Wednesday, June 20, 2012

The stability of the recovery

First, let me apologize for being away for so long. Work got busy and then I was overwhelmed by an apartment hunt (still am, in fact). It occurs to me that if everyone were busy with work and buying real estate then I suppose I wouldn't need to be making a case for optimism, nor would anyone be reading it, but that's not quite where we are, are we?

If you follow economic news, then when you aren't deluged with hand-wringing over Europe, you're getting slammed with worries over the recent jobs numbers. My take on Europe's influence on our economy is essentially unchanged since I last posted about it, so I am going to focus on the jobs concern. Employers don't seem to be adding jobs at a pace necessary to put everyone back to work within a reasonable amount of time. But as disturbing as this is, it doesn't mean we're headed toward another recession. For one thing, jobs lag demand (employers don't hire extra help until they can't keep up with customer demand) and consumer demand growth is steady, if unspectacular. Meanwhile, improvements in consumer sentiment and buying power suggest that it's reasonable to expect demand growth to accelerate modestly going forward.

Ok, I know this chart is ridiculous, but bear with me.

The solid blue line is showing changes in the total disposable income of US consumers from January, 2007 through April, 2012. It has been adjusted for inflation, so it is a good measure of consumer buying power - as the line goes up, consumers are collectively able to buy more stuff than they were before, and as the line goes down either inflation is rising or income is declining, or some combination of the two is taking place.

The red dotted line represents the consumer savings rate, defined as the percentage of disposable income that isn't spent. There are different reasons why this can fluctuate over time, but one of them certainly is consumer sentiment. If you are pessimistic about your financial future, you are likely to try to save more, and the opposite is true - if you feel relatively secure, there is less of a sense of urgency to prepare for seemingly unlikely bad times. So, it's fairly intuitive to appreciate how consumer spending is a function of these two factors; meanwhile, a review of how they have fluctuated in recent years lends insight into our prospects. 

Consider the shaded period (1). This corresponds roughly with the last recession, and it's plain to see that not only was buying power lower at the end of the recession than it was at the beginning, but also the savings rate ends the recession higher. (By the way, if you're curious about that income spike in early 2008, that was Bush's emergency stimulus tax rebates he sent out. It's interesting to note that the savings rate spiked along with it, indicating that people chose to save the rebate rather than spend it, which is entirely consistent with how you would expect a pessimistic populace to behave.) These trends are precisely what we should expect to see: bad times were occasioned by - if not defined by - a drop in buying power, and we collectively responded by getting more conservative in our spending habits. Indeed, almost half of the drop in consumer spending during the recession can be attributed to the increased savings rate.

Now look at the second shaded period (2), basically representing the last two years, where we see the opposite happened. Buying power rose slowly but surely, and the savings rate dropped like a stone. This is likewise intuitive; as our situation improved, we loosened the purse strings. Analyzing the consumer spending gains during this period, it's interesting that fully 60% of the increased consumer spending over the last two years was due to brightening consumer sentiment as articulated in the drop in the savings rate.

What does all this mean going forward? One conclusion we can easily draw is that, now that the savings rate is more-or-less back down to pre-recession levels, each additional dollar of buying power will generate more consumer spending than it did previously. So, to the extent we base our expectations on recent history (as the so-called conventional wisdom often tends to do), we will underestimate the effect even modest increases in buying power will have on consumer demand and, eventually, on job growth.

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