The Resilience(?) of the American Consumer

With all the hype about green shoots, “reassuring” stress tests and stock markets rallies, not to mention the fabulous New York weather, I felt a sudden urge to go shopping!

Yet, except from a birthday present and the obligatory ticket to Star Trek *The Movie*, I couldn’t do it… I still have trouble convincing myself to splurge on anything that I can’t eat.

Just to double-check I don’t suffer from some kind of acute post-crisis hoarding syndrome, I had a look at the data to see how far (or not) I stand from the average American consumer.

In fact, the point of the exercise went beyond my own syndrome-check: The green shoot story rests partly on the view that the liquidation of inventories we have been witnessing for the past year and a half will have to give way to a re-building of stocks—read production! I mean, there are only so many times you can go to BestBuy and look for your favorite laptop in vain, before you start screaming at management.

But here is the catch… for this to work, you must want to buy a new laptop in the first place! In other words, demand must remain robust enough to encourage inventory re-building. And consumption is a big part of demand. So how resilient is the American consumer?

The data are actually pretty mixed. After consumers’ effective “abstinence” from anything and everything in the last months of 2008, first-quarter personal consumption increased 2.2% in real terms, stirring optimism about the ability of the American consumer to steer us out of the crisis.

But the optimism may have been premature. Indeed, speaking of laptops, part of the growth was due to a 9.4% increase in the consumption of durable goods—electronics, refrigerators and the like. While this might have reflected pent-up demand “post-abstinence”, some (cynics, surely!) pointed out that the surge in durables consumption could actually be related to the liquidation of Circuit City back in January.

The bears (sorry, cynics) got another boost today, after disappointing retail sales for April, and downward revisions for March, which doesn’t bode well for consumption growth this quarter.

“Surprise surprise”, you might say.. with unemployment hitting 8.5%, wages falling in real terms and wealth being destructed as house prices continue to collapse, no wonder consumption is falling. After all, in the long-run, consumption is driven by the level of income and wealth, no?

Actually, the picture is less clear-cut. First, because American consumers are getting a LOT of support from Uncle Sam. Just to give you an idea, households, on aggregate, saw their labor income decline by $15 billion in the first quarter, together with a near $25 billion drop in their income from housing and financial assets. That’s $40 billion down in a quarter!

But on the other side of the “equation” was a whopping boost from the government, in the form of transfers and lower tax payments—some $70 billion in total during the same period!

A hefty part of this reflects “automatic stabilizers” at work—e.g. as labor and investment incomes fall, tax payments drop too; similarly, as unemployment rises, this prompts larger transfers from the government to those who lost their jobs. These should continue to mitigate the drop in disposable incomes while the economy remains weak.

Then we have the stimulus package, which has already come on stream. I’m talking about measures like the Making Work Pay credit and the Social Security Economic Recovery payment, which should add around $55 billion to disposable incomes this year—a big chunk of which in the second quarter. And of course you have the Fed trying to fight a rise in long-term rates, which, IF it succeeded (big IF), could help create more room for spending for households that manage to refinance their mortgages at lower rates.

Uncle Sam regardless, there remain a few question-marks here, especially when one looks beyond the second quarter.

The first is a technical one: The dollar-for-dollar analysis above is not entirely appropriate for assessing the impact on consumption—if for nothing else, for focusing on aggregate numbers. For example, part of the drop in income taxes is due to lower taxes on interest income and capital gains. But the people helped by this decline may not be the same ones who lost their jobs and/or are cash constrained. On the other hand, to the extent transfers are well-targeted, they are more likely to be spent.

Another question mark has to do with the impact of “wealth effects” on consumption. The argument goes that the unadulterated destruction of wealth over the past year should force consumption down to more “sustainable” levels. This is because, at the moment, the level of personal consumption relative to income is still way above what might be predicted by a long-term equilibrium relation between consumption, disposable income and net wealth. So, surely, consumption should correct, right?

Well, not exactly. You see, for the long-run equilibrium to be re-established, the adjustment doesn’t have to come from the consumption side—it could also come from income, from net wealth or from all three. In fact, as a NY Fed paper argues here, historically most of the adjustment has come from the wealth side, while very little has come from consumption. In other words, consumption has not over-reacted to short-term wealth exuberance but has been slower to adjust by responding instead to “permanent” changes in wealth.

I recommend the “braver” readers of this blog to read the paper itself, but my bottom line here is that the impact of the recent wealth destruction on consumption may not be as severe as many analysts fear. The one caveat I should mention, however, is that, in this recent cycle, many households perceived the increase in their housing wealth as permanent, to the point that they even borrowed against it. The result may have well been a more rapid than "due" rise in consumption that now has to adjust downwards.

The third question mark is probably the most relevant for the consumption outlook (not least because it’s the most relevant for my own consumption pattern!). It’s called labor market or, rather, labor market UNCERTAINTY. With unemployment still on the rise, real wages will likely continue to decline, while job uncertainty will be a drag on consumer spending: I may have survived N rounds of layoffs, but if I think there might be round N+1 (or more) I’ll simply refuse to splurge.

Finally let me throw a “bonus” question mark, which is the potential (downward) impact on consumption from uncertainty about the tax regime going forward, especially as fiscal deficits are forecast to rise and debt sustainability (if we still believe in such a thing) will require higher taxes in the future.

If there is a bottom line in all this is that the American consumer may be more resilient than some headline numbers suggest, e.g. when it comes to wealth effects, but will likely require life (read government) support for months to come, barring a surprise recovery in the labor market.

I guess it’s exactly the moment when Spock’s legendary salute would be most welcome: “Live long and prosper!”