Let’s Look at the Issues: Consumer spending

What does Nobel laureate economist Paul Krugman have to say about the recent decline in consumer spending? Let’s take a look at his perspective and prescription, from the New York Times:

The long-feared capitulation of American consumers has arrived. According to Thursday’s G.D.P. report, real consumer spending fell at an annual rate of 3.1 percent in the third quarter; real spending on durable goods (stuff like cars and TVs) fell at an annual rate of 14 percent.

Paul Krugman

To appreciate the significance of these numbers, you need to know that American consumers almost never cut spending. Consumer demand kept rising right through the 2001 recession; the last time it fell even for a single quarter was in 1991, and there hasn’t been a decline this steep since 1980, when the economy was suffering from a severe recession combined with double-digit inflation.

Also, these numbers are from the third quarter — the months of July, August, and September. So these data are basically telling us what happened before confidence collapsed after the fall of Lehman Brothers in mid-September, not to mention before the Dow plunged below 10,000. Nor do the data show the full effects of the sharp cutback in the availability of consumer credit, which is still under way.

So this looks like the beginning of a very big change in consumer behavior. And it couldn’t have come at a worse time.

It’s true that American consumers have long been living beyond their means. In the mid-1980s Americans saved about 10 percent of their income. Lately, however, the savings rate has generally been below 2 percent — sometimes it has even been negative — and consumer debt has risen to 98 percent of G.D.P., twice its level a quarter-century ago.

Some economists told us not to worry because Americans were offsetting their growing debt with the ever-rising values of their homes and stock portfolios. Somehow, though, we’re not hearing that argument much lately.

Sooner or later, then, consumers were going to have to pull in their belts. But the timing of the new sobriety is deeply unfortunate. One is tempted to echo St. Augustine’s plea: “Grant me chastity and continence, but not yet.” For consumers are cutting back just as the U.S. economy has fallen into a liquidity trap — a situation in which the Federal Reserve has lost its grip on the economy.

Some background: one of the high points of the semester, if you’re a teacher of introductory macroeconomics, comes when you explain how individual virtue can be public vice, how attempts by consumers to do the right thing by saving more can leave everyone worse off. The point is that if consumers cut their spending, and nothing else takes the place of that spending, the economy will slide into a recession, reducing everyone’s income.

In fact, consumers’ income may actually fall more than their spending, so that their attempt to save more backfires — a possibility known as the paradox of thrift.

At this point, however, the instructor hastens to explain that virtue isn’t really vice: in practice, if consumers were to cut back, the Fed would respond by slashing interest rates, which would help the economy avoid recession and lead to a rise in investment. So virtue is virtue after all, unless for some reason the Fed can’t offset the fall in consumer spending.

I’ll bet you can guess what’s coming next.

For the fact is that we are in a liquidity trap right now: Fed policy has lost most of its traction. It’s true that Ben Bernanke hasn’t yet reduced interest rates all the way to zero, as the Japanese did in the 1990s. But it’s hard to believe that cutting the federal funds rate from 1 percent to nothing would have much positive effect on the economy. In particular, the financial crisis has made Fed policy largely irrelevant for much of the private sector: The Fed has been steadily cutting away, yet mortgage rates and the interest rates many businesses pay are higher than they were early this year.

The capitulation of the American consumer, then, is coming at a particularly bad time. But it’s no use whining. What we need is a policy response.

The ongoing efforts to bail out the financial system, even if they work, won’t do more than slightly mitigate the problem. Maybe some consumers will be able to keep their credit cards, but as we’ve seen, Americans were overextended even before banks started cutting them off.

No, what the economy needs now is something to take the place of retrenching consumers. That means a major fiscal stimulus. And this time the stimulus should take the form of actual government spending rather than rebate checks that consumers probably wouldn’t spend.

Let’s hope, then, that Congress gets to work on a package to rescue the economy as soon as the election is behind us. And let’s also hope that the lame-duck Bush administration doesn’t get in the way.

17 thoughts on “Let’s Look at the Issues: Consumer spending

  1. Ross Levin Post author

    Just so it’s clear – I don’t necessarily agree with this. Don’t know enough about economics to feel one way or another about it. I just respect Krugman and it’s always good to post something that most people reading it will disagree with. It’s bound to get at least a few of them thinking.

  2. Trent Hill

    Oh? Milton Friedman won one too, and him and Krugman have opposite views. The Nobel Prize in Economics is awarded by the Swiss Central Bank.

  3. Catholic Trotskyist

    I agree with Krugman, but winning a Nobel prize isn’t a garuntee of greatness. The horribly untalented Toni Morrison won a literature prize, and Henry Kissinger and Theodore Roosevelt won peace prizes.

  4. G.E.

    Krugman is a moron and not even really an economist. He’s a shill for the state and central banking — just like every other “Nobel” winner except Hayek, who shared his “prize” with a Swedish Communist. The “Nobel” isn’t even “Nobel.” Krugman is even worse than Bush and could very well be the most evil and stupid person alive today.

  5. AnthonyD

    Boy, you can almost hear the giddiness in Krugman’s voice as he gets all hot and bothered at the thought of government getting to spend more phony-baloney money.

    Horribly biased article that is written to justify government action in response to a s0-called crisis. He writes, “Maybe some consumers will be able to keep their credit cards.” Some? What planet is this guy living on? I work in the collections industy dealing with bad credit card debt. I speak with people in the credit card industry. I can assure you the only people who won’t be getting credit cards are the ones who shouldn’t have had them in the first place. I have a friend who handles student loans for a bank here in Cleveland. Guess what? The spigots for student loans are still open.

    Krugman is a moron.

  6. Ross Levin Post author

    It’s an oped. Of course it’s “biased.’

    So maybe, AnthonyD, your view of the world isn’t universal. And maybe Krugman’s isn’t either.

  7. Deran

    “Krugman is even worse than Bush and could very well be the most evil and stupid person alive today”

    LOL! Dude, your list of “the most evil” is long and gets longer by the day! You and Stalin.

    My beef with Krugman is that he is a neoliberal at heart; loves loves loves free trade. In a recent lengthy essay og why deficiet spending is useful during economic depressions, he completely fails to mention reductions in the Pentagon and DHS’s budgets are at the very least a starting point toward reducing deficits. Him, and all the Neo-Clintonites may well cop some Keynes, Galbraith, etc, but all in order to keep globalist capitalism afloat. People like Krugman avoid that last step over that line into a critique of capitalism. they just to help it along.

  8. Steve LaBianca

    Just like every “economist”, bureaucrat and talking head who shills for the government, Krugman goes through his analysis with blinders on.

    He fails to point out that all this economic activity, non-activity, savings, spending, etc. is the gross distortion of markets by instituting political goals through the central banking mechanisms. But then, Krugman himself is a strong proponent of his own political goals through central baning and control of the economy. Is such failure on Krugman’s part intentional?

    Of course it is, as doing so would strip away the cover story of their manipulation of markets as though the “experts” (like Krugman) are manipulating puppets (us!). We’re supposed to behave in certain ways, and when things go awry, “experts” like Krugman say that the wrong puppet strings were pulled.

    This folks, is why G.E. says, “Krugman is a moron and not even really an economist. He’s a shill for the state and central banking”.

  9. Ross Levin Post author

    I don’t think this is some sort of conspiracy. Maybe, through some horrific chain of events, many people have come to believe that central banking is a legitimate thing.

    Now, I don’t know anything about economics really, but I do know that it’s not a sin to challenge your beliefs or at least respect someone who believes something different from you.

  10. Bill Woolsey

    Thank you for posting this article.

    I was surprised that Krugman applies the concepts of vulgar Keynesian economics so thoughtlessly in support of his goal–even more rapid increases in government spending.

    Krugman seems to misrember the meaning of “liquidity trap.” That is a situation in which the creation of money fails to reduce interest rates because at some low level of interest, liquidity preference becomes absolute. Households and firms will hold unlmited quantities of money without spending it, and interest rates remain stubbornly high.

    There is no evidence that this is true of the U.S. today. Interest rates have decreased–for low risk borrowers. Oddly enough, The Federal Reserve began paying interest on reserve balances to keep interest rates from falling! (The lower limit on nominal interest rates is negative, and equal to the cost of storing currency. However, while targetting interest rates may make sense during a period of macroeconmic stability, it is potentially disastrous with a deep recession or out of control inflation.)

    I have little use for the concept of the “paradox of thrift,” considering it a diversion from what can be problems with an imbalance between the supply and demand for money that the market system automatically corrects, poorly, through changes in the price level. However, I had assumed that Krugman had at least checked to see that the decrease in consumption spending in the third quarter really reflected an increase in saving.

    The reality, however, is that during the third quarter, saving dropped at a massive 200% annual rate! (It fell in half in three months.)

    The reason consumption fell wasn’t an increase saving. It was rather due to a decrease in disposable income. Every element of personal income rose–except dividends and income to farmers. But tax payments rose at a 25% annual rate. Government transfers to individuals (like social security and “welfare” also dropped significantly.)

    A spike in inflation (especially inflation at a 7% annual rate in July) along with a rapid increase in taxes (and cut in transfers) turned a very mild increase in the dollar value of consumer spending into a drop in the real volume of consumer goods and services purchased. The drop was less than 1%, but if it continues for a year, it would be the 3.1% after a year, as reported.

    Government spending continued to grow at a rapid pace. (At a 14% annual rate.) Krugman would like even more government spending. However, blaming households burdened by rapidly growing taxes because they failed to expand consumer spending enough to keep up with inflation–well, I suppose even Nobel-prize winners can be careless.

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