Editor's Note: Karen Dynan testified before the Joint Economic Committee that there is a great deal of uncertainty about the strength and speed of the nation’s recovery, with gradual expansion being the most likely economic scenario. She says that consumer spending is likely to grow modestly over the next few years because of weak income growth, higher saving and lower borrowing. Policymakers have options to bolster the recovery but they should be mindful of the long-run costs, particularly in terms of the budget deficit, she says.
Chair Maloney, Vice Chairman Schumer, Ranking Members Brady and Brownback, and members of the Committee, I appreciate the opportunity to appear before you today to discuss the outlook for consumer spending and the broader economic recovery.
The Outlook for Consumer Spending
I will begin with the outlook for consumer spending on goods and services, as it is the largest component of GDP, and it played an important role fueling the economic expansion earlier in the decade. The available information suggests that the fundamental determinants of consumption will support only moderate growth in consumption over the next couple of years.
One factor that will probably restrain consumption will be tepid growth in households’ labor income. As you know, the sharp decline in aggregate demand for output has led to one of the largest percent declines in employment since the Second World War. Payroll employment has fallen by more than 7 million since the recession began, and, although the rate of decline has abated in recent months, we are unlikely to see substantial gains in employment in the near future. When labor demand picks up again, firms are likely to increase workers’ average hours - which fell noticeably during the downturn - before increasing the number of workers they employ. Firms tend to pursue this strategy because raising hours is less costly and easier to reverse than hiring new workers if the recovery proves transient. Of course, longer workweeks would increase workers’ earnings, but the magnitude of this response is also likely to be muted.
If employment and average hours worked rise only slowly, labor income could advance rapidly only if compensation per hour rose rapidly. However, compensation has been moving up quite sluggishly in recent quarters, and, with the unemployment rate at its highest level since the early 1980s, it is likely to continue to do so.
Of course, one caveat to this perspective is that household income is not independent of consumer spending. If, for example, the other fundamental determinants of consumption were to change in a favorable way, then consumer spending would likely grow more rapidly, which would, in turn, feed back into greater strength in income. However, as conditions stand now, the most likely outcome is for lackluster income growth over the next couple of years.
Under current law, consumption will also be restrained by a significant increase in tax payments over the next few years, as several key tax provisions expire. First, the temporary higher exemption limits for the Alternative Minimum Tax (AMT) are scheduled to expire at the end of 2009; if allowed to do so, many more taxpayers will be subject to the AMT. Second, the tax cuts provided by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), along with the Making Work Pay tax credit enacted in the American Recovery and Reinvestment Act (ARRA), are scheduled to expire by the end of 2010.
Moreover, additional forces should damp consumption relative to after-tax income. Compared with the situation prior to the crisis, saving is likely to represent a markedly higher share of after-tax income, and consumption is likely to represent a markedly lower share of after-tax income.
The most powerful of these forces is the massive declines that we have seen in household wealth. In the years leading up to the financial crisis, the saving needs of many households were met by substantial capital gains on homes and on holdings of corporate equities. However, the sharp reversals in the prices of these assets over the past couple of years have changed the picture dramatically. I recently studied data from surveys of household finances done in 1962, 1983 and then every three years since 1989. I estimated that recent declines in asset prices have reduced the ratio of non-pension wealth to income for the median household below the levels seen over the past quarter-century and similar to the level seen in the early 1960s. Households above the median have been left with about as much wealth relative to income as their counterparts in the late 1980s and only slightly more than their counterparts in the early 1960s. Meanwhile, households at the 25th percentile have seen their wealth-to-income ratio fall to the level recorded in the early 1960s, and households at the 10th percentile have negative wealth for the first time in at least half a century.
The recent declines in wealth should have the opposite effect of the earlier increases in wealth - they will likely induce households to reduce their consumption and increase their saving in order to rebuild their wealth. Indeed, the weight of evidence from statistical studies over the years suggests that one fewer dollar of wealth leads to a permanent decline in the level of household consumption of about three to five cents, although this range does not encompass the conclusions of every researcher. For the most part, the evidence in these studies also suggests that households move toward their new lower levels of spending gradually over a period of one to three years.
Applying the results of these studies to the declines in wealth that households have seen over the past couple of years, I estimate that wealth effects should damp consumption growth this year by between 2 and 3½ percentage points and hold down next year’s consumption growth by between ½ and 1 percentage point. In doing this calculation, I assumed that household wealth rises at about the same rate as disposable income through the end of next year. The negative wealth effects could be even larger if stock prices turn down again or house prices continue to fall (a topic to which I will return later in my remarks).
The personal saving rate will probably also be boosted by factors beyond wealth. Earlier this decade, many analysts came to the view that the economy had entered a “Great Moderation,” a marked long-run reduction in economic volatility. The experience of the past couple of years has presented a substantial challenge to that view. Many households have likely revised upward the amount of risk they see in their economic environment. Accordingly, one would expect households to reduce their spending so as to raise their precautionary savings.
Part of this increase in precautionary saving may occur as a reduction in borrowing. Households have just had a vivid lesson about the risks associated with high leverage, and many will be more reluctant to take on large amounts of debt to fund spending.
Households’ borrowing to finance consumption is also likely to be crimped by a more restrictive supply of credit. Since the financial crisis and economic downturn began, lenders have sharply reduced their willingness to extend credit to households. With unemployment rates remaining very high in coming quarters, lenders are likely to continue to see heightened risk in lending to households for some time to come. Further, the supply of credit seems unlikely to return to the levels seen earlier this decade even after the economy returns to full strength, as lenders, like households, have probably marked up their expectations of economic volatility over the long run. Regulatory actions should serve to reinforce the greater restrictiveness of lenders; indeed, the Federal Reserve and Congress have already taken steps to restrict some types of mortgage lending and certain practices among credit card lenders.
All told, I expect that consumer spending will move up at a modest pace in coming quarters because of weak income growth as well as higher saving and lower borrowing. Although this outlook contributes importantly to my expectation of a relatively weak overall recovery, I should note that higher household saving and lower household borrowing have the important positive aspect of leaving the economy in a more solid and more sustainable position. At the household level, the restructuring of balance sheets will leave households less vulnerable to disruptions to their incomes and to unexpected spending needs. At the national level, higher saving will help to correct what many analysts believe are unsustainable imbalances in trade and capital flows between countries.