© David Collett 2010 ANCHORAGE INVESTMENTS

Part II: The Originating Causes of the Credit Crisis

US Edging towards a double dip recession – is the economic recovery
blocked by an invisible wall?

July 15, 2010

by David Collett

Introduction

Why is the world, especially the United States, edging towards a double dip
recession? What is the ‘invisible wall’, that some, including Alan Greenspan, refer
to, that is holding us back from a sustainable recovery?

Despite using the nuclear option of quantitative easing and government stimulus,
the US has failed to create sufficient new jobs that can support a sustainable
economic recovery, failed to extend much needed credit to small businesses and
failed to counter the slide in the housing market. Global shipping (Baltic Dry
Index) has made a turn for the worse and consumer confidence is down. Daryl
Montgomery, Organizer of the New York Investing Meetup, summarised the
bleak outlook for a recovery by stating that “Government spending didn't just
stimulate the recovery, government spending WAS the recovery”.

In trying to determine what this invisible wall is and why it is holding us back,
we must first determine what the dominant causes of credit crisis are. We
started to discuss this in our previous blog titled “The Dominant Causes of the
Credit Crisis and How To Solve it” and will continue to develop this theme
throughout a series of blogs. Most of our initial focus will be on the US economy.
As we progress, the role of major European and Asian countries will also be
discussed. Unless we specifically refer to another country by name, the reader
can assume that we are referring to the United States.

The Six Decades (1947 – 2007) Preceding the Credit Crisis

The fifties and sixties were periods of high growth in productivity and income. It
was a period of increasing prosperity for Americans across the wealth spectrum,
measured by either income or net worth. GDP growth for the fifties (48.3% over
10 year period) and sixties (49.4%) was significantly higher than any of the
decades (below 40%) that followed. Top marginal tax rates were above 70% and
income inequalities narrowed substantially from the 1930’s. Industrial capacity
utilization was between 80% and 90% for most of the sixties. From around 1947
to the 1970’s, the relative high growth in real household income was evenly
spread between all wealth groups of the US. During this period the United States
was the world's leading export powerhouse, running a sizeable surplus.

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Subtle changes came about in the 1970’s and intensified in the subsequent
decades (1980 – 2007). These changes were to influence the US and world’s
economic history in a significant way. It was a time when economic imbalances
were building up to a point where a major correction became inevitable, a
correction which is still in process today.

The Divide between productivity and income growth

US growth in real income and productivity rose together in lockstep from the
forties until around the middle seventies. All income groups benefitted equally
from the relative high growth in productivity of about 2.7% annually from 1949
to 1973 as average wages kept pace with growth in productivity.

A major change came about in 1973, when the growth rate in productivity
decreased to around 1.5% annually until 1995. But an even bigger change came
in the form of a substantially lower growth in real income over the same period.
Growth in median income of US households slowed to less than ½% annually,
and mean income of households slowed to around 1% annually. The real median
earnings of a full time male worker basically came to a standstill as his real
annual earnings of $42,573 in 1973, dropped to $40,064i in 1995. The changes in
the growth rate of productivity are shown by this chart posted by the FRBSF
Economic Letter 2007-25; August 31, 2007:

Source: Federal Reserve Bank of San Francisco

http://www.frbsf.org/publications/economics/letter/2007/el2007-25.html

From around 1995 to 2007 the pace of productivity growth increased to around
2.5% per annum. Although the pace of growth in both median and mean income
picked up in the period between 1995 and 2000, it slowed substantially from
2001 onwards. From 1995 to 2007 it grew at less than half the pace at which

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productivity grew. A report by Isabel Sawhill from the Brookings Institution and
John E. Morton from The Pew Charitable Trusts, discusses how the benefits of
economic growth have not been shared evenly, referring to the growing divide
between growth rates of productivity and mean family income.

The report states: “Finally, even if growth were to resume at its former pace, a
growing gap between U.S. productivity and median family income challenges the
notion that a rising tide will lift all boats. For nearly thirty years after the end of
World War II, productivity growth and median household income rose together in
lockstep. Then, beginning in the mid-1970s, we see a growing gulf between the two,
which widens dramatically at the turn of the century. As the data in Figures 6-9
indicate, the benefits of productivity growth have not been broadly shared in recent
years.”

A graph from the above report illustrates this divide between growth rates of
productivity and mean family income.

Source: European Tribune

Author’s calculations of U.S. Census Bureau and Bureau of Labor Statitics data.* Income includes before tax earnings,
interest, rent, government cash assistance, pension, child support, and other cash income. It does not include the value of non-
cash compensation such as employer-contributions to health insurance and retirement benefits, the effect of taxes or non-
cash benefits. Graph sourced from http://www.eurotrib.com/story/2007/5/30/6525/77055

This growing divide forms one of the cornerstones of the so called invisible wall
– the barrier that makes it so difficult for the US and world economy to escape
the clutches of the Credit Crisis. As we will show below, increasing productivity
and the divide between it and growth in median income are one of the
originating causes of the Credit Crisis.

For a period (1970 – 2000) the wages or compensation of workers with a

bachelor’s degree seemed to do better by moving in lockstep with growth in

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productivity, but since 2001 even this relationship disconnected as shown by the
graph below from The Economic Policy Institute.

Source: Economic Policy Institute epi.bluestatedigital.com/.../

In an article posted by Lawrence Mishel , president of the Economic Policy

Institute in Washington, D.C. ON MARCH 27, 2007, Mishel acknowledged the
growing gap between the increase in income of the American workforce and the
increase in productivity

“Americans are working not just harder and longer, but more productively. The
economy has grown enormously, in large part because the American workforce has
been among the most productive in the world. Output per hour of work increased
71% from 1980 to 2005, making possible a dramatic rise in our living standards.
But the real compensation, including benefits, of nonsupervisory employees rose
only 4%. Productivity over the past 5 years rose almost 20%, but inflation-adjusted
wages for workers with a college education have been flat, just as they have for
those with a high school diploma.”ii

But what does this have to do with the causes of the Credit Crisis? Well, if your
workers produce more goods and services but get less compensation, who is
going to buy those extra goods and services? Interestingly enough, this problem
was identified long ago by Henry Ford in 1914 when he more than doubled the
minimum wages of his employees. Part of his underlying philosophy for paying
workers more, was that the workers had to earn enough income in order to buy
the cars they built.

It is important to realise that from the middle seventies the average worker
became relatively less able to buy the products that he produced with his
employer. But how did the American work force continue to consume the
production from 1973 to 2006, even though the growth in their income did not
keep up with the growth in productivity? The short answer - Americans worked

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longer hours, got more credit, enjoyed significant tax cuts which increased
disposable income and used their savings to keep on spending.

The divide between supply and demand

Since the late 1960’s there was a general downward trend in the utilization of
production capacity. Although there was some stabilization in the 2nd half of the
1980’s and nineties, the downtrend (lower highs and lower lows) were confirmed
by the steepest post World War II decline at the beginning of the 21st century. In
simple terms; the production facilities created by private investment could
increasingly produce more goods than what the consumer could afford (middle
income groups) or wished (high income groups) to consume. One can therefore
conclude that one or a combination of the following occurred:

 The private sector increasingly over invested in production capacity,

and/or
 Demand expectations failed to realize, and/or
 There was more competition from foreign production facilities, and/or
 Productivity’s pace of progress was much faster than expectations.

The graph below shows production and capacity growth from 1967 to 2010. It
illustrates the gap between capacity and production and how that gap grew
during recessions (grey lines) and narrowed during economic recoveries.

Source: Federal Reserve www.federalreserve.gov/releases/g17/20100315/

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But it is the overall trend reflected in the graph below that is of most concern. It
shows how much of the industrial capacity (percentage wise) was used annually
for actual production over the same period as the previous graph. During each
major recession (three widest grey lines), the usage of capacity dropped lower
than the previous major recession while recoveries in capacity after each
recession, settled at a lower level than the previous high. In other words, since
approximately 1975 we see a general downward trend in capacity utilization
which reached record low levels in 2009.

Source: Federal Reserve Bank of St. Louis http://research.stlouisfed.org/fred2/series/TCU

What does this say about the current economic situation? We have an overhang
of capacity. If needed, the producers could increase supply substantially to
satisfy any increase in demand without any major requirement for new fixed
investments.

In simple terms, we don’t have a supply problem, but one of demand. What
would further fixed private investment achieve? Would it not create a bigger
under utilization of capacity, resulting in more idle capital? Yes, it probably will -
which leaves us with the next question; how do we grow the economy if not by
private investment? At the end of this series of blogs on the “Dominant Causes of
the Credit Crisis” we will come back to this very important question.

What caused this underutilization of capacity?

Factors that had a significant impact on supply and demand are the following:

1. Firstly, the United States increased outsourcing (importing products or

parts of products) and off shoring (moving factories to foreign countries)

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some of its production to countries with lower production cost, especially

where labour constituted a major part of total input cost. This happened
increasingly more so at the beginning of the 21st century when the
United States upped the pace of outsourcing and off shoring to China and
other Asian countries.

2. As shown above, median wages started to stagnate from the early

seventies. This created an increasing gap between what was produced
and the capability of the wage earners to buy it for consumption. Even
the so-called white collar graduates started to fall off the wagon in the
early part of the 21st century.

3. The above graphs which refer to the capacity overhang, relates mainly to
the manufacturing of goods for consumption. The United States economy
has grown more and more into a service consuming community. From
around 1970, the consumption of services exceeded the 50% mark as
part of total annual personal consumption. By 2008, services contributed
more than 65% to total consumption. An increasing part of income was
therefore allocated to services and service related products. The service
component obviously competed with the above manufactured goods for a
piece of the consumer’s spending power.

4. Increased productivity, outsourcing and off shoring led to significant

decreases in the prices of some goods, especially electronic goods. This
made some goods more affordable. Therefore, although the average
consumer’s income did not keep pace with growing productivity or
production, he could still afford to consume more of these goods
(measured by quantity) as long as prices decreased relative to his income.
This, to some extent, slowed the growing divide between supply and
demand.

But why should the above cause overcapacity? Why did investors not simply
reduce fixed investment to eliminate excess capacity and the idle use of capital?
Fixed investment is a long term commitment built on future expectations which
is often based on past performances. When these assumptions don’t
materialized, overcapacity becomes a reality. But the increasing under utilization
has been building up for some time now (nearly four decades) and if capital is
scarce one can imagine that the highly payed CEO’s and their talented executive
teams would be more nimble in adjusting their investments in order to minimize
excess capacity. The reason for the over investment in capacity however, might
be more intricate than one would guess.

Falling wages (except for top income groups) meant that more benefits (income)
accrued to the owners of capital, business owners and high earners. Significant
reductions in top marginal tax rates since 1980 increased the savings of the top
income earners even more. Most of the top income earners, however, did not
spend all their income on the consumption of goods and services. In fact some
surveys suggest that they saved an increasingly larger part of their income over
the last three decades whereas the lower income groups tended to save less and

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increasingly dipped into their savings to keep up to the Jones’s; or simply spent
in an attempt to maintain a certain standard of living. As savings continuously
accumulated at the top end of the income and wealth curve, these savings
obviously had to be invested somewhere.

Any form of investment in newly issued shares, corporate bonds, bank deposits
and other financial instruments are all destined to end up in financing the
production and supply of goods and services. Alternatively it is used to supply
credit to those who spend such money on the goods and services created by the
above investments. The resultant returns on such investments are trading and
capital profits, interest, dividends, rents, royalties etc. If more and more capital
accumulates, competition for limited investment opportunities will increase.
Owners of capital then have to accept lower returns on their investment. Lower
interest rates are usually a consequence of such a glut of savings.

Too much capital did accrue to the top wealth groups during the 29 year period
from 1979 to 2008 (see detailed discussion of this period later in this blog). This
accumulated capital could and still can, produce more goods and services than
the average consumer can afford to consume. In addition, the consumer has too
little income to take on more credit. Furthermore, due to decreasing home
values, few have the collateral to qualify for further credit. Clearly, the consumer
now has to do without further credit - in sharp contrast to the previous two
decades, when escalating credit helped to bridge the gap between supply and
demand.

In conclusion, when too much capital competes for limited investment

opportunities, investors will tend to over invest in production capacity (for goods
or services) and over lend to those who are potential buyers of goods and
services.

What can one do about overcapacity or insufficient demand? Well, the top wealth
groups can increase their own consumption to absurd levels (e.g. each buying an
additional 100 cars or boats), destroy existing capacity (e.g. war) to create room
for new investment, or they can follow Henry Ford’s example and pay the middle
income groups more in wages in order to enable them to consume more goods
and services. The first two options are obviously impractical or undesirable.
With regard to wages; it’s difficult to argue for higher wages when business
enterprises have justification for their attempts to minimize input costs.
Globalization will make any reversal of the downward trend in wages, very
difficult. That leaves us in a stalemate position. Breaking this stalemate will be
very hard, unless we can find a way to restructure the economy and the fabric of
society in such a manner that we can take advantage of the benefits and
abundance that productivity, innovation and technology has brought to our
world.

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The divide in income growth

From the middle to end of the 1970’s, the divide between the growth in
productivity and median income had a severe affect on the unequal distribution
of income. This naturally raises the question; if the fruits of increase productivity
did not go to the average worker, where did it go? Before attempting to answer
this question, it is necessary that the reader grasps the differences between the
terms “median income”, “mean or average income” and income for each
“quintile”.

“Median income” is the middle income of all households; 50% of households earn
more than the median income and 50% earn less. With few exceptions, it is
representative of the typical household income of a country. The “mean” or
“average” household income might differ significantly from the median
household income. Average income is calculated by dividing total income by the
total number of households. Where the higher income households have a large
influence on the average household income, the average income will be higher
than the median income. Cases where the average income is higher than the
median income, and where the difference between them increases, are indicative
of a growing gap between the typical household and those households in the
higher income brackets. For example; for the period 1975 -1980 the mean
income exceeded the median by 18.9% (Collett 2010: p.50)iii and for the period
2001 -2005, mean income exceeded the median income by 36.7% (Collett 2010:
p.50)iv - indicating that households in the upper income brackets got an
increasing larger share of total income.

When one divides the total population of income earners or households in five
categories (e.g. each categories represents 20% of total households), it is referred
to it as a “quintile”; alternatively one refers to the various quintiles as the
bottom 20%; middle 20% ; top 20% or one can add four quintiles together to call
it the bottom 80%.

The following graphs from The Working Group on Extreme Inequality show the
extent of growth in the value of each quintile’s real household income for the 32
year period 1947 to 1979. During this period the income for all quintile groups
increased by nearly 100% with the higher increases going to the lowest, third
and fourth quintiles (which accounts for the improvement in income equality). In
simple terms, poor households and the middle class’ income grew slightly faster
than the highest income earners. Alternatively, one could say that all household
shared equally in the increase in productivity with the scale tipped slightly to the
lower and middle class groups.

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Source: Analysis of U.S. Census Bureau data in Economic Policy Institute, The State of Working
America 1994-95 (M.E. Sharpe: 1994) p. 37, cited Working Group on Extreme Inequality
extremeinequality.org/?page_id=8

In the subsequent 29 year period from 1979 to 2008, the improvement in

income inequality since the beginning of the Great Depression was completely
reversed. As shown by the graph below, for the 29 year period from 1979 to
2008, the distribution of increases in income were heavily skewed in favour of
the top 20% quintile while the two bottom quintiles went backwards. Within the
top 20% the distribution of income were even more skewed towards the top 5%.
More importantly, what the graph below doesn’t show is how the income curve
becomes much steeper as you continue upwards, past the 5% percentile to the
very top of the income curve.

Source: U.S. Census Bureau, Historical Income Tables, Table F-3 (for income changes) and Table F-1
(for income ranges in 2008 dollars), cited Working Group on Extreme Inequality
extremeinequality.org/?page_id=8

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The next graph is important in that it shows why all quintiles were better off
when measured by disposable income (income after tax). Disposable income
grew relatively faster than gross income, courtesy of significant tax cuts since
1980. This had a positively effect on demand for goods and services from all
quintiles groups. As said above, inequality in the income distribution curve
within the top quintile was even more pronounced. The after tax income growth
of the top 1% is a phenomenal 256%, outpacing the middle 20% - quintile’s
growth rate by more than 12 times. This is no small matter as the top 1% share
of total income constituted more than 20% of total income. Since then the top
1% share of total income has grown to nearly 25% and real income for the lower
quintiles decreased from 2008 onwards.

Source: Congressional Budget Office, “Average Household After-Tax Income,” Data on the Distribution
of Federal Taxes and Household Income, April, 2009, cited Working Group on Extreme Inequality
http://extremeinequality.org/?page_id=8

The graph below is sourced from a report drafted by Jonathan Wang, Ph.D. titled
the Real Causes For US Financial Meltdown and Global Recession. It shows to what
extend the top 1% group’s share of total income has grown since the mid 1970’s
when it bottomed at 8.9%. At the end of 2006 the 1% groups share moved up to
around 22% and by 2009 it was closer to 25%. As can be seen from the graph
below, the only other time this group’s share of total income was as high, was in
1928 – shortly before the onset of the Great Depression.

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Source: Amlink http://www.amlinkint.com/English/global_recession_cause_3.html

The importance of the growth in the unequal distribution of income from around
the mid seventies till 2008 and beyond had profound effects on the world
economy:

1. It significantly contributed to the concentration of wealth and capital in

the hands of the top households measured by income or net worth,
especially the top 1%.

2. The top households were therefore able to save more whereas the middle
to lower income groups consumed their savings in order to maintain a
higher standard of living than that allowed by their wage income.

3. The size of top earners’ (mostly executives) income, mainly via bonuses,
was dependent on growing the profits and share values of their respective
companies. Cutting labour cost to the bone, outsourcing or off shoring
most of the manufacturing processes to lower cost centre (often low
paying Asian countries) and increasing mechanization were often the main
focus in achieving higher profits and hence higher bonuses. After slashing
costs and payrolls, and riding the wave of many governments’ stimulus
packages and many US companies (especially those who operate on an
international scale) have been racking up enormous profits in the last
decade, while the ordinary US citizen has been fighting desperately,
especially since 2008, to keep head above water.

4. This over time led to increased savings at the top end of the income curve
and consumption of savings (savings used to pay for consumption of goods
and services) at the middle and lower end of the income curve. As
explained above, the accumulated savings must be invested, creating
capacity for the production of goods and services which the vast majority
of income earners (bottom 80 -90%) cannot afford and for which the top
income earners (top 5%) has insufficient needs. This growing gap
between supply and demand or income available for consumption and
capacity to produce; have in the past three decades been bridged by

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negative savings (savings used for consumption), Americans working more

hours, reduced income taxes and steep growth in credit. These sources
are now just about fully tapped and there is little left for any further
assistance from these sources.

5. Growth in productivity of both labour and capital has greatly increased

man’s ability to produce abundance. But once it reaches a stage where
such abundance cannot be effectively distributed by current economic
structures to ensure continued growth, the economy stagnates and
eventually contracts. When the imbalances become too great, the
contraction may become so severe that it can cause social upheaval and
further economic destruction. Unless huge sacrifices are made by all
income and wealth groups, in order to establish a new equilibrium, the
invisible wall may become an impenetrable curse to all of us.

In the subsequent blogs we will look at both the consumption and accumulation
of savings on an international scale; increasing outsourcing and off shoring to
China and other Asian countries; how outsourcing and off shoring negatively
affects income inequality and the imbalance between supply and demand on a
global scale and how this caused a global glut in savings which laid the
foundations for the many bubbles in the lead up to the Credit Crisis. We will also
look at previous major crises to see if there are similarities in the build up to the
climax of such a crisis, how all of the above factors eventually paved the way for
debt bubbles, asset bubbles and stock market bubbles. Finally, we will discuss
the potential remedies and why it will be difficult to implement a workable
solution.

David Collett is a chartered accountant with more than 25 years experience in the field of
forensic investigation. He has acted as an expert on many subjects such as business,
investment and share valuations; fair presentation in financial statements and prospectuses;
lax credit standards, credit risks and professional liability.

Over the past decade he closely followed the financial markets. Through a series of
presentations made to the finance and investment communities, he forecasted the collapse of
financial markets and the 2008 stock market crash.

For more information about David and his work, please visit http://www.false-gods-fleece-the-
faithful.com/.

© Copyright David Collett 2010.

Whilst every effort was made to ensure the accuracy of this article, neither this document; nor its
author, David Collett; nor any publisher of this article; offer any warranties (whether express, implied or
otherwise) as to the reliability, accuracy or completeness of the information appearing in this article.
Neither do any of the above parties assume any liability for the consequences of any reliance placed on
opinions expressed or any other information contained in the above article, or any omissions from it. Its
content is subject to change without notice. Any information offered, is intended to be general in nature
and does not represent any investment or business advice of any nature whatsoever. If you choose to
rely on such information you do so entirely at your own risk. Neither David Collett nor any third party
involved in publishing this article, assume any responsibility or liability for the outcome of such reliance .

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i Table A -2 U.S. Census Bureau

ii Mishel L., ‘The right to organize, freedom, and the middle class squeeze (testimony)’, The Economic Policy
Institute, 26 March 2010
http://epi.bluestatedigital.com/publications/entry/webfeatures_efca_testimony_20070326/
iii Collett D, Collett Z, ‘The Current Crisis’, False Gods Fleece the Faithful, Anchorage Investments: Australia

2010, p.50
iv Collett D, Collett Z, ‘The Current Crisis’, False Gods Fleece the Faithful, Anchorage Investments: Australia

2010, p.50

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