Paradox of Thrift and Animal Spirits

Behold - the savings rate was 5% in January, the highest in 14 years: Savings Rate Hits 5%

This is both good news and bad news. Good in the sense that folks are getting real about fixing their horrid balance sheets (saving more, cutting down on debt). Bad - possibly very bad - in the sense that this increased savings will exacerbate the recession. See this very excellent and very wonky (warning!) discussion of "The Paradox of Thrift: http://www.econbrowser.com/archives/2009/02/the_paradox_of.html

The biggest issue here would seem to be how best to thread the needle - get folks to save more, but gradually and over time. It's all about the velocity of the change from spending to savings. If folks save too much too fast, you can kill growth dead as the economy cannot adjust quickly enough. This would appear to be happening as we speak. Makes me recall Best Buy's CEO telling analysts in November that he was seeing 'a seismic shift' in consumer spending, the likes of which the firm hadn't seen it its 42-year history. That includes the '73 and '82 recessions folks.

I worry a whole lot about a bunch of negative feedback loops that are fast emerging, and self-reinforcing, and are almost impossible for policy fixes - whether monetary or fiscal - to reverse.

A few such loops:

1. Consumers saving more = lower corporate profits = layoffs = consumers retrench further
2. Banks afraid to lend = less spending = lower profits = layoffs (see above)
3. Asian exports in free-fall = currency devaluations = trade wars = protectionism = contracted global commerce = depression (a la 1930s?)

There are many more, but for a really excellent analysis of such processes, many of which are more psychological than truly economic, look, as always, to Robert Shiller of Yale, and his recent discussions about "Animal Spirits"

Here's Dr Shiller in the WSJ recently - Robert J. Shiller: Animal Spirits Depend on Trust - WSJ.com (emphasis mine)

A critical aspect of animal spirits is trust, an emotional state that dismisses doubts about others. In talking about animal spirits, Keynes sought to convey the message that swings in confidence are not always logical. The business cycle is in good part driven by animal spirits. There are good times when people have substantial trust and associated feelings that contribute to an environment of confidence. They make decisions spontaneously. They believe instinctively that they will be successful, and they suspend their suspicions. As long as large groups of people remain trusting, people's somewhat rash, impulsive decision-making is not discovered....

In due course our animal spirits will once again turn positive, but we would rather that happen this year or the next rather than five or 10 years from now. There is only one way to speed this process: greatly expand governmental support of credit markets and pass a much larger fiscal stimulus plan than is now proposed.

Shiller wrote this in late January. Since then a too-small stimulus bill was passed, and government support of credit markets is still extremely murky and uncertain. Had he been polled in yesterday's Times, might he have stated that this may not end for another 5 or 10 years?

I rather suspect so

Let's lay the basic foundation for the mess we're in

Why is this meltdown so epic? Why is this not merely another recession, from which we will emerge perhaps scarred but generally OK?

Well, because, to put it quite simply, America has been on a 35-year Boomer-led bender, based on overconsumption, too much credit, and too little savings. Each one of those trends was itself disturbing and unsustainable, but throw them all together at once and you have the ingredients for a crisis. The only real question for years now had been "when will these behaviors end". Guess what? They ended last year. We're in a new age in which folks will borrow less, spend less and save more - out of both keen desire and sheer necessity. This process will be long-term and nationwide, and will affect almost every household in the nation, save for those who live in "Upper Richistan" (thanks to Robert Frank)

A few little factoids to chew on:

• We can no longer borrow from our homes to fuel consumption, because those homes have collapsed in value, and because banks no longer wish to lend. In 2006, we were borrowing at an annual pace of almost $1Trillion, or ~10% of household income. Today, mortgage equity withdrawal (MEW) is zero. Nada. Nil. That's $1Trillion off the table, never again to return.
• We are heading toward a return to a national savings rate in the historic range of 8-10%. Consumers, their balance sheets in shreds, simply have no choice. This is a good thing in the long run, but in the near and mid-term means a painful national adjustment needs to be made, as we transition from a nation of spenders to one of savers. And remember, for every 1% gain in savings rates, you're looking at ~$100Billion in reduced spending. A 10% savings rate would take a Trillion dollars off the table
• So, between the MEW cliff-dive and the rise in savings, you're looking at a hole in the consumer economy that could easily approach $2Trillion

This would seem to strongly argue for a rather dramatic re-configuration of this nation's economy, from consumer spending being the greatest driver of growth (70% of GDP) to one in which corporate and government spending both must rise to fill the fast-emerging and (imo) long term decline in consumer spending. This reconfiguration poses massive challenges to the Obama administration, of which they are fully aware, but the policy responses to are anything but clear

Another thing that augers for a national economic re-wiring: The wealthy, however you define them, have represented a disproportionate slice of overall consumer spending. Some studies show that the wealthiest 10% of households account for 50-60% of overall consumer spending. And guess what? The wealthy are getting hammered in this Great Recession. The more skin you've had in the game - whether real estate, equities, bonds, commodities, collectibles, currencies - the more you've lost. There has been nowhere to hide in this meltdown, save for treasuries and FDIC-insured deposit accounts. In 2008 millionaires lost, on average, 30% of their net worth, and one fifth lost 50% (Millionaires Lose 30% of Their Fortunes ) Sure, cue the tiny violins (thanks Hans!), but this engine of consumer spending has seriously stalled, and shows no signs of revving up until the rich have repaired their accounts, and that could take many, many years (look out S&P 600!). In the interim, expect the wealthy to devote more of their income to savings, just like folks lower down on the income ladder

This all leaves us in a rather tricky and messy situation - how to adjust the world's largest economy on the fly from overconsumption to something more balanced? And how to do it in conjunction with the rest of the globe? Frankly, no one knows how to do this - to get Americans to spend less, China to spend more, and everyone to borrow less. We are thus living through the largest macroeconomic experiment in modern history.

And oh, I haven't even mentioned that pesky little ($3Trillion+) banking crisis, or the ongoing risk of deflation, and then the risk of hyperinflation, and then the risk of a collapse of the dollar. And, gulp, the rest of the world would appear to be going down the tubes faster than we are. See Eastern Europe for starters. Then slide over to Asia, and observe the epic collapse of exports from Japan, Taiwan, Sand outh Korea. Even China has seen dramatic contraction of both imports and exports. Back in Europe, the UK is teetering with all of our problems, only worse (London is "Reykjavik on the Thames", Spain and Italy are in crisis, and Sweden faces its own banking crisis (again). Not a pretty picture. Even Russia (energy price collapse, ruble collapse), India (scandals, weakening currency) and Brazil (caught the global flu) are now sinking with the rest of us....

So, in the next few posts I will try to add further dimension to these scary realities, and will begin to describe some of the most scary dragons that lurk.

In the meantime dear readers, buy stuff you can afford with money that you have. And pray that the very excellent Obama team can thread about five needles simultaneously.