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YOU DECIDE: Does it make sense?

February 05, 2010

MEDIA CONTACT: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu


Dr. Mike Walden
Media representatives:For a high-resolution version of this photo, call 919.513.3127 or e-mail dave_caldwell@ncsu.edu.

Understanding a problem is the first step to solving it. So when we look at the overriding problem in the country today - the recession and the likelihood of a slow recovery - our initial task is to understand how we got here. Let me see if I can weave a story that makes sense.

The starting point is you and me - the consumer - for the simple reason that we drive the economy. Three decades ago our behavior in the economy began to change. First, our wealth started to rise. Driven by the good stock market in the 1980s and 1990s and then the booming housing market in the decade from 1997 to 2007, average wealth per person (after taking out inflation) jumped 100 percent from 1980 to 2007. Never before were consumers so rich!

Simple economics dictated what happened next. With more wealth at hand, consumers were motivated to take on more debt. A big part of this debt came directly out of the rising value of our homes in the form of home equity loans. Consumers used this debt to purchase bigger homes, more vehicles and all the electronic gadgets that are so much a part of today's society.

Even with our greater borrowing, consumer debt rose at a slower rate than consumer wealth (75 percent versus 100 percent, again per person and adjusted for inflation). Furthermore, because interest rates on loans were falling after the early 1980s, consumers easily financed this additional borrowing from their budgets. Indeed, consumer debt payments as a percent of their income rose only 30 percent during the period - less than one-third as fast as wealth.

And because our wealth was rising from the booming stock and housing markets, we had less motivation to save money out of our paychecks. The personal saving rate dropped from 10 percent in 1980 to almost nothing by the mid-2000s.

So here's the situation for consumers in 2007: they had a record level of debt and were spending virtually everything from their paychecks. Yet it didn't matter because consumer wealth was also at a record high. In fact, on paper, consumers' financial situation looked very strong. Life was good!

Then, literally, the bottom fell out. Beginning in 2007 and continuing into 2008 and 2009, the wheels fell off both the stock and housing markets, causing an unprecedented (at least for modern times) plunge in consumer wealth. At the worst point, consumers collectively lost $13 trillion of wealth, a full 20 percent of what they had before the recession.

With wealth down, consumers' high debt loads became exposed. The only way out of this situation was for consumers to spend less, save more and pay down on debt.

Lo and behold, this is exactly what consumers are doing. In the past two years, consumers have paid down 7 percent of their debt and have increased their saving rate from nothing to almost 5 percent. Debt payments as a percent of consumer income have also fallen by a full percentage point.

These individual actions are certainly good for consumers. It's a way for consumers to get their financial balance sheets back in order, and it's what any financial adviser would recommend. But what's good for the individual consumer may not be good for the overall economy.

Here's the issue. Spending by consumers still accounts for the majority of economic activity. If consumer spending is sluggish because people are spending less and saving more in order to reduce debt, then the economy will also be sluggish. A sluggish economy means jobs - even when they start to come back - will return very slowly.

This is why the majority of economists think the time period after the recession will continue to be challenging. Although the stock market has regained some of its losses and housing values seem to have stabilized, few forecast a return to pre-recessionary wealth levels any time soon. This means the frugality consumers started during the recession will continue even after the recession - perhaps for several years.

Some say we lived high on the hog in the almost 30 years from 1980 to 2007, and now we must pay for that party by tightening our collective belts. I don't totally agree with this characterization because it implies consumers threw caution to the wind when they spent more and saved less. However, as I've tried to explain, this high-spending and low-saving behavior made perfect sense when consumer wealth was rising.

Perhaps the lesson here is to be cautious of your wealth. We've certainly seen in the last three years that wealth can evaporate very quickly. Our wealth will increase again but probably at a slower pace. Yet maybe, you'll decide, this is a better way!

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Dr. Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University’s College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The Department of Communication Services provides his You Decide column every two weeks. Earlier You Decide columns are at http://www.cals.ncsu.edu/agcomm/writing/walden/decide.htm

Related audio files are at http://www.ncsu.edu/waldenradio/

Posted by Dave at February 5, 2010 08:26 AM