Consumer spending and the 'new normal' economy

Economists, sociologists and other observers are divided in their view of consumer spending in the post-recession era that lies (somewhere) ahead. While there is little controversy about the short term outlook — the dominant consensus is that consumers will spend less and save more — the opinions of analysts diverge for the years after 2010, says Lee McPheters, editor of Economy@W. P. Carey. Some believe that consumer spending will show considerable strength as unemployment rates fall and consumers move to replace ageing durable goods such as autos and appliances. The alternative view is that the current contraction has been a "game changer" for consumers. High unemployment rates, foreclosures and tight credit markets have combined to bring a permanent new frugality to consumer behavior that will linger for years, bringing a "New Normal" economy with a reduced emphasis on the consumer.

Economists, sociologists and other observers are divided in their view of consumer spending in the post-recession era that lies (somewhere) ahead. There is little controversy about the short term outlook. The dominant consensus is that consumers will spend less and save more.

After household liabilities in 2008 rose to a level exceeding 130 percent of personal income, consumers have started to rebuild balance sheets by cutting spending and reducing debt. Outstanding consumer credit is down more than 4 percent in the past year. And, after decreasing for many years, saving as a percent of disposable income is on the rise.

As a result, consumer spending for all of 2009 is expected to be below the level of the previous year, for the second consecutive year. The W. P. Carey School of Business projects that consumer spending in 2009 will be down by 0.5 percent, and rise by only 1.5 percent in 2010. There is little expectation of a strong consumer-led rebound for the economy in the near term.

Frugality Is In

The opinions of analysts diverge for the years after 2010. Some believe that consumer spending will show considerable strength as unemployment rates fall and consumers move to replace aging durable goods such as autos and appliances. The alternative view is that the current contraction has been a "game changer" for consumers.

High unemployment rates, foreclosures and tight credit markets have combined to bring a permanent new frugality to consumer behavior that will linger for years in a "New Normal" economy with a reduced emphasis on the consumer. If frugality is in and bling and excess are out, this New Normal environment would tend to affect the ratio of consumer spending to overall Gross Domestic Product.

This ratio has been rising for several decades (see figure). From a low near 60 percent in the 1960s, consumer spending has steadily taken a larger and larger share of output, as measured by GDP. In 2003, consumer spending first accounted for 70 percent of GDP, and with minor fluctuations stayed at that level through 2008.

Ratio May Rise, Fall or Stabilize

Going forward, consumer spending as a share of GDP can increase, decrease, or stabilize. Advocates of the view that consumer spending will begin to decrease as a percent of GDP note that the 70 percent level was achieved and then maintained by expanded use of credit cards and home equity loans.

Without these funding sources, consumers will have to learn to live with less leveraging, will borrow less and spend less, even as the economy grows. The New Normal under this view would bring a ratio of consumption to GDP lower than today. But if consumption as a proportion of GDP is to decrease, some individual components of consumer spending must lag while incomes are rising.

Services account for two-thirds of consumer expenditures, and as disposable income rises, outlays on services rise faster. This trend seems unstoppable and unlikely to change. We may find that the New Normal does not involve (or require) a reduction in consumer spending to 62 or 65 percent of GDP. Instead, the ratio of consumer spending to GDP may tend to flatten out near or just below the 70 percent level.

This version of the New Normal would be a setting where the consumption share has ceased to increase, but is stable even as the economy grows. The third alternative, a continuing upward trend, while not impossible, seems to take us into uncharted territory.

Reasonably, there is a limit to consumption's share of output, since an economy must have private investment and public infrastructure Compared to other nations, consumption's share of GDP is larger in the U.S. In 2008, consumption accounted for 56 percent of German GDP. The ratio in Japan was 58 percent, and in the U.K. it was 64 percent. Neighboring Canada had one of the lower ratios, at 55 percent.

In China, where consumer markets are much less well developed, consumption by households accounted for 36 percent of GDP. At this point, it seems safe to hypothesize that the New Normal will extend over the life of the next business cycle at least, and will be an environment characterized by consumption growth rates rarely greater than the overall growth of GDP.

It can be argued that the long term well-being of the nation would be enhanced by a decline in consumption's share, freeing up resources for private investment. But the trends of the past several decades seem to suggest that even a stabilization of consumption's share of GDP will be a major change for our economy.