Business Outlook: Why Consumer Spending Won't Drive a Recovery

Consumers are in the middle of a wrenching—and historic—adjustment. They are casting off debt taken on over the past decade as a result of cheap financing, lax lending standards, and a surge in wealth from home values and stock prices that made it easier to carry the load. The subsequent reversal of fortune, with wealth losses since early 2007 totaling $13.9 trillion through the first quarter, is forcing households to divert more income away from spending and toward savings and paying down debt. In April they socked away 5.7% of their earnings, the most in 14 years.

Efforts to unload debt and rebuild savings are sure to limit the recovery's strength. But households have already made progress in realigning their finances. Deleveraging has been under way for more than a year, and the saving rate may be close to topping out. So this ongoing adjustment is unlikely to prevent at least a modest upturn in the economy in the second half.

Still, debt reduction has a long way to go. So far in this decade, households' debt-to-income ratio has risen twice as fast as it did in the 1990s. Liabilities have declined to 131.1% of aftertax income in the first quarter from a peak of 138.6% in the fourth quarter of 2007. No one knows the optimal level, but if the ratio had grown along the slower trend of the 1990s, it would be about 110% right now. That level would imply that households today, at a time of sharply lower wealth and weak labor markets, have some $2.2 trillion in excessive debt they need to eliminate.

On the plus side, net additions to household debt began to slow in 2007, and since the third quarter of last year liabilities have shrunk by $421 billion. For the first time ever, households have paid off more debt than they took on for two quarters in a row. Despite that shrinkage, consumer spending already has stabilized after plunging in the second half of 2008. Over the coming year, deleveraging will continue, but the pace should slow after the initial wave of debt reduction, which has been fueled by an accelerated rate of mortgage and consumer loan defaults.

Wealth losses seem likely to slow as well. Household net worth—assets minus liabilities—fell $1.3 trillion in the first quarter, but that was half the average quarterly decline in 2008. Given the stock market rebound in the second quarter, economists at UBS (UBS) estimate net worth is on track to increase by some $3 trillion this quarter. That would be the first gain in two years, despite the ongoing loss of housing wealth because of falling home prices. In fact, financial assets are still the major mover of household net worth: Lost housing wealth has accounted for only $3.9 trillion of the total $13.9 trillion drop.

Plunging wealth is the chief reason households are saving more of their income. But if the decline in net worth is bottoming out, then the increase in the saving rate may be about over, too. The ratio of wealth to income, which tends to track the saving rate, is now about where it was in the mid-1990s, when the rate was about 5%. So many economists figure it may well be about as high as it needs to go.

Moreover, the saving rate might be substantially higher than indicated by current data. Based on preliminary information, economists expect the government's major revisions to gross domestic product, due on July 31 and covering previous years, to show weaker consumer spending and stronger income growth. That should result in a notable upward revision in the saving rate and would be another sign that most of households' upward adjustment in their saving behavior already has occurred.

Given that consumer spending has stabilized this year despite the ongoing realignment in household finances, the adjustment will not likely prolong the recession. But much will depend on the labor markets. The slower they heal, the more drawn out the process will be, and the less consumers will be able to contribute to the recovery.

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