Dean Baker: The Media Are Understating the Problem of Consumer Debt

Economist Dean Baker, in his newsletter (Feb. 9, 2004):

Growth Again, but Slower
Nell Henderson
Washington Post, January 31, 2004, Page E1
http://www.washingtonpost.com/wp-dyn/articles/A64693-2004Jan30. html

Economy Remained Strong in 4 th Quarter, U.S. Says
Edmund L. Andrews
New York Times , January 2631, 2004, Page CA1
http://www.cepr.net/Economic_Reporting_Review/nytimesarticles/economyremainedstrong. htm

Debt-Heavy Economy May Be Too Jittery About Rates
Eduardo Porter
New York Times , January 31, 2004, Page B1
http://www.cepr.net/Economic_Reporting_Review/nytimesarticles/debtheavyeconomy. htm

These articles report on the economy's near-term prospects in the wake of the release of new government data on fourth quarter GDP and debt burdens. None of the articles noted that the savings rate out of disposable income reported for the fourth quarter was 1.5 percent, the second lowest quarterly savings rate on record.

This is important, because such a low savings rate implies extremely high levels of consumer borrowing, which are unlikely to be sustained. During the sixties, seventies, and eighties, savings out of disposable income averaged more than 8 percent. The low savings rate of recent quarters is especially striking because the demographics of the labor force, with the bulk of the baby boomers in their peak savings years, should be leading to a higher than normal savings rate.

If the savings rate moved toward a more normal level  for example if it rose to 4.0 percent by the fourth quarter of next year (still a historically low savings rate)  real income would have to grow by 2.6 percent just to leave consumption steady. In order for consumption to maintain a modest 3.0 percent rate of growth over this period, real personal income would have to rise by 5.7 percent, a rate that is 3.2 percentage points faster than its growth rate over the last year. In other words, the low current savings rate implies that consumption growth is likely to be much weaker (and possibly negative) in the future, as the savings rate moves towards a more sustainable level.

The Post article noted that investment spending on equipment and software grew at a 10 percent annual rate in the fourth quarter, which it described as “strong.” In the event that consumption spending slows, the economy will need far more rapid growth in this sector to sustain a healthy overall growth pace. Consumption spending accounts for approximately 70 percent of GDP, while equipment and software spending accounts for less than 8 percent of GDP. Furthermore, close to half the spending on equipment and software goes to buying imported goods, and therefore provides no direct boost to the U.S. economy. Given the relative size of the two sectors, if the growth in consumption spending falls by 1.0 percentage point, the growth in spending on equipment and software will have to increase by approximately 17 percentage points to compensate. This means that, given the likely weakness of future consumption growth, investment spending of the size that we have been seeing will not be fast enough to sustain the pace of GDP growth over the last year.

The article by Andrews also raised the possibility that restocking of inventories will lead to more rapid growth in the future. While the pace of inventory restocking is likely to be faster in future quarters than it was in the fourth quarter, the impact on GDP growth would be limited. A large percentage of the goods kept in inventories are imported. This means that more rapid growth in inventories will be associated with an increase in imports, and therefore the impact on domestic GDP will be considerably smaller than would otherwise be implied by a more rapid rate of inventory accumulation.

The Post article discusses the prospect that households will receive big tax refunds this spring, which it suggests will help to sustain consumption. Actually, it is unlikely that refunds will be much higher this year than last year. While tax rates were lowered in the middle of the year, which means that many taxpayers overpaid in the first half of the year and therefore should be entitled to large refunds, this is likely to be offset by the rising stock market. With the large rise in the stock market in 2003, taxpayers are likely to have substantial capital gains tax liability for the first time since 2001. In that year, the government collected $100 billion in capital gains taxes (down from $119 billion in 2000). This compares to capital gains tax receipts of just $45 billion in 2003. If capital gains tax collections were raised just halfway back to their 2000 level, it will almost completely offset the refunds attributable to the tax cut.   

In assessing the near-term prospects for the future of the economy and the implications of the large consumer debt burden, the article by Porter comments that “most economists are quite sanguine” about the risks posed by high consumer debt levels. It is worth noting that nearly all economists were quite sanguine about the risks posed by the stock bubble in the late nineties, and that virtually all of them failed to foresee the stock market crash and the onset of the recession of 2001. In September of 2000, the average 2001 growth forecast of the Blue Chip top fifty economic forecasters was 3.5 percent. Not one of the Blue Chip fifty predicted a recession  the lowest growth forecast among the group 2.8 percent. (Actual growth for 2001 was 0.0 percent.)