Tapped-out consumers rediscover concept of thrift
After spending much of this decade treating their homes and stock portfolios as their piggy banks, debt-burdened American households are now desperately beginning to save the oldfashioned way.
The personal savings rate has been rising steeply this year as formerly profligate consumers frantically try to recoup part of the $14 trillion in losses they suffered since mid-2007 from the bear market and the bursting of the housing bubble. Many of the 78 million baby boomers are now revising their retirement plans while fending off foreclosure, which has reached record levels as the unemployment rate soars.
What a difference a year makes. In April 2008, four months after the recession began, Americans were saving none of their after-tax incomes. A year later, after an additional 5 million jobs were lost, after home prices continued to plummet and after the stock market recently hit a 12-year low, the savings rate jumped to 5.7 percent in April — its highest level in 14 years.
To generate the savings, consumers ratcheted down their spending faster than their incomes were falling. Until the second half of last year, when consumer spending plunged at an annual rate of more than 4 percent, American households had not reduced their spending in any quarter since 1991.
Even throughout the 2001 recession, consumer spending continued to rise. During the last six months of 2008, however, consumer spending declined a record six months in a row.
The steep drop in consumer spending last year has contributed to the longest, and perhaps steepest, recession since World War II.
Analysts do not believe the new-found thrift will be fleeting. As a result, the economic recovery, which many economists expect to begin during the second half of this year, will be more sluggish.
“There has been a fundamental shift in the behavior of American households,” said Bernard Baumohl, chief global economist for the Economic Outlook Group. He expects the savings rate will continue rising, eventually reaching 7 percent to 9 percent, where it will likely remain for several years.
“Americans have learned a cruel, cold, hard lesson. People are scared. And that’s led them to replenish their savings because they now realize that their retirement nest eggs will no longer increase on automatic pilot,” Mr. Baumohl said.
“The consumer mind-set has definitely changed,” agreed Scott Hoyt, senior director of consumer economics at Moody’s Economy.com. “Their balance sheets have been decimated, and they are heavily burdened with debt.”
During the past 30 to 35 years, as Americans saved less and less, consumer spending grew faster than the overall economy, Mr. Hoyt noted. Consumption, which accounted for 62 percent of gross domestic product (GDP) during the 1960s, comprised 70 percent of gross domestic product during the 2000-2007 period. Meanwhile, the personal savings rate, which averaged 8.3 percent during the 1960s, averaged a mere 1.5 percent of after-tax income from 2000 through 2007. During the 2005-2007 period, savings averaged just 0.6 percent, the lowest rate since the Great Depression.
Mr. Hoyt said consumer spending may grow slower than GDP during the next decade as households try to replenish their savings. As a result, the recovery will be slower than it otherwise would be as households concentrate on increasing their savings and reducing their onerous debt burdens, Mr. Hoyt said.
“Many Americans thought they were going to meet their financial goals on the cheap as their home values and 401(k)s soared. Now folks realize they are going to have to do it the old-fashioned way — spend less, save more.”
Since the summer of 2007, when the credit crisis erupted, the stock market neared its peak and home values began declining in earnest, there has been an ongoing shock to household wealth, said Mark Vitner, senior economist at Wachovia Economics Group. After the recession began in December 2007, job losses have hammered household income, exacerbating the wealth shock.
“Many Americans thought they were going to meet their financial goals on the cheap as their home values and 401(k)s soared,” Mr. Vitner said. “Now folks realize they are going to have to do it the old-fashioned way — spend less, save more.”
The shock to household wealth has been extraordinary.
From the middle of 2007 through March of this year, the Federal Reserve estimates that household net worth plunged $14 trillion, or 21.5 percent. During the second half of 2008 alone, household net wor th plummeted nearly $8 trillion, including an unprecedented $4.9 trillion dip in the fourth quarter.
The broad-based Standard & Poor’s 500-stock index shed 57 percent of its value between October 2007 and March 2009. While the S&P 500 has increased 36 percent since its March low, it is still 41 percent below its 2007 peak.
From the beginning of 2000 through the middle of 2006, U.S. home prices increased 93 percent, according to the S&P/Case-Shiller National Home Price Index. In some markets, such as Los Angeles and Miami, home prices increased about 175 percent. Throughout this period, millions of homeowners used their houses as ATM machines by withdrawing equity and using the funds to finance their consumption.
Since their peak in mid-2006, however, national home prices have plunged 32 percent. In some markets, prices have plummeted between 40 percent and 55 percent. People who purchased their homes when prices peaked or repeatedly refinanced their mortgages to tap their equity have been hit especially hard by the collapse of home prices. Moody’s Economy.com estimates that nearly one in five homeowners is now underwater, meaning they owe more on their mortgages than their homes are worth.
Home prices will likely fall another 10 percent during the next year, said Guy Cecala, publisher of Inside Mortgage Finance.
The collapse of home prices decimated the balance sheets of banks and led to a tightening of lending standards. Most lenders now require a 20 percent down payment, Mr. Cecala said. That has provided further incentive to save.
“Do the math,” Mr. Cecala said. “A $200,000 home with a 20 percent down payment and $8,000 in closing costs means that the purchaser will have to come up with nearly $50,000. We’re back to the days when buyers need to save,” Mr. Cecala said. “The 20 percent down pay- ment requirement, which isn’t going away anytime soon, will be the biggest obstacle for home buyers, especially first-time home buyers.”
At 9.4 percent in May, the unemployment rate has reached its highest level in more than 25 years, and it is expected to continue rising through much of next year. Many economists project the unemployment rate will average more than 10 percent throughout next year. Workers who were not accustomed to saving in the past now appreciate the need for a financial cushion in case they lose their jobs in the future.
Mr. Baumohl of the Economic Outlook Group forecasts “the mother of all jobless recoveries.” That’s saying a lot, considering that the unemployment rate continued to rise long after the 1990-91 and 2001 recessions ended. “People are aware that employers are in no mood to rehire,” he said. That provides still more incentives for savings.
“If American households become more frugal, it wouldn’t be bad for the long term, but it could be problematic in the short run,” said William Gale, director of economic studies at the Brookings Institution.
The rising saving rate will be a constraint on economic growth, said Mr. Baumohl, who estimates the economy will expand between 2 percent and 2.5 percent for the first two years of the recovery. That’s substantially slower than the recoveries following the deep recessions of 1973-75 and 1981-82. During the first two years of those earlier recoveries, the economy grew at annual rates of 4.6 percent and 6.5 percent, respectively.
Some economists emphasize the “paradox of thrift,” a concept first developed during the Great Depression by John Maynard Keynes. If everybody consumes less to save more, then nobody will be better off because falling consumption will lead to declining output, which will lead to decreasing wages and rising unemployment. In the end, savings will not have increased — thus the paradox.
Over the long run, however, economists agree that a rising American savings rate produces huge benefits.
More savings could be channeled into greater business investment, which raises productivity, the basic building block for a rising standard of living. Home-grown savings could also be used to finance the budget deficit of the federal government, which would no longer have to rely as much on Chinese and other foreign investors, whose long-term interests may not be the same as those of more frugal Americans.