It's been a glorious run for the consumer. In the past 25 years, Americans have kept shopping through good times and bad. In every quarter except one since 1981, consumer spending rose over the previous year, adjusted for inflation. The exception was the first quarter of 1991, and even then the decrease was a mild 0.4% dip.
The main fuel for the spending was easy access to credit. Banks and other financial institutions were willing to lend households ever increasing amounts of money. Any particular individual might default, but in the aggregate, loans to consumers were viewed as low-risk and profitable.
The subprime crisis, however, marks the beginning of the end for the long consumer borrow-and-buy boom. The financial sector, wrestling with hundreds of billions in losses, can no longer treat consumers as a safe bet. Already, standards for real estate lending have been raised, including those for jumbo mortgages for high-end houses. Credit cards are still widely available, but it may only be a matter of time before issuers get tougher.
What comes next could be scary—the largest pullback in consumer spending in decades, perhaps as much as $200 billion to $300 billion, or 2%-3% of personal income. Reduced access to credit will combine with falling real estate values to hit poor and rich alike. "We're in uncharted territory," says David Rosenberg, chief North American economist at Merrill Lynch (MER ), who's forecasting a mild drop in consumer spending in the first half of 2008. "It's pretty rare we go through such a pronounced tightening in credit standards."
And to cut to the chase, what will the results of that be?
Research by economist Carroll suggests that every $1 decline in house prices lops about 9 cents off of spending. The current value of residential housing is about $21 trillion, according to the Federal Reserve. So if home prices fall by 10%, as many people expect, that would lead to roughly a $200 billion hit to spending over the next couple of years. A 15% tumble in home prices would produce a $300 billion pullback in spending, or about 3% of personal income.
That accords well with calculations by BEA economists. They figure that households took out $340 billion in cash from mortgage and home-equity financing in 2006. That source of funding could largely disappear over the next couple of years.
Three percent—that doesn't sound like a lot. Look a little closer, though, and it's a bigger hit than it seems. The reason is that much of what the government counts as consumer spending is not directly controlled by households. For example, the $1.7 trillion in medical costs is counted as consumer spending, but 85% of that is spent by the government and health insurers, not individuals. And $1.5 trillion in "housing services" is listed as part of consumer spending, but for homeowners it really just represents the value of living in a home rather than any spending they can change. It's mainly a bookkeeping convention, not a real outlay.
So that 2%-3% decline in income directly hits the wallet and the discretionary purchases that households actually control.
This article doesn't really expand its scope to what the outlook will be for average Americans and instead focuses on what'll happen to business in America, as if that's more important, but hey, it is Business Week. I don't know that the situation we saw with the mortgage market will be repeated with the credit card market, but the Fed can hardly afford to lower interest rates at this point, practically the only move they can make to alleviate the burden of credit, but which, ironically, only spurs people to borrow and spend even more. I'm not a real business analyst but it may be that the American economy is setting up for a real credit crash in a couple of years. We'll just have to track it and see.
In somewhat related news, the dollar is sinking faster than the Titanic.