Monday, October 27, 2008
The primary argument supporting the worst recession since the Great Depression is that U.S. households are horribly overly leveraged, and will soon be forced to reduce their debt burden. In the second quarter, the average household debt service payment was 6.12% of GDP, down from an unsustainable 6.33% in the first quarter.
In this case, reduced consumption – increased saving - will result in several negative quarters of growth, but following an arduous transition, growth will eventually resume. The dollars used to consume are transferred to the investment or export sectors – expanding businesses, infrastructure, roads – and eventually GDP growth rebounds. The economic transition, however, is arduous.
So will we return to 1960s-style consumption rates, or 62% of GDP?
Because asset prices and home values are falling?
I suspect that yes, saving will rise for many consumers, but the aggregate effect depends on whose saving is rising. In the 1990s - when household consumption as a share of GDP rose substantially with a surge in equity values - personal saving fell, but only for about 20% of the income distribution. Studies show that in the 1990s, 40% of the income distribution actually increased saving rates, while the aggregate personal saving rate fell. So as long as the top households in the income distribution do not significantly reduce saving, and even though saving will rise for the majority of the population, aggregate personal saving rate should not rise substantially.
However, record losses in wealth are bound to pass through to consumption even for the wealthy, and consumption growth is likely to be negative in the third and fourth quarter. So the real question is the following: Does one expect aggregate consumption to fall back sharply, and for those who are calling the worst recession since the Great Depression, back to its level in 1960s when it was just 62% of GDP? I suspect not. Even reducing consumption back to levels in the 1980s – consumption at 64% of GDP – implies saving would be in the 5%-10% range (see this post).
The risks are severe, with the credit markets still in disarray and the next shoe getting ready to drop on consumer credit, and my scenario depends on the stabilization of the credit markets. But don’t forget about the recent sharp drop in gas prices. This is good news, especially heading into winter. Consumption suffers like it has in every recession, but this time around some of the consumption loss will be offset by gas prices that are back to one penny cheaper than year.
Finally, many are barking at how saving is going to rise, but would it be so bad if saving did rise back to 1980s ? Economic growth suffers in the short term, but going forward, the economy sits on a more solid foundation – with strong investment spending and a financial focus on the future (a transition to investment spending).