we look to real median household incomes. I think it is safe to suggest that the vast majority of Americans have yet to reach that ideal point of standard of living and thus are still willing to work more hours to move toward that ideal point of satisfaction. As such we can also safely suggest that as real median household incomes increase American’s standard of living or satisfaction is improving toward that point.
Now for those that want to jump on me for suggesting money equals happiness, that is not what this implies. It implies more money, given it meets my requirement to work more does provide more satisfaction, however, just paying me more, if it doesn’t meet my requirement means less satisfaction and thus I will choose not to work more. Please think about that for a moment before going on if it is not clear as it important we agree that real median income is our measure for standard of living.
I know some of you are also thinking consumption may actually be a better measure of standard of living. And this a very good thought. Because what is income other than a representation of what we can ultimately consume? While that is true, income provides a sense of security above what consumption does. That is, savings provides me future consumption which I know is uncorrelated to consumption today. Me eating today doesn’t mean I eat tomorrow. However, savings today does mean I eat tomorrow.
This idea of consumption also leads to the concept of debt. That is, debt means even more consumption than perhaps even my savings would provide. And so isn’t that the real measure given it provides me the most consumption? Therefore shouldn’t we consider both income and debt given that equates to my total consumption? Mr. Liesman and most Keynesians would certainly agree with such a proposition otherwise he wouldn’t purport that more consumer debt is needed. That is of course assuming he wouldn’t recommend something he feels is detrimental to American’s standard of living, and thus must believe consumer debt does improve standard of living.
Well let’s think about how debt works. Consumer debt allows me to borrow money today so that I can consume today that which I otherwise wouldn’t. However, there is an interest charge to debt. And so my future consumption is going to be less by the principal amount borrowed plus the real rate of interest I’m paying on it. So let’s say I borrow $100 today at a real interest rate of 5% in order to have a nice dinner. That means at some point in the future I will have to forego $105 of consumption. And so I will only do it if I believe consuming $100 today is worth more than consuming $105 in the future. The cost of borrowing then is very important in determining if we will choose to consume today over tomorrow. This helps us understand why ZiRP or NIRP policies will be fairly permanent. For if interest was 50% I would probably not think eating $100 of food today is better than eating $150 of food in the future. So then does this mean we can improve our standard of living with debt consumption or not?
Well it means we can give up future consumption to have some lesser amount of consumption today. Now in the case of education, and student loans are considered consumer debt in the Fed calculation, for a small and decreasing amount of borrowers, consumer debt can lead to future and overall improvements to standard of living. Unfortunately it is the one area of consumer debt Liesman does not advise taking on. And in fairness to Liesman, a vast amount of student debt in recent years is being used as an alternative source of income rather than an investment. Also due to tuition costs skyrocketing while incomes decline it becomes much harder to make the investment in education pay off these days. And so student loans are frequently leading to declining standard of living. Cars, dinners, clothes, vacations, etc these are typically what consumer debt is used for in America and again while they appear to have an immediate improvement to our lives the future cost tends to be far greater.
As we take on more consumer debt our interest rates increase leading to exponentially more future consumption being given up for each dollar consumed on debt today. And so we would conclude that consumer debt does not lead to a higher standard of living but a lower standard. It is the very reason we don’t use debt as an indicator of an individuals financial success whereas we do use income. And while all that may sound slightly confusing it is, in fact, very simple. Your mother doesn’t brag to her bridge club about how much you consume each year but how well your job pays. If consumption from debt did, in fact, raise our standard of living your mother would brag about it.
But then why has consumer debt moved to such incredible all time highs and why is it that guys like Liesman believe America needs more consumer debt? The answer is because it increases GDP. On the one hand guys like Liesman fail to understand that GDP growth is meaningless. Our policymakers on the other hand have been educated in economics. They understand very well the role consumer debt is playing in America. Now because both private and public funds have increasingly been misallocated for several decades, consumer demand has been falling due to declining real median incomes. It beg’s the question, how is it that while families are brining home less income, GDP has continued its valiant march higher? The answer is consumer debt. Consumer debt is actually the bridge between demand deterioration and rising GDP, not working hard and playing hard.
This is exactly what I meant when I recently wrote about the largest con job in the history of the world. The government and its appointed policymakers have the market, the working class, the media muppets, everyone so narrowly focused on the indicators that we have failed to notice the very thing the indicators were ultimately meant to indicate, i.e. our well being, is deteriorating at an accelerating rate. When was the last time you heard the media muppets or the Fed discuss the epidemic of falling real median incomes? Exactly, it is never mentioned. In order to keep the con going the American working class has been flooded with consumer debt to prop up GDP growth and to defraud us into believing our lives are improving.
We take on more consumer debt because it’s made available to us no matter what our credit is. We’ve all seen the adverts that say “No money down and no credit check”! We take on more consumer debt because our policymakers tell us things are vastly improving and that the job market is as strong as it’s ever been. And we take on more consumer debt because of the irresponsible ‘chief economic correspondents’ like Steve Liesman who preach it’s what we need.
We are bombarded with the idea that we need more consumer debt. This is all part of the giant con. For if we were to recognize that consumer debt actually degrades our living standards and that GDP growth is not inherently good, well the con would be over. While the policymakers are deathly frightened of it, I don’t expect most have taken the time to truly comprehend the bloodbath that awaits us once the jig is up. Let’s move on to some charts that pull this all together for us. (Subsequent chart data sourced from St. Louis Fed)
The chart indicates that standard of life peaked in the late 1990’s and has dropped since. I expect, even anecdotally, most of us old enough to do so, reminisce about the late 1990’s as being very good economic times indeed. Now in order to alleviate short term bumps we can look at the longer term trend and it tells us that standard of living was improving through the late 1990’s at which time it generally plateaued through 2007. However, subsequent to 2007 even the long term trend has turned negative. Meaning our standard of life, even after smoothing for bumps in the road is truly on the decline. This does not bode well for millennials and I expect they understand that more than we give them credit.
But so how can this be when we see real GDP still accelerating? We are constantly being led to believe that as long as GDP is growing, America is doing well. So let’s have a look at real GDP.
We see a very different story here with real GDP than we saw with real median household incomes. Real GDP is currently at all time highs and the long term trend is very much positive. Now as we discussed in the example earlier simple population growth could potentially explain this so let’s see if it really is that easy.
We see that even GDP per capita continues along a strong growth trend, so we cannot chalk it up to population growth. However, I added real median incomes to the above chart to show a rather disturbing trend that ties in to our discussion. Notice that real GDP per capita is now almost higher than real median household income. Real median household income is an aggregate measure of income from all earners in a household, while GDP per capita splits the nation’s total income among each individual in the nation. And so we would expect that real median household income must be larger than real GDP per capita, and 30 years ago that was very much the case.
What is so scary about the chart above is that we are almost to the point that real GDP per capita is higher than real median household income. How can that be?? That is exactly what we need to find out!
But so how does GDP grow so much faster than real median household incomes? Well it is with debt that this can happen. You see consumption makes up around 65% of GDP, but GDP does not differentiate between consumption and debt consumption. And so while real median household incomes are declining taking our standard of living with it, we are using consumer debt to synthesize a higher standard of living via our GDP proxy. In reality, and it will become realized, we are only trading away higher amounts of future comforts to falsify our current lifestyles. The problem is that because of debt service, we are burning up larger and larger amounts of future comforts to get smaller amounts of current comforts.
Now this is all starting to make sense. So because real total consumption cannot be increased through debt we don’t include debt consumption in our measure of individual or household income. Is there a way then that we can look to GDP to sort of equalize it to represent our real median household incomes but for the nation? I expect that we can and to know that we’ve got it right we should look to see a high correlation between the nations, let’s call it ‘Adjusted Real Change in GDP’ that will incorporate only true growth factors, and our real median household income.
What we’ve just unravelled is that real GDP is growing significantly faster than real median household income because real GDP includes debt consumption whereas real median household income does not. So let’s take real GDP and exclude all of our spending that is beyond our means to see if we are still growing or if we find a similar negative trend in the adjusted real GDP figure. So in order to adjust GDP to represent a standard of living for the nation rather than just simply inflating GDP with debt we have to amend the calculation of GDP. We will need to subtract the annual budget deficit because that just represents borrowed money or essentially what equates to the nations consumer debt and then add back government transfers because they are already excluded and some of those transfers may be caught up in the deficit so we don’t want to subtract them twice. Lastly we have to subtract out changes in consumer debt. So the calculation will look like this:
Adj GDP Growth = Change in GDP + Surplus/Deficit + Change is Gov Transfers – Change in Consumer Credit
Then we can use the implicit GDP deflator to get Real Adjusted GDP Growth, which is what I’ve done in the following chart. What we should find remember, is that Real Adjusted Change in GDP should look very similar to Real Median Household Income.
And voila! I’d say we have a winner. You see the key to understanding what is happening is really by looking at GDP per capita vs real median household incomes. It depicts an unnatural divergence between the delta’s of each. As consumer debt levels grew it meant we were adding consumption purchased on debt in GDP whereas it was not being included in real median household income. That is where the divergence laid. And that is the con. We falsify the well being of the nation by inserting debt consumption into our national income figure, which we use as a proxy for the well being of the nation and then we keep everyone focused on that proxy. However, at the individual level, we all know not to include our debt as income and thus it does not mislead us about our standard of living. For we understand debt consumption is rarely better than a zero sum game and almost always a net negative.
From here the next step is to understand why real median household incomes continue to decline and then how to correct it. I’ve written extensively about that topic in previous articles. It all comes back to financial policies that incentivize investors to avoid economic boosting investments and toward financial investments that have no economic benefit. The result is a narrowing of income distribution exasperating the down spiral, while inflating wealth to the already wealthy. As long as these policies remain intact the American quality of life will continue to spiral downward while the wealth at the top continues to accelerate until one day when the top pops off and all that wealth goes abroad. And that Mr. Liesman is what we call economics.