In a “closed economy”, savings is the source of all capital (textbook: “a country can invest no more than it saves”). With open economies, there is the possibility to tap the savings of other countries. It is the ability of the U.S. to borrow from the rest of the world that has permitted us to have solid growth in consumption as well as in investment (new homes construction and plant and equipment etc.) which has amounted to around 15% of GDP while our savings had amounted to substantially less.

The economy imploded in the fourth quarter of 2008 when consumers decided to move their saving rate (out of disposable income) from near zero levels to around 5% (nothing to brag about! In the late 1970s, the saving rate was over 10%). This meant that retail sales declined by hundreds of billions of dollars, starving the bloated number of strip malls, retailer outlets and restaurants built to feed our partying during the 2003-07 period.

So, now instead of building the 1.6 million new housing units thought to be needed on a trend basis, we are building 600,000 (down from 2.2 million late in 2006). That means that credit demands to support the construction of 1 million or more housing units is gone. New car purchases are running 5 million below “norm”, no credit demand to finance those. Capital spending (plans and actual outlays) among small firms (NFIB Small Business Economic Trends) is at 35 year lows. More firms still plan to reduce inventories than to increase them. Consumers are paying down their credit card debt nearly every month. Loans are down because demand is down, not because banks are refusing to make good loans (of course credit is harder to get than in 2007, credit standards have returned! And there is a recession, cash flow is down).

With private credit demand so low, it is not so surprising that we financed last year’s $1.4 trillion federal deficit without much pressure on interest rates. But, going forward, as private credit demands revive, they will begin to collide with the need to finance $1.5 trillion dollar federal deficits. This can only produce higher interest rates, especially if providers of foreign savings become less willing to lend to the U.S. While private parties are sensitive to interest rates (like mortgage rates), the government is not and will always win this contest, paying its interest expense from tax revenues. This “crowding out headwind” is likely to slow the economic recovery going forward. Raising taxes to reduce the size of the Federal deficit will certainly not stimulate the economy either, even if it reduces government credit demands and “pay go” doesn’t seem to be slowing spending since everything is an “emergency” and exempt from the restriction. It’s going to be painful.