U.S. consumers have been a hardy breed in recent years. The 2000 stock market meltdown? They kept spending. The 2001 recession? Didn't miss a beat. The terrorist attacks? They spent even faster. And so it went until what will likely go down as the 2007-2009 recession. With almost every possible support under household buying now crumbling, consumers have finally met their match, and they are leading the economy into probably the longest and maybe one of the worst downturns since World War II. What's more, households not only face a debilitating set of short-term woes, but they also will have to make a long-term adjustment to borrowing less and saving more.
The third quarter's 3.7% annual rate of decline in real consumer spending, the largest drop since the 1980 credit controls, was shocking enough. It now appears outlays will contract even more in the fourth quarter, and many economists expect a further drop in 2009. Spending has never fallen for three quarters in a row since quarterly data were first gathered in 1947, and the peak-to-trough decline could be the largest in any postwar recession.
The unusually heavy drag from consumers is the biggest factor in the recession's severity. After household spending hit a wall in the third quarter, businesses began to cut back sharply as orders dried up. From August through October, factory orders plunged 12%—a record three-month drop—and companies are slashing capital spending and hiring. New orders for equipment have dropped like a stone, and the loss of 533,000 jobs in November, together with declines totaling 725,000 in September and October, made up the biggest three-month drop since 1975.
This is the classic recession pattern: Weakness in the economy feeds on itself—as consumers retrench, companies cut back, further undercutting spending. This time, the cycle is magnified by the credit crunch and the breadth of the slump. Households are even curbing outlays for services, such as recreation and other discretionary activities. That's a factor in the record loss of service jobs in recent months.
The swoon in car buying is having an especially large impact. Falling sales, which have been hit by a double blow from the earlier surge in gas prices and the later intensification of the financial crisis, accounted for a third of the drop in third-quarter household outlays. The drag will be far greater in the fourth quarter, since the sales drop-off was twice as big. November auto inventories ballooned to more than a 100-day supply, implying large production cuts in coming months.
Consumers will hold back economic growth throughout 2009. They are now more dependent on income growth to finance their spending and saving and less so on credit and wealth. In recent years, households have used their big multiyear wealth gains as a means to afford more debt and as a surrogate form of savings, instead of socking away more of their pay. But by the end of 2008, economists estimate households will have lost more than $5 trillion in net worth since the summer of 2007 because of falling home equity and stock prices.
Households are overleveraged and underfunded, which means 2009 will be a transition year for savings behavior. Personal savings, measured as aftertax income not spent, is already rising as a percentage of income, after sinking close to zero. Each percentage point increase in the savings rate takes a point off the growth of spending, and economists think the savings rate could go as high as 4% to 5%. Plus, consumers are under pressure to save more at a time when poor job markets are squeezing paychecks.
In this dismal holiday shopping season, wealth losses are proving to be a major depressant on sales at high-end retailers. But low-end stores might get some help from the 60% plunge in gasoline prices since July, which has boosted the buying power of middle-income households. Still, that's a small reprieve amid a major shift in consumer spending that will depress economic growth for some time.