Can We Count on the Consumer to Lift Us Out of the Economic Doldrums?

Among the more notable features of the last batch of economic data were the readings on consumer spending. On an inflation-adjusted basis, real personal consumption expenditures rose at an annual rate of 2.5 percent in the third quarter. This figure is hardly spectacular, but it was solid and represented a decided pick-up from the 1.5 percent pace of growth seen in the first half of the year. Moreover, it was the leading contributor to the acceleration in our nation’s real output that, together with the European agreement on debt, propelled the stock market to its highest level in nearly three months yesterday.

The pick-up in consumer spending is a bit of a surprise when you consider what is going on with the usual drivers. Income gains are certainly not behind the increase: the real after-tax income of households actually fell in the third quarter after weak gains in the first half of the year. Confidence has dropped to levels not seen since the financial crisis, and the bearish performance of the stock market in the latter part of the summer drove household wealth down further. Low interest rates may have raised the cash flow of some mortgage borrowers who have been able to refinance their loans, but we know that significant obstacles are blocking many households from pursuing this option (at least until the recently announced revisions to the administration’s mortgage refinancing program take effect).

The best explanation for why consumers are opening their wallets may be that we are seeing a release of what economists call “pent-up demand.” The lackluster economy of the past few years has led many households to defer a lot of spending that they would otherwise do. But, such prudence has its limits. At some point, people find that their socks have gotten too ratty and that it is just not practical to repair the old dishwasher one more time. Spending, in turn, increases.

The bad news would be that this higher level of spending is likely putting many households that are already stretched thin on yet less solid financing footing. Without income gains, some people are dipping into their savings to increase their outlays. Others are taking advantage of thawing credit conditions to borrow more, notwithstanding the need for many households to do more deleveraging. This dissaving is showing through to the aggregate personal saving rate, which dropped by a percentage point to 4.1 percent in the third quarter. Monthly data released today show that households saved less as the quarter went on, with the September saving rate of 3.6 percent the lowest reading since late 2007.

Optimists might argue that there is a potential silver lining to the higher consumer spending. In principle, it could jumpstart a stronger recovery if retailers and their suppliers respond to the higher demand by bringing on more workers. More hiring would lead to higher incomes, which could, in turn, spur more spending, and so on. However, it is not at all clear whether this spurt of consumer spending is enough to overcome the obstacles and gloom that have been making businesses reluctant to hire for some time now. As much as I would like to see a virtuous cycle kick in, I would not count on it unless we see policymakers commit to the big fixes our economy needs.