A Scenario for a U.S. and Global Recovery, Part 1: The U.S. Consumer

It has been widely acknowledged that the global economy is experiencing its hardest “stress test” since the Great Depression era.

Consumer and business confidence keeps falling everywhere in the world. Politicians are struggling everyday to jumpstart their economies with massive influxes of fiscal and monetary stimulus money. Regulators are getting headaches thinking at the most efficient solutions to stop the capital bleeding from zombie banks. Traders scrutinize every little market uptick or downtick as a sign of an imminent trend reversal.

In this confused environment, it makes sense to consider the situation with a calm head and cool nerves. It makes even more sense to stay away from the deluge of daily bad news and indicators, and to try to bring toghether all the pieces of the puzzle.

The first piece of the puzzle that I will deal with here is the role played by the US consumer in the recovery process.

1. The US consumer is the key starter for the US and global economy

It has often been said that the US and the world would not be in such a mess today if Americans saved more, spend less, and exported more than they imported over the last decade. The argument carries some weight in academic debates and in policy circles discussing the long term strategy for the US economy, but it misses the urgency of the current situation. You can’t change the rules of the game in the middle of the game. If consumption played such a major role in growth over a decade – acounting for 81% of GDP growth over the 1997-2007 period (see the chart and table below) -, then the only way to restart the US economy is to revive consumption.

Besides, as the pre-crisis surge in domestic consumption has been largely met with imported goods (again see the chart and table below), a revival of the US consumer - that presides over US$10 trillion of spending, equivalent to three times the GDP of China ! - is likely to benefit strongly to the export-driven economies of Germany, China, and Japan.

click to enlarge

Source : BEA data, personal calculations

Source : BEA data, personal calculations

2. Don’t expect too much from the housing market

The housing bubble has played a tremendous role in the consumption surge of the last decade. Cheap interest rates, growing incomes boosted by the Bush era tax cuts, lax regulations, and wicked financial engineering have all contributed to the build up of the housing bubble. As you might have noticed from the table above, residential investment per se has played almost no role in US GDP growth over the last decade. But the wealth effect generated by rising home prices on private consumption been enormous as can be spoted from the chart below. Well, the least we can say now is that the housing-driven era of growth is over.

Source: Eric S. Belsky, Housing Wealth Effects and the Course of the US Economy: Theory, Evidence, and Policy Implications, November 2008, W08-7, Joint Center for Housing Studies, Harvard University

The truth is that the housing market is so clogged with inventories of unsold houses that it would be foolish to expect any price stabilization in the coming 12 months, let alone any positive contribution to growth. What is much needed is to break the vicious circle of ever rising foreclosures leading to ever lower prices. This is the rationale behind President Obama’s new US$75 billion housing support plan. But, this may not be enough to stop borrowers with negative equity from defaulting on their mortgages.

3. Don’t expect too much from the fiscal stimulus either

Given the lackluster prospect for the housing market, we could expect some help from the US$ 787 billion fiscal stimulus package voted by Congress under the American Recovery and Reinvestment Act.

But, can the fiscal stimulus really save the US consumer ?

First, the true amount of stimulus money that will directly benefit US households over the next 12 months is only a fraction of the US$ 787 billion spending program that is projected over the 2009-2019 period.

Indeed, on the basis of a document from the Congressional Budget Office (CBO), one can check that only US$115 billion of stimulus money would go directly to businesses and households in 2009. This is less than 1% of GDP ! This US$115 billion includes US$40 billion of assistance to unemployed workers and struggling families, and USD$70 billion in tax provisions targeting the middle classes. Other spending measures (discretionary spending from federal administrations, fiscal assistance to the states) will add US$70 to this US$115 billion of direct support bringing the total stimulus spending to US$185 in 2009. But I believe the later measures will have less impact on private consumption than the former ones.

Second, the efficiency of the stimulus is based on the assumption that households will spend all this extra money rather than save it. This is a highly speculative assumption given the high level of households debt, and rising unemployment. Besides, it is much harder to stimulate consumer spending in the wake of a financial deleveraging process, than what the standard textbook economic theory predicts.

The bottom line is that, all other things being equal, the fiscal stimulus will have a very limited - if any - direct effect on consumption in the short term. It could prevent people from looting the shops and putting fire to cars in poor neighborhoods. It could support single mothers with children and unemployed workers. In a word, it could probably prevent the risk of social dislocation. But it falls a great deal short of reviving consumer spending on the level and scale of the pre-crisis years.

4. The audacity of hope and animal spirits

So, is there any hope left for the US consumer?

Here it is all a matter of confidence, and as you know a return of confidence is the hardest thing to predict. Since the seventies, economists have been aware on the central importance of expectations in the functioning of an economy. Expectations are driven partly by rational factors, but they are also partly driven by so called animal spirits. They can be driven by the feeling that things can, and will, eventually get better. On this account, the Obama stimulus package, despite its shortcomings, has already produced a very positive effect, as the polls show.

Many more actions may be needed to restore confidence, including a comprehensive bailout of the financial system. But, after all, this is exactly what President Obama has been elected for. He based his entire campaign on the audacity of hope. Now is the time for him to deliver.

To be continued...

Comments

[OldLimey:]

"You can’t change the rules of the game in the middle of the game." - Why not? The government does it every other day.

"So, is there any hope left for the US consumer? Here it is all a matter of confidence, and as you know a return of confidence is the hardest thing to predict." - Confidence, not indebtedness?

Feb 27 01:51 PM

[@TexasER:]

>You can’t change the rules of the game in the middle of the game. If >consumption >played such a major role in growth over a decade…then the >only way to restart the US >economy is to revive consumption.

I think you should have said the only way to restart the economy *quickly* is through consumer spending.

Yes, the economy will restart. No, it won’t be quick.

And while you might not be able to change the rules in the middle of the game, they surely can be changed for you.

Feb 27 02:27 PM

[Fred Voetsch:]

"He based his entire campaign on the audacity of hope. Now is the time for him to deliver."

I like Obama and he seems like a nice man with a lot of charisma but we knew going into this that he had never delivered so why would we suddenly expect him to change?

It seems to me we already have plenty of hope and in fact, isn't hope what got us into this mess in the first place? Hope that house prices would go up forever; hope that the consumer would never stop spending based on hope that the banks would forever increase their lines of credit based on hope that the housing market would continue to go up...whoops, isn't this where we started?

Feb 28 07:48 PM