The U.S. economy continues to lose momentum despite the Federal Reserve’s use of conventional techniques and numerous experimental measures to spur growth. In the first half of the year, real GDP grew at only a 1.2% annual rate while real per capita GDP increased by a minimal 0.3% annual rate. Such increases are insufficient to raise the standard of living, which, as measured by real median household income, stands at the same level as it did 17 years ago (Chart 1).
Over the latest five years ending June 30, 2014, real GDP expanded at a paltry 2.2% annual rate. In comparison, from 1791 through 1999, the growth in real GDP was 3.9% per annum. Similarly, real per capita GDP recorded a dismal 1.4% annual growth rate over the past five years, 26% less than the long-term growth rate. A large contributor to this remarkable downshift in economic growth was that in 1999 the combined public and private debt reached a critical range of 250%-275% of GDP. Econometric studies have shown that a country’s growth rate will lose about 25% of its “normal experience growth rate” when this occurs. Further, as debt relative to GDP moves above critical threshold levels, some researchers have found the negative consequences of debt on economic activity actually worsens at a greater rate, thus becoming non-linear. The post-1999 record is consistent with these findings as the U.S. debt-to-GDP levels swelled to a peak as high as 360%, well above the critical level noted in various economic studies.
In terms of growth, it looks as if the second half of 2014 will continue to follow this slow growth pattern. Although all of the data has not yet been reported, it appears that the year-over-year growth in real GDP for the just ended third quarter period is unlikely to exceed the 2.2% pace of the past five years. Economic vigor is absent, and the final quarter of the year looks to be weaker than the third quarter.
Poor domestic business conditions in the U.S. are echoed in Europe and Japan. The issue for Europe is whether the economy triple dips into recession or manages to merely stagnate. For Japan, the question is the degree of the erosion in economic activity. This is for an economy where nominal GDP has been unchanged for almost 22 years. U.S. growth is outpacing that of Europe and Japan primarily because those economies carry much higher debt-to-GDP ratios. Based on the latest available data, aggregate debt in the U.S. stands at 334%, compared with 460% in the 17 economies in the euro currency zone and 655% in Japan. Economic research has suggested that the more advanced the debt level, the worse the economic performance, and this theory is in fact validated by the real world data.
Falling worldwide inflation
In this debt-constrained environment, it is not surprising that inflation is receding sharply in almost every major economy, including China. The drop in price pressures in the U.S. and Europe is significant, and the fall in Chinese inflation to 2%, from a peak of nearly 9% in 2008, is notable.
In the latest 12 months, the CPI in the euro currency zone rose a scant 0.3% (Chart 2), the lowest since 2009, while the core CPI increased by 0.7%, near the all-time lows for the series. The yearly gain in the U.S. for both core and overall CPI was 1.7%. Since 1958 when the core CPI came into existence, it and the overall CPI have increased at an average annual rate of 3.8% and 3.9%, respectively, over 200 basis points greater than the current rates. Both the overall and core personal consumption expenditures U.S. price indices rose by 1.5% in the 12 months ending August 2014. Both of these are near the all-time lows for their respective series.
The risk of outright deflation in Europe with inflation at such low levels, and the danger of similar developments in the U.S., should not be minimized as inflation has fallen in almost every previous U.S. and European economic contraction. Lower inflation is, in fact, almost as much of a hallmark of recessions as is decreasing real GDP. From peak to trough the rate of CPI inflation fell by an average of slightly more than 300 basis points in and around the mild U.S. recessions of 1990-91 and 2000-01. Starting from a much lower point, the CPI in Europe at those same times dropped by an average of 150 basis points. Given that inflation is already so minimal in both the U.S. and Europe, even the mildest recession could put both economies in deflation.
Japan’s recent quantitative easing has helped devalue its currency by 44% versus the dollar, since the 2011 lows. This import-dependent country has therefore seen its costs rise dramatically. This, along with higher consumption taxes, has created a current year-over-year inflation rate of 3.3%. These higher prices are an enormous drag on economic growth as incomes fail to rise commensurately. Thus negative GDP growth will result in a continuing pattern of deflation. Japan’s CPI has been zero or negative on a year-over-year basis in 16 of the last 23 quarters.
Declining money velocity a global event
One factor that connects poor growth with the low inflation and low bond yields evident in the U.S., Europe and Japan is that the velocity of money (V) is falling in all three areas.
Functionally, many things influence V. The factors that could theoretically influence V in at least some minimal fashion are too numerous to count. A key variable, however, appears to be the productivity of debt. Money and debt are created simultaneously. If the debt produces a sustaining income stream to repay principal and interest, then V will rise since GDP will rise by more than the initial borrowing. If the debt is unproductive or counterproductive, meaning that a sustaining income stream is absent, or worse the debt subtracts from future income, then V will fall. Debt utilized for the purpose of consumption or paying of interest, or debt that is defaulted on will be either unproductive or counterproductive, leading to a decline in V.
The Nobel laureate Milton Friedman, as well as economist Irving Fisher, commented on the causal determinants of V. Friedman thought V was stable while Fisher believed it was variable. Presently, the evidence suggests that Fisher’s view has prevailed. Fisher would not be at all surprised by the current impact of excessive debt, since he argued in his famous 1933 paper, “The Debt-Deflation Theory of Great Depressions,” that falling money velocity is a symptom of extreme over-indebtedness.
Tracking that theory, it is interesting to note that velocity is below historical norms in all three major economic areas with existing over indebtedness. The U.S. V is higher than European V, which in turn is higher than Japanese V. This pattern is entirely consistent since Japan is more highly indebted than Europe, which is more highly indebted than the U.S.
Unfortunately, broad monetary conditions (M2 money growth and velocity) are deteriorating, with 2014 displaying conditions worse than at the end of last year. The poor trend in the velocity for all three areas indicates that monetary policy for these countries is not a factor in influencing economic activity in any meaningful way.
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