There is one clear lesson from the last 25 years. Economists are fixated on the national income accounts; they can tell you to the last dollar who spent every dollar of GDP last quarter. They systematically understate the importance of pressures for change originating in the nation’s balance sheets.
This is important because balance sheets are bigger. Size does matter. GDP in the second quarter was $12.4 trillion, which sounds like a good-sized number. But our balance sheet is much larger, amounting to more than $160 trillion in total assets (thirteen year’s worth of total GDP), comprised of $111 trillion in financial assets, and some $50 trillion in tangible assets, with a net worth of $50 trillion. These figures, by the way, do not include the value of the more than 700 million acres of land owned by the federal government, which would conservatively be valued at twice the national debt in the hands of the public.)
The Delphi bankruptcy is a balance sheet event. The concept of solvency, itself, refers strictly to the balance sheet, not to the P&L. It is the magnitude of Delphi’s liabilities, including the drag of prior pension and health care costs, that pushed them over the edge. It is the liabilities that will ultimately be pushed onto GM that have people talking about a possible GM bankruptcy.
The Delphi bankruptcy reveals the deflationary pressure on corporate balance sheets, in the same way an earthquake reveals the tectonic pressures deep underground. And like the earthquake, we should not ignore the signs.
You can illustrate this deflationary pressure in several ways. In the gap between Delphi’s $65 per hour labor cost ($23 wages, $42 current and legacy benefit costs) and the pay scale in the BMW plant that Bob Mundell and I visited in Shenyang, in Northern China, two weeks ago. In the downward price pressure the post-Chapter-11 Delphi (relieved of the need to pay creditors) will exert on other US suppliers. In the downward pressure on fixed asset prices from the inevitable asset sales during the subsequent restructuring.
These balance sheet pressures are the reasons the people who are wringing their hands over the inflation danger are going to be proved wrong again. Our respective service sectors–the lion’s share of total output–are now connected with fiber optic cables. The massive arbitrage between prices and wages in Asia and the US will not allow continuing inflation to happen.
Recent price level increases in the US have been driven by spikes in oil and industrial commodities that reflect actual supply restrictions caused by rapid growth in Asia. Supply reductions raise prices and reduce output. The Fed cannot dial back the relative price of oil by raising the Fed funds rate. They can, however, throw the US into recession by adding a second dose of output restriction.
Controlling inflation is important. But the Fed only controls demand. The only way the Fed can erase the impact of higher oil prices on the price level would be to systematically drive the other prices–including wage rates–down. If they do, the next headline you see will be GM.