Markets got a boost in recent months when economic data showed that consumer spending had not continued to decline as rapidly in the first quarter of this year as it had at the end of last year. Those looking for bullish signals took it as a sign that we may have seen the worst of the economic downturn. The hope was that consumer spending—a key driver of the economy over the past decade—might rebound thanks to government stimulus and renewed perceptions of economic strength.
Unfortunately, this view may be too optimistic. The data about personal wealth in the US suggests that consumer spending may be settling in at a permanently reduced level and personal savings rates permanently increasing. In the short to medium term, this could be a recipe for a protracted economic slowdown. In the long run, however, we could be looking at an economy built on a far healthier base.
Perhaps the most dramatic change in the financial habits of the American people was the dramatic decline in savings rates that began in 1995. From 1980 through 1994, the U.S. saving rate averaged 8%. In the mid-1990s, however, it began to fall steeply. By 2000, the personal savings rate averaged approximately 1%. A few years later, the savings rate actually went negative, with Americans consuming more than they were earning.
This was often discussed as the resiliency of the American consumer. Indeed, the failure of savings to increase even in the face of the financial downturn following the dot-com crash convinced many observers that the US consumer was somehow super-powered and immune to adjustments that, in the past, had caused economic pullbacks. Even though the stock market’s value shrank dramatically in the early part of this decade, consumers kept right on spending. The size of their investment portfolios did not seem to give American spenders pause.
The best explanation for this resiliency isn’t that consumers were immune to the shock of being poor. It’s that is that although consumers were experiencing a steep decline in the size of their stock portfolios in the early years of this decade, they weren’t getting poorer because their homes were increasing in value. It seems that consumer behavior is stimulated by a “wealth effect,” in which increases in the real value of assets stimulate consumption. In other words, the reason consumers kept on consuming at ever higher levels is that they felt wealthier thanks to the housing bubble.
Now we’re likely to see that played out in reverse. Despite the recent rally in the stock market, Americans are still trillions of dollars poorer than they believed they were at this time last year. Somewhere near $11 trillion of value has been erased from our collective balance sheets, much of it due to the continuing decline in housing. Instead of a “wealth effect” fueling consumption, we’re experiencing a “impoverished effect” that is likely to fuel savings.
By most estimates, the housing market will not soon return to earlier values. This means that Americans will experience something they haven’t in a very long time—a permanent loss of wealth. And this is likely to spur a new desire to save against future losses of wealth. In this way, the housing decline encourages a kind of doubling down on savings. You don’t spend as much because you feel poorer, and you save even more in case your wealth takes a second hit.
The failure of financial innovation to provide a stable base for the economy has put liquidity constraints on many households, decreasing their access to the credit markets. Although the government is trying to combat this by encouraging securitization and subsidizing certain types of lending, the results so far have been meager. The decline of consumer credit will be accompanied by a consumption slump.
None of this is necessarily horrific news. The economy will have to undergo a difficult adjustment to new spending habits based on expectations of a more constrained economy and diminished wealth. But with more Americans saving for a rainy day, we should be better prepared to get through the next economic storm.
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June 04, 2009