Tuesday, April 14, 2009

The Recovery and the U.S. Consumer

I wrote some time ago (here) about the over-leverage of the U.S. household. As we think about a possible rebound in activity, I think it is important to keep this fundamental misalignment in mind. IF I am right and this is the recession where we begin to make progress on these imbalance THEN no recovery can occur while the U.S. household still consumes a disproportionate amount of GDP

In my mind, the easiest way to understand the over-leverage of the U.S. household is to look at the ratio of consumption to GDP. This number is essentially the amount of U.S. income devoted to consumption as opposed to investment or exports. The higher is this number the more households have borrowed to support their consumption.

The share of income allocated to consumption in the United States has risen from 62 percent in 1980 to over 70 percent in 2008. Over 40 percent of the rise has occurred since 2000. This level of consumption is way too high. It is high by historical post-war U.S. standards and it is high by contemporary international standards.

Take a look at the inset box. Of the major industrial economies, the United Kingdom has the highest ratio. At 64 percent of GDP, however, the United Kingdom has only reached levels of consumption similar to that of the early 1980s United States.

To make a stronger link with leverage, one can glean similar insights from the current account deficit of the United States. Over exactly the same period that consumption as a share of GDP has been rising, the current account deficit of the United States has been falling. The match is close even to the point of matching the three percentage point jump since 2000. The current account deficit represents real indebtedness to foreign economies. It does not matter whether this debt is incurred because oil prices have risen or because we buy a lot of TV’s.

The share of income allocated to consumption in the United States has risen from 62 percent in 1980 to over 70 percent in 2008. Over 40 percent of the rise has occurred since 2000. This level of consumption is way too high. It is high by historical post-war U.S. standards and it is high by contemporary international standards.

The share of consumption to GDP in the United States must fall and it seems that we are, finally, at the turning point. There are only two ways for this adjustment to occur: either consumption must fall or the other components of GDP must rise.

How far does consumption have to fall? It depends on how far the ratio of consumption to GDP must move. I believe the ratio is likely to return to 1980 levels but a strong case can be made that the ratio need only fall back to the level of the late 1990s.

Assuming no growth in other components of GDP, consumption would have to fall 3.2 percent per year to bring the ratio back to its 2000 level within five years. For the ratio of consumption to GDP to fall back to its 1980’s level within five years, consumption would have to fall 7.4 percent per year. If we allow 10 years for the ratio to return to its 1980’s level, consumption only needs to fall 3.2 percent per year.

These falls are huge and well beyond anything in the modern historical record for industrial economies with the possible exception of the Great Depression. Only Argentina (and perhaps some of the Asians during the Asian Financial Crisis, though I have not checked) suffered falls of this magnitude. In 2001 and 2001, Argentina experienced repeated double-digit falls in consumption.

Of course the consumption numbers are all relative to the other components of GDP. Consumption does not have to fall as much if other parts of the NIPA accounts are growing. However, because consumption has such a large share of output, the other components would have to grow very fast indeed to keep consumption from having to fall at all. In addition, I have trouble imagining components like investment expanding when consumption is falling at these rates.

These numbers are scary.

And these numbers are just as scary as when I first posted this idea. The U.S. consumer has a long way to go and I do not believe we can have a sustainable recovery before they have at least begun to move along this path.


NorthGG said...

As always, great work SE.

Decoupling was one of the most bone headed ideas of all time. Now after 25 years of the private sector underestimating real rates the US government is going to try the same trick. This is a classic debt deflation. The government cannot create a sustainable recovery by borrowing money at high real yields. Asset prices need to clear so they can be profitable again. Look at US tax revenues (bberg code FDDSNR) the long term trend is lower growth. The fiscal policy being employed is going to be a disaster as the tax base weakens with the ageing boomers. Rates are too high. Nothing more democratic than a bust; why redistribute income through the tax curve when you can redistribute assets through liquidations and DIP. It is downright bad advice to lever an already levered system with such poor demographics. Obama administration is being sold a bad bag of goods. Hopefully he will realize that even at zero per cent rates, you can pay too much for things. The more they try to stop / slow the deflation, the more painful the re-balance will get. US should be prudent fiscally and force the rest of world into the final demand space. Toxic assets will soon include loans to factories. Credit in the production space is massively overvalued.

david bath said...

if taxes were to rise sharply during a recovery, would you consider this the government "saving" for the population? The question is will the government have to "force" a reduction in consumption using taxes?

NorthGG said...

Governments cumulative deficit policy (before the bust) was already forcing a decline in consumption in the future. Private sector debt and government debt are already too big for the tax base. The stock of debt could only be supported by asset price increases. Game over. Consumption and tax reciepts are both collapsing reflecting the economies long term dependence on credit growth to generate incremental cash flow. Tax the reduced cash flow state of the economy and this will force consumption even lower in my view, particularly in the US where the boomers are moving to the liability side of the tax base rapidly.

Secret Economist said...

NorthGG, no argument from me. The government is issuing a lot of short-term debt at low nominal rates. If you are right this is a high real rate already. In any case, when they try to roll over the debt during the recovery this will be bad.

Secret Economist said...

Response to David Bath

Raising taxes it the flipside of too much spending. So higher taxes are bad.

Higher taxes without extra spending must come back to the population in the form of transfers. If they are paying back debt, the transfers go to the bond holders. If not, the transfers go to some set of the politically preferred.

So high taxes without government spending do not stop private consumption -- somebody is getting the money.

Taxes are distortionary; but at the levels we are talking, this is second order. (Taxes can be high enough to be first order (see Zimbabwe) but I don't think that's in the cards for the industrialized economies.

Government spending diverts real resources -- crowding out. (I like effecient government spending. Anything with a high social return works for me.) Taxes and debt are smoke and mirrors.

Anonymous said...

I appreciate all that has been posted, but the real truth is, it is not going to matter when inflation hits us like a freight train. U want to reduce consumption by 7.4% per year for 10 years, give me inflation of 15%+. I often wonder if the goal is not to borrow as much money as possible because we know there is no way it can be paid back under any circumstance. The future demographics simply will not support it. Kind of reminds me of a person who is filing bankruptcy and goes on a spending spree before filing a bankruptcy case.