When the International Monetary Fund lowered its forecast for U.S. growth this year and 2011, it pointed to “sluggish personal consumption” as the main drag on the economy. Since consumer spending accounts for 70 percent of the U.S. economy, the question of why spending remains so low is central to any inquiry into the future of our economy.
How Houses Became ATMS
The usual reasons given for the slump in consumer spending don’t go far enough. Sure household wealth deteriorated thanks to housing prices. Tight credit has made it harder to get credit cards or buy big ticket items. High unemploymentmeans many Americans just lack income to spend. Fear of unemployment drives even employed Americans to put a little more away for the proverbial rainy day.
But there is a deeper reason Americans aren’t spending as much. Typically it goes under the rubric of a “desire to save more”—although that is more of a description than an explanation. If Americans suddenly desire to save more, it’s worth trying to find out why.
After all, until the financial crisis kicked in, the American consumer was described as “resilient” by those who wanted to promote spending. Critics called Americans “spendthrifts.” Either description seems accurate on the surface. For much of the past decade, the US savings rate was negative—meaning Americans were spending more than they earned. This was made possible, by and large, because the housing market bubble seemed to be creating so much wealth that Americans could “use their houses as ATMs”—withdrawing equity to finance current spending.
Why were Americans so willing to spend down the equity in their homes? Critics of American spending patterns liked to just say that Americans were in love with spending on big cars and fancy appliances. A sort of demonology of the American spender was created to explain this kind of behavior. The bursting of the housing bubble and the subsequent pull-back in consumer spending is just a kind of cosmic justice in this way of thinking.
That’s a nice fairy tale. But it’s not reality. The main reason Americans spent so much is not that they were especially “resilient’ in their desire to have flat-screen televisions or “spendthrift.” It’s that they expected to keep accumulating wealth through rising home prices. They might have been spending more than they earned but they weren’t overspending based on their expected future wealth.
Handicapping Future Income
To understand why future wealth and income is more important for questions of spending and savings, just think about college students. Almost every college student in America has an enormous negative savings rate. Just tuition alone not only dwarfs their earnings, it also dwarfs their accumulated savings. Many students take on enormous debt loads to finance education spending. All of this would be completely irrational if not for their expected increases in future income. It’s okay for them to spend now because they expect to earn enough later to handle the debt load.
A study I first noticed a year ago from Federal Reserve economist Laurie Pounder made this clear. Pounder studied the spending habits of Americans and compared them to their expected future net wealth and income. Looked at in this way, Americans weren’t irrational spendthrifts—they were irrational savers. They were actually spending less than an economically rational person would, given their expectations of increased wealth.
To put it differently, Americans were overspending not because of some character flaw or spendthrift animal spirit loose upon the land. We were overspending because we had over-estimated our future wealth. If our expectations about home price appreciation had been correct, we would have found ourselves with abundant savings. It was the fact that our expectations were too rosy that proved crippling for the economy.
Why did so many of us make similar errors about future wealth? Why were so many people so wrong? What happened to the wisdom of crowds?
Policy Problems & Distorted Perceptions
What seems to have happened can be explained by looking at what I’ll call the Consumer Cycle Theory, which is a sort of photographic negative of the Austrian Business Cycle Theory. The Federal Reserve lowered interests rates. Consumers viewed the effects of lower rates—increased business spending, rising home prices—as a sign that the real wealth in the economy was greater than it actually was. The impression of additional wealth created the expectation of future prosperity. When housing prices began to crash, it became apparent that much of the current wealth was illusionary and therefore expectations of future wealth needed to be reigned in.
For policy makers, it is inconvenient to discover that error was the root of overspending. In the one place, central bank policy helped create the error—which is embarrassing. Second, widespread errors are harder to correct through public policy simply because we often don’t know we are making mistakes until afterwards. Regulators are not better than everyone else—in many ways they are worse—at spotting economic bubbles.
But if Americans are not spendthrifts—indeed, they are irrationally prudent savers—there may be little the government can do to spur on consumer spending so long as Americans have lowered expectation of future wealth. This is one reason current Federal Reserve policy may be counter-productive.
Breaking The Cycle
By keeping interests rates at such extremely low rates and publicly debating the need to engage in quantitative easing, the Fed may be reinforcing the impression that our economic prospects are grim. Stimulus spending, too can be counterproductive in this situation. It reminds Americans that the economy is troubled. It also creates the expectation of higher taxes to pay for current spending, and higher taxes means Americans will be less wealthy in the future.
Consumer spending went away because it had been built on a mistake. The only way to raise it again is to either trick Americans into making the same mistake—something that is unlikely and undesirable—or to actually improve the prospects of Americans to become wealthier. Unfortunately, mounting debt, a larger role for government in the economy, and the prospect of tax increases are doing exactly the opposite—diminishing our prospects. Until this cycle is broken, don’t expect anyone to start talking about a “resilient” American consumer again.
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