Don't Blame Consumer Deleveraging

When we ask why the recovery has been so tepid, many prognosticators have proposed reasons why. One of the more widely cited reasons has been that consumers are deleveraging -- namely, diverting funds from consumption to either pay down debt or build savings.

This seems fairly intuitive until one actually considers behavior at the level of individual households, aggregated up to the broader economy. And here is where the Boston Fed did some research that concludes that deleveraging is not, in fact, a cause of slower economic growth. 

The Boston Fed studied data for individual households and found a relatively small and limited balance-sheet adjustment, in a way that hasn't affected overall economic growth. Sure, many households reduced their risky assets and reallocated to safer instruments after the market downturn. But these changes have tended to be relatively small and in some cases transitory. The researchers conclude that there is no evidence that household balance-sheet repair ¿ paying down debt and building savings ¿ played a role in slowing economic growth thus far. The reflexive of that is that this factor wouldn't, then, restrain economic growth going forward.

Essentially, households haven't necessarily added to savings or actively paid down debt. I use the word "actively" because there has been debt reduction, but it has come about through default, not diligence, as foreclosures erased household debt. Debt reduction, the researchers found, has not reduced economic growth. The savings rate has risen, of course, but not to a large degree relative to history. Many households have simply lacked the wherewithal to save more or to reduce debt.

At the same time, consumers have taken on less non-housing debt. Not adding to debt isn't the same as paying it down, but it can still affect economic growth nonetheless. After all, I can finance a dollar's worth of spending by either borrowing it or earning it; less borrowing can mean less spending. However, another twist to this is that the less I expect to earn, the less I will spend ¿ and also the less I will borrow.

This is where other research comes into play, as income growth and income expectations play a larger role in slow economic growth. In a recent paper, the Federal Reserve asked the question, "Why Have Americans' Income Expectations Declined So Sharply?" In answering that question, the researchers note that income expectations, as measured by the University of Michigan Surveys of Consumers (otherwise known as the consumer sentiment survey), have fallen across income levels, age groups and educational status during and after the recession. They note that the "pessimism of households about their future income is deep and broad based."

Because income expectations have fallen even for those over age 60 (some of whom might be presumably retired), the researchers posit that income expectations have been driven by their recent experiences. In other words, the recession has left some lasting scars on consumers' collective psyche. That is borne out by the fact that those who are better off financially have witnessed less of a decline in income expectations than those who are worse off financially. And more of those who are worse off see their condition as more lasting than temporary. That further reduces their income expectations ¿ and thus their propensity to consume.

Of course, consumers' recent experience with actual inflation-adjusted income growth is hardly a case for surging optimism: Real average hourly earnings increased by just 0.7% from August 2012 to August 2013, according to data from the Bureau of Labor Statistics. That reflects just those who are working.

When you consider that a smaller proportion of the population is employed, reflecting more people who are unemployed, retired or otherwise not in the labor force, real median household incomes are now back to 1996 levels, when adjusted for inflation, according to data from the Census Bureau. Since the beginning of the recession, median household incomes fell 6.1% to $52,100 in June 2013 from $55,438 in 2007. This reflects a 1.8% drop during the recession and a 4.4% fall since the recovery began.

Any way you slice it, the data don't point to consumers who have an inclination to borrow or spend, since actual earnings growth has been minimal. Importantly, consumers don't expect that trend to improve by much. A lack of income growth and subdued expectations for future improvement -- not deleveraging -- point to a headwind the economy faces that won't change easily, no matter how many or how few bonds the Fed buys.