Wednesday, March 14, 2012

Last Recession Saw Greatest Decline In Consumption Spending Since WWII: Due To Lower Expectations Of Future Income Growth And Lower Wealth From Declines In Stock Market And Housing Values: The Stock Market Being A Larger Factor Than Home Value Declines: Fed Is Useless In Changing Income Expectations

According to a recent Chicago Fed study quoted below, the severity and duration of the past recession are due to declines in consumer expectations of future income and declines in the value of the stock market and homes, which are also measures of the future economy, with the loss of wealth in the stock market being a more important factor than home value losses.

Income (consumption spending) and corporate earnings growth (stock market value) come from future worker productivity and technological improvements. Other studies show that the decline in US productivity coincides with the past collapse of home prices and the beginning of the past recession. Additonally, the Chicago Fed research found that the wealthier consumers are more pessimistic about future income growth than the poorer, less wealthy consumers.

Policies Needed To Favor Income Growth

The best policies to get the US economy growing robustly would be policies that favor and promote future strong income and earnings growth. The US needs policies that promote private investment and wealth creation, such as lowering taxes on investment gains and wealth creation, incentivizing, promoting and lowering the intitial costs of start-ups, business formations and entrepreneurship, promoting advancement of talented and gifted individuals and recognizing that a strongly growing economy will produce wealth in a successful few that will motivate many others to follow in their footsteps. In other words, policies in exact opposite of those promoted by our President and his staff.

Many economists think that the Federal Reserves' current policy of increasing the money supply is by itself enough to get the US economy rolling again. However, the Fed has been feeding the money supply since the start of the recession and the US economy and employment are still lagging. The Fed is beginning to look like a fireman who keeps throwing useless water on a grease fire. Eventually, the fire will use up all the grease, will burn itself out and the fireman will take the credit for putting it out with water. Eventually, the US economy will grow again and economists and the Fed's chairman will credit the Fed's loose monetary policy, but one has to wonder whether, after so much time, the Fed's loose monetary policy is like the fireman that throws water on a grease fire and then takes credit for his ineffective firefighting methods.

From The Federal Reserve Bank of Chicago, Economic Perspectives, "Consumption and the Great Recession" by Mariacristina De Nardi, Eric French, and David Benson:
The Great Recession of 2008–09 was characterized by the most severe year-over-year decline in consumption the United States had experienced since 1945. The consumption slump was both deep and long lived. It took almost 12 quarters for total real personal consumption expenditures (PCE) to go back to its level at the previous peak (2007:Q4).
Our main findings from the macrodata are the following. First, the Great Recession marked the most severe and persistent decline in aggregate consumption since World War II. All subcomponents of consumption declined during this period. However, the large drop in services consumption stands out most, relative to previous recessions. Second, while the decline was historic, the trends in consumption and its subcomponents leading up the recession were not substantially different from past recessionary periods. Third, the recovery path of consumption following the Great Recession has been uncharacteristically weak. It took nearly three years for total consumption to return to its level just prior to the recession. In contrast the second-worst rebound observed in the data followed the 1974 recession and lasted just over one year. We find that this persistence is reflected most in the subcomponents of nondurables and especially in services.

Our main findings from the analysis of the microdata are as follows. First, expected nominal income growth declined significantly during the Great Recession. This is the worst drop ever observed in these data, and this measure has not yet fully recovered to pre-recession levels. Second, the decline exists for all age groups, education levels, and income quintiles. Relative to previous recessions, those with higher levels of income and education are more pessimistic coming out of this recession than their poorer and less-educated counterparts. Third, expectations for real income growth have also declined, and the decline in expected real income growth is more severe when personal inflation expectations are used instead of actual Consumer Price Index (CPI) inflation. Fourth, expected income growth is a strong predictor of actual future income growth. Since expected income growth is a very important determinant of consumption decisions, the observed drop in expected income has the potential to explain at least part of the observed decline in consumption.

In the context of a simple permanent-income model, we find that the negative wealth effect (coming from decreased stock market valuations and housing prices) and consumers’ decreased income expectations were big factors in determining the observed consumption drop. In fact, we find that in this model, the observed drops in wealth and income expectations can explain the observed drop in consumption in its entirety....
Data from the Federal Reserve Board of Governors' flow of funds accounts show that in 2008, American households experienced a loss of $13.6 trillion in wealth, with most of the loss concentrated in stock market wealth. While stock market wealth has partially recovered since then, housing wealth has continued to decline. The resulting wealth loss, combined with lower expected income growth, has the potential to explain the extent to which consumers cut back consumption during the Great Recession.
we find that the negative wealth effect (coming from decreased stock market valuations and house prices) and decreased consumer income expectations were crucial factors in determining the observed consumption drop. In fact, we find that in this model, the observed drops in wealth and income expectations can explain the observed drop in consumption in its entirety.... [Emphasis Added.]

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