Fears that a bear market in the United States will dampen consumer spending and cause a recession are unfounded. This is not to say that the U.S. 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 link between the stock market and the real economy based on the belief that higher consumption prompted by a “wealth effect” has been the driving force behind America’s impressive 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 U.S. was an unsustainable expansion based on illusions supported by the loose-credit policies of the U.S. Federal Reserve. Now for the real shocker. Fed Chairman Alan Greenspan is the source of the problem, so he cannot provide a cure.
It is not the value of stocks that determines spending. Perceptions of increased wealth — as in the much-ballyhooed “wealth effect” — cannot make an economy grow faster, at least not indefinitely. For this to be true, the economy would have to 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.
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.
In all events, 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 fueled consumption, 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 by blue-chip firms about declining profits. 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 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. Yet this is also likely to be proved false. In fact, the reported gains in productivity are also tied to the loose-credit policies of the Fed.
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.
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, which most people would consider nonsense. Yet averaging prices used in the exchange of goods and services somehow passes muster.
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. Under these conditions, deflators 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 U.S. rose most rapidly following some of the most aggressive monetary pumping by the Fed.
There is nothing new about the U.S. economy or about the nature of 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.
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