July 29, 2010

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Awaiting the Prudence Payback

Lambasting big-economy consumers for their excesses has become a popular recession-time sport. Chastened by the exposure of their self-engineered plight, many consumers have hunkered down, quietly working down excesses and deleveraging. Their activities are obvious in consumer spending data; this large chunk of the world economy has been a soft spot. Is the new prudence paying off?

One look at indebtedness data, and it doesn’t seem to be doing anything. Consumer debt as a share of disposable income is still sky-high, an ominous signal that a full consumer recovery is no slam dunk. But these data always look worst just after a recession. As incomes recover, debt ratios can improve markedly. A better gauge of current consumer prudence is the change in savings patterns.

Shift back a generation, and the attitude toward savings was radically different from today’s norm. Consumers in most industrialized economies socked away at least 10% of their disposable income. That number has steadily eroded to low single digits in the US, Japan, the UK and Canada, and although rates are higher there, the same trend holds in Germany. Savings rates continued to test new lows right to the brink of recession, falling to a dangerously thin 1% in the US.

Recession brought these consumers to their collective senses. The shortage of cash caused consumers to rein in spending and boost savings. The US savings rate jumped swiftly to just under 4%. French consumers jacked up their savings at the same rate. In short order, Canadians boosted their savings from 2.4% to 4.3% of disposable income. In Germany, not satisfied with the already-high 11% savings rate, consumers added another full percentage point to savings.

The efforts are commendable, even if the timing is off. A better approach might be to save for a rainy day, and then spend when the heavens eventually burst open. Raising savings during a recession actually sets off what John Maynard Keynes referred to as the paradox of thrift: collective increases in savings reduce aggregate demand enough to actually lower the level of total savings across the economy. Has current growth been affected? The implied reduction in consumer spending of Germany’s increase in savings amounts to 0.6% of GDP. By the same measure GDP took a 1.8% direct hit in Canada, and 2.4% in both France and the US. These are substantial negative impacts.

Fortunately, it seems as if the worst is behind us. In most cases, savings rates appear to be stabilizing, and the OECD is actually forecasting a mild decline in the near term. While a return to the perilous pre-recession lows would be frowned on, the end of the ramp-up is positive for current growth. The magic of getting to this point is that, without any increase in employment, wages or any other income-enhancing development in the economy, consumers will spend more. For a number of quarters, spending growth has by definition been considerably lower than income growth. Once consumers are comfortable with their pace of saving, whatever the rate, spending can now rise to match income growth. That’s prudence’s real payback. It is substantial, and happily, it’s imminent.

The bottom line? Consumers awoke to their chronic overspending too late in the cycle, and their reaction has exacerbated the recession. But the negative effects are almost over, giving way to stronger spending growth, and setting saving patterns that will in time lead to better financial health.