July 17, 2011
[see note at bottom.]
David Leonhardt tells us that consumer demand is still surprisingly weak. This should have drawn a big “huh?”
The savings rate through most of the post-war period was around 8.0 percent. This began to fall at the end of the 80s and more rapidly in the 90s as the stock bubble generated trillions of dollars of bubble wealth. The wealth effect, which economists have known about for a century, predicts that consumers would spend 3-4 cents more for additional dollar of stock wealth. By the peak of the bubble in 2000, we had close to $10 trillion in stock bubble wealth, which implies $300-$400 billion in additional consumption. This would correspond to a drop in the savings rate of 4-5 percentage points, which is what we in fact saw.
In the last decade, the housing wealth effect became more important. At the peak of the bubble in 2006, there was close to $8 trillion in housing wealth. The housing wealth effect is usually estimated at 5-7 cents on the dollar. This implies an increase in annual consumption of between $400-$560 billion a year.
Now that these bubbles have largely deflated, how could anyone who knows any economics be surprised by the weakness of consumption? This is 100 percent predictable based on the knowledge that most students should get from an intro econ class. In fact, if anything consumption is surprisingly high. The savings rate is still close to 5 percent, somewhat below the pre-bubble average. With most of the huge baby boom cohort still in their peak saving years, we should expect to see somewhat higher than normal savings, even if we were not recovering from the collapse of the housing bubble.
It would have been helpful if this piece relied more on economists familiar with basic economic relationships.
Correction:
On a second read this headline should have really been “economists continue to be surprised by the economy.” Leonhardt gets it largely right, although the article would have benefited from an explicit reference to the wealth effect. If the bubble wealth was real, then there was no sense in which people were over-spending in the 90s and 00s. Perhaps they should have known better to listen to Alan Greenspan and other leading economists, but the problem was in the assessment of the economy that they were getting from on high, not their personal savings habits based on this assessment being true.
Also, the article is wrong in implying that the United States need fear a rush of foreign investors to the door. The result of such a rush would be a sharp decline in the value of the dollar. This would make imports to the United States far more expensive and make our exports much cheaper for people living in other countries. That would lead to a surge in exports and reduction in imports, which is exactly the rebalancing the U.S. economy desperately needs. In fact, because other countries do not want to see their trade balance with the United States deteriorate, their governments would almost certainly intervene to prevent their currencies from rising too much against the dollar.
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