Savings, Consumption & The US Economy

Below are two graphs that look at the relationship between personal consumption and personal savings and GDP.  The first looks at the year-over-year change in both real personal consumption expenditures (PCE) and real GDP since 1959. Overlaid on that is the personal savings rate. Note that there is a significant change in the behavior of the savings rate from about the mid-1980’s onwards.

The second graph looks at personal consumption and savings as a percent of GDP (this is somewhat different than the personal savings rate since it is a percentage of disposable personal income, not of GDP). The second graph starts in 1978 to better focus on the period after the savings rate started its secular decline.

Notice how closely correlated the change in PCE (blue line) is with the change in GDP (green line). This should not be a total surprise, since PCE has always been the biggest component of GDP. Also notice that the change in the savings rate is generally negatively correlated with changes in GDP growth, although the relationship is clearly weaker than the positive correlation GDP and PCE have with each other.

The GDP line is generally more volatile than the PCE series. Even though PCE currently makes up more than 70% of GDP, it tends to be the more stable part of the economy. Investment (including residential investment) is the part of GDP that tends to fluctuate wildly and causes booms and busts. However, if over time the blue line spends as much time below the green line as it does above it, the savings rate should generally remain stable and PCE should be a constant share of the economy.

Turning now to the second graph, it is clear that as the savings rate declined (to effectively zero), personal consumption rose as a share of the economy. In recent months we have seen a rebound in the savings rate. If it is sustained, it should over time lead to personal consumption being a smaller share of the economy.

If it were to, over the medium term (say 5 years), return to even the low end of the historic range, say 7.5% (late Reagan- through early Clinton-era levels), we should expect to see PCE decline as a share of the economy, perhaps down to as low as 65% or so. However, what will rise to take its place?  Will businesses step up their investments in new plants and equipment? Why would they if the consumer is buying less?

Will we reverse the current account deficit and export our way out of this situation? That would be a nice solution, but most other economies in the world are also in distress and they are not likely to be dramatically increasing their consumption of the goods we produce. And what is it we produce again in terms of tradable goods?

I suspect for that to happen, the dollar will have to really plunge. Will the Japanese stand by as their industry is destroyed by an exchange rate of 60 yen to the dollar? Will the Germans be happy with a Euro that is worth $2? Recall that these are our creditors and hold lots of dollars, and they would see such a devaluation of the dollar as a partial reneging on the debt. Under standard GDP accounting, if Consumption is going to decline, and Investment is not going to rise and Net Exports are not going to rise, that means that either government spending is going to rise, or GDP is going to fall.

Let’s suppose for a minute that PCE will fall to its mid-1980’s level of 65% of GDP. How much of a decline would that take if the other components of GDP were to remain unchanged? Well, in the third quarter PCE was 70.5% of GDP. If it were to decline by 5%, it would — all other things being equal — reduce GDP by 3.53%, so that would not bring PCE down the 65% level of GDP. Even a 10% reduction in PCE would only result in bringing PCE down to 67.2% of GDP, since it would be accompanied by an over 7% decline in real GDP.

In reality, it would require a 22.3% reduction in PCE to bring it down to 65% of GDP, provided everything else stays the same. In such an environment, it seems likely that Investment would not only not stay the same, but would also fall.

This recession has the potential to be much deeper and longer than is currently accepted by the majority of investors and the public. Without a well-designed stimulus package (and Government spending rising to take up some of the slack caused by falling PCE), this economy could be in extreme danger.

Even with a big package, we are in for a difficult time. I would avoid the entire Consumer Discretionary sector. This most certainly includes homebuilders like D.R. Horton (NYSE:DHI), retailers like The Gap (NYSE:GPS) and makers of toys for big boys like Harley-Davidson (NYSE:HOG).

Just as Augustine prayed, “Lord, make me Chaste, but not yet,” America needs to pray, “Lord, make me Thrifty, but not yet” — or at least make us thrifty gradually.

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