[The Actuary]

Ironically I agree with alot of this article-particularly the end. It is why I believe the rate hikes although paused are not over. It is ironic because ultimately it is bad for the US economy but it is for almost the diametrically opposite reasons most think.

Economic Mythology
SmartMoney.com ^ | 9/22/06 | Don Luskin



THERE'S AN ENDURING modern myth among investors that the economy is about to collapse because consumers are going to stop spending.

Like all myths, this one starts with a grain or two of truth, and then embellishes that grain until it's a preposterous mountain.

These mythical mountains are dangerous only if you believe them. Lots of my readers do, and so do lots of my professional investor clients. And worst of all, so does the Federal Reserve - which is going to lead to some really bad monetary-policy errors.

I'm not sure why consumption is supposed to be so important. Sure, if I've heard it once, I've heard it a thousand times: "The consumer is 70% of the U.S. economy." But so what? The producer is 100% of the U.S. economy.

That's right. You can't consume what you haven't produced. Consumption is the reward for production, not an economic activity unto itself. So we should be worrying about whether the U.S. economy is producing - producing goods and services, producing jobs, and producing wages. It is, so consumption will take care of itself.

What's everyone so worried about? Take a look at the numbers. According to the Department of Commerce, in July, the last month for which figures are available, personal-consumption expenditures grew at a very healthy annualized pace of 10.2%. That's a huge acceleration over the already healthy average 6.3% pace of the previous 12 months.

What's that in dollars? A lot. From June 2005 to June 2006, the U.S. consumer spent $9.2 trillion dollars - up $555 billion from the previous 12 months.

And where did the U.S. consumer get that extra $555 billion to spend? The old-fashioned way - he worked for it. Over that same period, disposable personal income grew by $550 billion.

Yet many investors seem to believe that the consumer has only been spending because of gains in real estate during the so-called "housing bubble" of the last three years. They believe that when the value of your home rises, you experience a "wealth effect" - you are willing to spend more money, simply because your house is worth more.

Economists have studied the "wealth effect" in depth. Based on these studies, most economic models say that when the value of your house goes up by $100, you are willing to spend an additional $3 every year.

So how big is the "wealth effect" for housing? According to data from the Federal Reserve, the value of real estate held by households grew by $1.7 trillion over the last four quarters. Three percent of that is $50 billion.

So out of the $555 billion in spending growth over the last four quarters, the housing "wealth effect" explains only $50 billion. But what needs explaining in the first place? Simple income growth already explains all but $5 billion of the spending gains.

So who needs a housing "wealth effect?"

Another often-heard reason for doom-and-gloom about the consumer is high energy prices. Is that story any more true than the one about the housing wealth effect? Nope.

Since the end of 2002, according to the Department of Commerce, annual energy expenses for the average household have gone up by $688. That's a lot of money, to be sure, and the world would be a better place if somehow the average household didn't have to spend it on gasoline, home heating, and so on.

But over the same period, the disposable personal income of the average household has risen by $4,605. That's enough to fill 'er up, with an awful lot left over.

And what about debt? How often have we heard horror stories about how the U.S. consumer is up to his eyeballs in mortgage debt and credit-card debt? Sorry. You'll have to find something else to be pessimistic about.

According to the Federal Reserve, since the beginning of 2003, the fraction of the typical household's income that went to servicing mortgage debt did rise a little bit, from 9.7% to 11.1%. But the fraction that went to servicing credit-card debt went down, from 6.3% to 5.7%.

Overall, the fraction of household income that goes to servicing all the "must-pay" obligations that every family has - mortgage, credit cards, taxes, and so on - has stayed rock steady, rising almost imperceptibly from 18.4% to just 18.6%.

And how about those adjustable-rate mortgages that will become more expensive to pay off now that interest rates are so much higher than they were a couple years ago? Another myth!

The typical U.S. household actually does better when rates rise. Overall, according to the Federal Reserve, U.S. households hold about 50% more floating-rate assets than they have invested in floating-rate debt. So, yes, when rates rise, the adjustable-rate mortgage goes up, and so does the interest on credit-card debt. But at the same time, income rises - even more - from investments in money-market funds, bank accounts and bonds.

Want something real to worry about? Try this.

Even though much of the data I've cited here comes from the Federal Reserve, the Fed subscribes to the myth that the economy is slowing because the U.S. consumer is in trouble, mostly because of the cooling housing market. So they've left interest rates unchanged at the last two FOMC meetings, including the most recent one last Wednesday.

That's a problem. The economy isn't slowing, and the consumer is not in trouble. With the economy continuing to boom, and rates on hold at the Fed, that's a sure-fire formula for more inflation.

The Fed is going to realize that one of these days. And when they do, it will be too late. Then there will be nothing for the Fed to do but raise interest rates sky high. And then the consumer really will be in trouble - along with everyone else.