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April 14, 2005

Precarious Balance
by Albert SantaLuca

The economy is a dynamic, complex system whose components are constantly changing. Right now, an unusual situation has developed in which several important parts of the economy are coming together into temporary equilibrium. These parts are consumer spending (technically, Personal Consumption Expenditures), consumer income (technically, Disposable Personal Income), job creation, and laborforce growth. However, this delicate balancing act cannot last long as income, spending, employment, and the workforce slowly move away from their balance points. Most importantly, the directions in which they move after this brief convergence will determine whether the economy moves toward stagnation or recession or toward another period of expansion.

Where We Are

Most analysts believe that the economic expansion which began in 2002 will continue throughout 2005. While the recovery held on during 2004, the future may not be as clear-cut as most observers believe. They fail to take into account that this cyclical expansion has already lasted three years and that it peaked in the middle of 2003, almost two years ago. So even though the economy is still in a modest upturn, it could easily find itself on the downhill side of this cycle depending on how spending, income and job growth change. Because the current recovery has been weaker than normal in certain areas, particularly spending and job growth, and because it has lasted several years already, our focus should now be shifting to those developing weaknesses which might affect the sustainability of this expansion.

As our focus shifts, the unfolding equilibria become very significant. They represent the precarious balance between the forces of economic expansion and contraction. Any weakness in spending or income or job creation would bring the economy to a 'tipping point' - a point where the movement away from an equilibrium leads, over a short period of time, to relatively large changes in a system. In this case, the current weak economic expansion could easily turn into economic stagnation and then economic contraction. In the rest of this discussion, we will show how spending and income, job growth and laborforce growth have gradually moved into temporary balance and created these two possible tipping points.

Spending and Income

Personal spending and personal income have been slowly converging for years, until they are now almost equal. As a consequence, the level of personal savings (the difference between income and spending) has fallen to about 1% of income. The graph below shows how dramatically the personal savings rate has dropped since the early 1990's. It has fallen so drastically because, over the last 12 years, the year-over-year increase in spending has grown more than 0.5% faster than income has. (We use this period because it starts with the economic recovery of the early 1990's.) Also note that the Microsoft special dividend paid in December 2004 has exaggerated the 2004 savings rate because the Bureau of Economic Analysis annualizes all its data. Adjusted for the one-time nature of this dividend, the savings rate for December was about 0.4%, about 0.5% for the fourth quarter, and about 0.8% for all of 2004.

Personal Savings as % of Disposable Income 1992 - 2004

Years, Quarterly Data Points
Source: Bureau of Economic Analysis

In these circumstances, spending must inevitably come to equal income, and it appears we are close to that point. For all of 2004, disposable personal income, which was approximately $8.7 trillion, exceeded expenditures by less than $100 billion. If spending continues to outstrip income at the same rate that it has done in the last five years, this excess will be wiped out sometime next year. The time period used to calculate this rate does not really change the results. Even if spending and income continue to grow at their 2004 rates, then this differential still would be wiped sometime next year.

As income and spending come into balance, we do not know how consumers will react to the virtual absence of personal savings. But they have only several choices: they can spend less so the growth in spending equals rather than exceeds growth in income, or they can borrow more in an attempt to maintain spending at a higher rate than income.

A hint of consumers' likely response comes from comparing the trend in personal consumption expenditure growth over the last five years (when the savings rate dropped into the 1% - 2% range) with the previous seven years of economic expansion. As the personal savings rate fell, consumption expenditures began to grow much more slowly than they had in previous years. For example, in the first seven years of this period (1993 through 1999 when income was much greater than expenditures), spending grew about 1.0% faster than income, measured year-over-year. But as the gap between income and spending narrowed in the last five years, spending grew just 0.3% faster than income; evidently, consumers slowed their spending growth as their savings dwindled. As we approach the tipping point where spending equals income, we would expect spending to decelerate further, eventually putting pressure on GDP growth.

Can Consumers Add More Debt?

Year-over-Year Growth in Home Mortgage Debt and Consumer Credit

2000 - 2004, Quarterly Data
Source: Federal Reserve Board, Flow of Funds Statement Percent Change

We just showed that the growth rate of consumer spending has fallen as the savings rate fell below 2%. However, consumers could still adopt the second strategy, mentioned above, and increase debt at a faster rate than they have in the recent past. This would keep the consumer mill churning, which is extremely important to continued expansion in Gross Domestic Product since this one category accounts for about 70% of GDP.

However, this seems an unlikely outcome because consumers have actually slowed the rate at which they accumulated debt as the savings rate has fallen. As the graph above shows, the growth rate for consumer credit started to decline early in 2000, just as the job market faded and well before 9/11. Even as the growth in Consumer Credit started to decelerate, total credit continued to expand because consumers added mortgage debt at a faster rate than before. But mortgage debt growth finally peaked in the third quarter of 2003, coincident with peak GDP growth for this cycle. With the savings rate so low, consumers have little capacity for additional debt service and thus little capacity for additional debt. We can see the change in consumer behavior reflected in the decelerating growth rate of mortgage debt over the last year. Should consumers be less willing to add debt, then spending is unlikely to accelerate, and the economy would then be moving beyond the tipping point and into stagnation.

Job Growth and Population Growth

Many analysts would suggest that the drag on spending growth created by the savings shortfall would be resolved favorably when accelerating employment led to accelerating income growth. But when a modest turnaround in employment finally came in 2004, it did not produce the expected result. Yes, disposable personal income actually did accelerate, but personal spending grew even faster. As a result the savings rate still fell from 1.3% in 2003 to about 0.8% of disposable income for 2004 (adjusted for the onetime Microsoft special dividend paid in December 2004).

Job growth has so far failed to provide the catalyst for new consumer spending; in fact, it has been the Achilles heel of this recovery and it remains so even today. The year 2004 was actually the first year since 2000 that the economy created more jobs than it lost. However, net job growth in 2004 approximately equaled net laborforce growth, and this in the third year of a recovery. At a similar point after the 1991 recession, net job growth was significantly faster than laborforce growth. But so far, job growth in this recovery, with its subdued effects on personal income growth, is simply inadequate to ignite another consumption boom.

Two other issues underscore the seriousness of this recovery's lackluster job growth. First, as previously noted, the economy had large, net job losses in 2001 through 2003. And second, most analysts fail to integrate employment data within the broader context of laborforce growth.

On the first point, actual job losses in 2001-2003 greatly exceeded the initial estimates published in the monthly Nonfarm Payroll report. This information is available from the much more complete Business Employment Dynamics report (covering 6.5 million employers and issued by the Bureau of Labor Statistics eight months after the end of each quarter). This report showed that 3.7 million jobs were lost from 2001 to 2003, or 1.3 million more job losses than the monthly Payroll report had estimated at first. The most severe discrepancy was for 2001 when one million more jobs were lost than had initially been estimated. Even now, the Payroll report continues to overestimate new job creation. For the first quarter of 2004, the latest data available at the time of this writing, the Business Employment Dynamics report found 435,00 net new jobs created while the Nonfarm Payroll report had initially estimated 595,000 - an overcount of 165,000 for this three month period.

On the second point, most analysts seem to ignore laborforce growth when discussing job growth, though doing so distorts our picture of how well the economy is actually performing. The number of new entrants to the laborforce is significant: the Census Bureau has estimated that about three million people joined the workforce during 2001- 2003. To understand how this affects the labor market and the economy, we need to combine net job losses with the estimated growth in the laborforce for this time period. Doing this, we see that a return to the employment status quo of 2000 would require the economy to generate about 6.7 million net new jobs: about 3.7 million to replace those jobs that were lost, plus about another three million jobs to accommodate people who entered the workforce in these years. It is only by looking at job growth in this way that can we comprehend how much ground this recovery still has to make up.

Some would argue that the deficit in job creation in 2001-2003 has had little effect on consumer spending, but that would not be correct. In fact, Consumer Spending's contribution to GDP has declined during this period: it was just over 2% in 2001-2003, and down significantly from about 3% for the previous five years of 1996-2000. The deficit in job growth has definitely influenced consumers' ability to maintain spending growth at a level comparable to the late 1990's. Since 2000, the growth in consumer spending has been supported by the depletion in personal savings and the extraction of home equity through increased mortgage refinancing. Now, with personal savings almost depleted and the growth in mortgage debt decelerating, consumers cannot shield themselves for much longer from the effects of weak job creation. The longer that new jobs and new workers continue to grow at the same rate and thus stay in equilibrium, the more difficult it will be for consumers to maintain the current rate of consumption growth, let alone stage another consumption boom. Should job growth slow and fall below the rate of laborforce expansion, then this tipping point, just like the first, would push the economy into stagnation.

Conclusions

At the present time, we find two equilibrium points developing in the economy: one is the balance between consumer spending and consumer income, the second is the balance between new entrants to the laborforce and new job creation. Each of these represents a 'tipping point' for the economy: that is, a brief period of equilibrium from which the economy would swing into either a period of stagnation or expansion. The direction will depend on evolving trends in each of these areas: spending, income, job growth, and population growth. The current trends in these areas are not positive: they indicate that the economy could stumble along for a year or slightly longer before a period of stagnation or contraction develops.

The first tipping point, between spending and income, looks negative because consumer spending continues to grow at a faster rate than consumer income. This mismatch in growth rates has almost completely depleted personal savings. In fact, had it not been for Microsoft's special dividend, December personal savings would have been less than $10 billion. The decline in the personal savings rate has coincided with very poor job creation over the last four years, which leads to the second tipping point. This is the balance between net new jobs created and the constant flow of people entering the laborforce as the population grows. New job creation has been extremely weak over the last four years, nowhere near sufficient to provide jobs for all the new entrants to the laborforce. Nor has job growth been sufficient to eat into the overhand of jobs lost during 2001-2003.

What happens when the economy moves beyond these tipping points? If new job creation, income growth, and spending growth accelerate rapidly, then the economy could easily extend its recovery. But if net job creation, income growth, and spending growth continue their current trends or should they deteriorate from here, then the economy would be set up for a rather abrupt transition to stagnation or recession. With little evidence that job growth, income growth, and spending growth are accelerating out of their current trends, the current evidence favors stagnation or recession. This could happen within the next four to six quarters.

Albert P. SantaLuca, Ph.D.
Econ Today

© Copyright 2004-2005 by Albert P. SantaLuca, Ph.D. All Rights Reserved.

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