Stress test the consumer

July 6, 2009

Christopher Swann– Christopher Swann is a Reuters columnist. The views expressed are his own –

People can be divided into three classes, it has been said: the haves, the have-nots and the have-not-paid-for-what-they-haves. The prevalence of the third category may be the biggest single source of vulnerability for the U.S. recovery.

A stress test of the consumer could reveal more distressing results than the one conducted on the banking system.

Debt is at high levels — 130 percent of disposable income, or more than twice its peak in the late 1980s. A slide in net wealth has reduced the collateral Americans can draw upon for emergency loans. Finally, it is now harder to borrow money for new consumption or to roll over existing debt.

Like a compromised immune system, this weakness makes consumers extremely susceptible to further shocks. Traumatic as the recent bout of retail restraint may have felt, worse may be in store. After all, consumption rose by 18.5 percent in the seven years to 2008. So far it has only fallen back by less than 2 percent.

There are several potential mishaps that could swiftly undermine consumer spending and set the recovery back to square one.

Among the most likely problems would be a continued slide in house prices. Even on the conservative measures used by the Federal Reserve, the value of residential real estate has fallen 18 percent since 2006.

With signs of recovery still tentative, a further 10 percent slide is well within the realm of possibility — inflicting a further blow on the balance sheet and sense of well-being of American households. (If nervousness over swelling government debt pushes up bond yields, the outcome could be still worse.)

Homeowner’s equity, already down to 40 percent from close to 60 percent, would plunge to 35 percent. This would send household wealth down to its lowest level since the mid-1980s. While Americans can’t immediately rebuild the $12 billion of net worth lost over the past 2 years — equivalent to more than a year’s worth of consumption — further losses will heighten their sense of caution.

A second threat is also looking increasingly likely — wage cuts. Fifteen percent of employers surveyed by the Society for Human Resource Management reduced pay in the past six months, a threefold increase from earlier this year. It is no longer implausible to imagine nominal wages starting to decline on a nationwide basis.

The Employment Cost Index is already rising at its slowest rate since the early 1980s. Wage deflation would make it even harder for Americans to repay the $10.5 trillion of mortgage debt they hold or the $2.5 trillion of consumer credit.

Martha Olney, a professor at Berkeley, envisages disproportionate cuts in spending if wages dip. “For households that are paying 60 percent of their income in mortgage and credit payments a 10 percent pay cut does not mean a 10 percent fall in disposable income,” she says. “It’s a 25 percent fall.” This is the danger of leverage.

Even under a rosy scenario it could take years for American consumers to repair their finances. If the savings rate rises to 8 percent of disposable income — about $860 billion a year — it will now take four years for debt to return to its 2002 level. This steady drain alone is equivalent to almost 10 percent of consumer spending.

After such a substantial loss of wealth, Americans will be pressed to be even more frugal. Along the way American will be hyper-sensitive to any jolts from weaker than expected employment, house prices or financial markets.

Consumer spending may not merely stagnate as most economists expect. It could yet decline more sharply. And like the banks, consumers will almost certainly need more support from the central bank and government before this economic malaise is over.

26 comments

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The consumer is already stressed tested and now the bottom is falling out as this depression will be agrrevated by the government trying to bail us out with trillions of $$$’s………All the printed dollars that are piling up have no where to go (velocity) to get into the system if the jobless will not take out loans and start spending……I see DEFLATION Japanese style…America will feel this pain for decades….. for the Japanese are still able to go through this period because of individual savings…..American’s are just starting to save……It’s too late!!!

Posted by Mr. Anderson | Report as abusive

The sad fact is that the government’s stupidity, and the banking industry’s greed (well, everybody’s greed) has put us in this mess. Capitalism at its worst. Bank should never have given out loans to people who couldn’t afford to pay them back. It was insane. The trouble is that the idiots are now dragging everybody down with them. The banking industry across the globe should the same strict regulations (well, let’s hope they get some!). Alas, I see a lousy economic forecast ahead for the next several decades.

Posted by Elyse | Report as abusive

Naughty bankers may have exploited people who wanted to borrow more than they could afford to pay back, but that doesn’t absolve the people concerned from blame, nor, more importantly, does it get governments off the hook. For a generation now, governments have encouraged profligate borrowing because it allows them to claim that we’re all so much better off. What we’ve seen recently in the UK is the most extreme form of this: banks going under because of foolish lending and borrowing, introduced stringent conditions for new mortgages (25% deposit and so on). Very sensible on the face of it. NO! The government virtually ordered them to lend more! You couldn’t make this stuff up. We’re all in Never-never-land.

Posted by Matthew | Report as abusive

There are several fundamentally wrong things:

1. We cannot borrow our way out of debts. US is addicted to unsustainable way of life. People consume more than they can afford and cover deficit by borrowing against future income and assets. Finally we exhausted all reserves and… Government jumps in borrowing on our behalf put us as nation deeper into debts.

2. US pumps money to people/institutions who just prove that they cannot manage their money. At the same time government is taxing people who have proved that they can manage money.

3. US didn’t charge people who were at root of wrong decisions that affected whole society (AIG/Citi/Lehman/Bear/etc).

4. Gov overlooked second cause behind recent problems – Failing corporate governance. CEOs have heavy sway over corporate boards and rule unchecked. Instead of persuade interests of shareholders and public they play power brokers between unions/board/politicians and pocket unjustified compensations.

5. I am 39. There is no way current system can provide me with decent retirement.

Posted by Sergey | Report as abusive

What about the don’t wants ?

Posted by bloke nouvo | Report as abusive

Unfortunately, today we face the effects. Jobs are being lost. What was once a two income household is now a one or no income household? Granted many of us have borrowed against future income and now it is difficult or impossible to repay that loan. Many will make mortgage and car payment while buying food and what clothing is necessary and the rest will go by the wayside. The rest will just hope they don’t take home and car to soon. It is sad.

Now for anyone to state that Gas prices didn’t contribute to the collapse get off you bicycle and try driving to work. I would love to get off of gas and onto a better more economical and efficient mode of transportation but the auto industry has done nothing since the last oil crisis in the 70s to bring the internal combustion engine to its fullest potential or put out a viable alternative to the gas guzzlers. What do they give us but toy cars like the Volt and crap like the hybrid? No we should not have bailed out the auto industry. They have brought this debacle unto themselves. I would have loved to see new blood come out and take over our auto industry.

The consumer is always the ultimate payer. We pay while our voice is silent in Congress. We pay while CEOs are paid 100 times their worth. We pay as our retirement funds are slashed in half and our government does absolutely nothing to bail us out. You could run a consumer stress test but, we would fail.

Posted by B.Free | Report as abusive