The Great Deleveraging, will Consumer Spending Ever Recover?

Location: New York
Author: Knowledge@Wharton
Date: Wednesday, October 26, 2011

It is hard to overstate the importance of the consumer when it comes to the health of the U.S. economy. With roughly 70% of U.S. GDP coming from consumer spending, the purchasing habits of U.S. households are a critical contributor to economic health. But over the last three years consumers have been tightening their belts and paring their debt load. While that deleveraging bodes well for the financial health of households over the long term, it is also a drag on the economy at a time when concerns are mounting about the possibility of a double dip recession.

"People are feeling very uncertain," says Wharton professor of business and public policy Olivia S. Mitchell. "They are worried about losing their jobs, and it is harder to get credit." The moribund housing market, which has erased a large chunk of household wealth, makes a quick rebound unlikely. "It will take a long time to recover with that problem at the heart of the economy," Mitchell notes.

The current deleveraging comes after a massive buildup of consumer debt. According to data from the U.S. Federal Reserve, total household debt, including consumer credit and mortgage debt, just about doubled between 2000 and 2008, when it hit $13.8 trillion. Since then, it has been declining steadily, coming in at $13.3 trillion at the end of the second quarter of 2011. At the same time consumers are saving more. The personal savings rate -- savings as a percent of disposable income -- was 4.5% in August versus less than 2% in 2005. And while the Thomson Reuters/University of Michigan Index of Consumer Sentiment showed some improvement in September compared to August, it is still far off pre-recession levels. "Rather than spending more and taking on new debt, consumers are intent on rebalancing their finances to prepare for a new economic era," according to survey director Richard Curtin.

That new consumer frugality is mirrored by a massive buildup of cash on the part of corporations. According to data released by the U.S. Federal Reserve in mid-September, non-financial American companies held more than $2 trillion in cash and other liquid assets at the end of the second quarter of 2011. That put the percent of assets in cash at 7.1%, the highest level since 1963.

In contrast to the stockpiling of cash by companies, a good bit of the retrenching on the consumer side is involuntary, says Scott Hoyt, senior director of consumer economics at Moody's Analytics. "Most of that decline can be accounted for by mortgage defaults." And with credit card companies tightening standards, clearly some of the deleveraging is due to the inability to borrow. "People have become frugal because they have to become frugal," notes Chris Christopher, senior principal economist at IHS Global Insight.

Still, it is clear that for others, the shift is not entirely a forced one. "You have continued to see consumer spending and no net increase in debt," Moody's Analytics' Hoyt points out. "That is a significant change in behavior." IHS Global Insight's Christopher says the uncertainty surrounding everything from the employment picture to sovereign debt woes in Europe makes even consumers with good credit less likely to borrow. "Housing isn't doing well, employment is terrible and people are worried about what is happening in Europe," Christopher notes. "As a result, people are more prone now not to use credit even if they have it."

The contraction in household debt is in stark contrast to what occurred during the last recession in 2001. "Back in 2001, there was downsizing and the collapse of businesses that were predicated on an Internet reality that didn't quite work," according to Wharton marketing professor Stephen Hoch. "But unemployment didn't go up as much as it has this time around. And the collapse wasn't international. Plus, our houses were still worth something and there was readily available credit." But with the housing collapse, tight credit and 9.1% unemployment in the U.S., consumers' financial health has taken a battering. "Money is cheap right now, but it is not as readily available to those who need to borrow," says Hoch. "This time around, the consumer isn't going to spend us out of this mess."

Small Indulgences

One of the biggest reasons is the bloodbath in the housing market. Wharton finance professor Nikolai Roussanov has studied refinancing booms, and his work shows that those booms tend to occur when economic conditions deteriorate. A high proportion of the refinancings in those periods are cash-outs that allow consumers to pull equity out of their homes in the form of cash. Those cash-outs enable consumers to maintain their consumption levels even during tough economic times. With housing values taking a hit, however, consumers are less able to tap this source of funds. "There was a big surge of refinancings in 2008 and 2009 because interest rates fell," Roussanov notes. "But less of that was used for cash-outs because there was less equity in the homes."
How the housing piece of the equation nets out going forward is a big question mark. Roussanov says it is possible that if people come to the conclusion that economic growth in the future will be very slow overall, they will remain reluctant to tap sources of credit even when they are available. "If we think we are facing decades of slower growth, the whole picture of how much we want to borrow versus save is going to change," Roussanov points out. "There is the possibility people will borrow less, cash out less and save more."

At the same time, with consumers becoming more conservative, there are signs of changes in how they spend their money. Wharton marketing professor Barbara Kahn sees indications that while some people cut back on spending on themselves, they may be more inclined to spend money on their children. "You make purchases based on what gives you the biggest boost," she notes. "You see less selfish consumption, more tradeoffs in favor of the kids." In addition, they also may purchase small indulgences in place of big ticket items. "If you are scrimping and sacrificing all the time, that is hard to endure," she says. "You want to splurge occasionally. Maybe you can't afford a new car or even new shoes, but ... you can afford a $5 bottle of brightly-colored nail polish."

According to Kahn, this austerity poses major challenges for retailers. Earlier in the year, as costs for inputs like cotton went up, many retailers held off passing the full tab on to consumers. When there were some positive signs about the strength of the economy over the summer, retailers may have boosted their inventory levels, she adds. If the economy underperforms and the holiday season is disappointing, that could mean a double hit for the retail crowd. "If they miss forecasts on inventory levels, they will need to discount to get rid of that inventory," Kahn says. "If, on top of that, you are eating [these higher input] costs, that makes for very tight margins."

This tough retail environment has implications for small businesses, a crucial source of job creation. Christopher notes that smaller enterprises have a heavy weighting in the retail and construction sectors, two areas very reliant on consumer spending. The Small Business Optimism Index, a monthly indicator examining small business owners' outlook for business conditions, has declined for six months straight. And in the near term, "I don't expect a sudden wave of optimism," Christopher adds.

Longer term, it is less clear how the recession and the deleveraging of the consumer will change consumption patterns. Mitchell has teamed up with other academics to create a model that shows how the financial meltdown has impacted various groups of investors. The biggest impact is seen on those individuals closest to retirement. She predicts that this group will have to consume less both in the short term and the long term, work more and defer their retirement if possible. In fact, the model shows that older individuals hit with the recent financial and economic crisis will reduce their consumption 3.5% before retirement, and more -- by about 4.5% -- after the age of 80. The impacts in the simulation were less dramatic for younger groups. Still, Mitchell says there are potentially significant problems for those workers. "Long-term unemployment can have a scarring effect. We may have problems with people who have been out of the workforce for a long time and find that their skills and their networks are out of date."
According to Kahn, the current economic woes may have lasting effects on those younger workers. "The question is, when the economy does come around, will there be persistent effects similar to what we saw with the Depression-era babies?" Kahn asks. "Some surveys have shown younger generations don't expect to achieve the wealth of their parents. And I think that could cause a persistent effect."

That is not to say there is no silver lining to the consumer retrenchment. According to the U.S. Federal Reserve, the household debt service ratio, which is an estimate of the ratio of debt payments to disposable income, has fallen significantly in the recession. That ratio peaked in the middle of 2007 at nearly 14% and has since come down to just over 11%, a level not seen since the mid-1990s, thanks to low interest rates and the paring of debt by consumers.

"Clearly in the short term, it is a negative because consumers can't grow their spending as much because they aren't borrowing," says Hoyt. "But it is a positive long term. If consumers' financial situation is better down the road, when they choose to spend, they will have more wherewithal to do it." That pickup, however, is unlikely to occur until the jobs picture improves. "As long as the unemployment rate is around 9%, we probably won't see that increase," Hoyt notes.  

Published: October 12, 2011 in Knowledge@Wharton