Consumers: The great sobriety

It looks as though American households have reached a kind of financial inflection point. The great de-leveraging that they began in the aftermath of 2008–09 financial crisis seems to have run its course and stabilized. Consumers, fortunately, have not returned to their old habit of heavy spending and borrowing. They remain cautious, but seem to have settled on a moderate path, sustaining reasonable savings flows by keeping their spending more or less in line with income growth. Such a pattern going forward should allow still modest improvements in their finances, generating spending growth sufficient to propel the overall economic recovery, sluggish as it will likely remain, and stand as proof against another recessionary dip.
In many respects, the de-leveraging that has been occurring in the household sector since 2008 stands as a truly remarkable economic event, especially given the American consumer’s well-entrenched, spendthrift habits. Prior to the crisis, households hardly saved at all. In late 2007, for example, they set aside a mere 2.1% of their disposable income,1 significantly weakening their overall finances. But as the crisis hit, consumers changed dramatically. Even as the economic decline from mid-2008 to late 2009 reduced incomes 5.6%, households began to repair their finances. They cut back on spending so substantially that savings rates soared, at times to more than 6% of disposable income and averaged more than 5% into 2011—a rate not seen on a sustainable basis for decades. Considering that many people had lost their jobs and, by necessity, were dipping into their savings, the jump in overall savings rates underscored the extent of the unfolding behavioral change.
The shift in behavior yielded dramatic improvements in household finances. Between 2008 and 2011, their debt burden fell by more than 6%, or almost $850 billion.2 Much of this decline, of course, was due to foreclosures, for the debt disappears when the bank seizes the property. But it was not all owing to foreclosures. Consumer credit fell as well during much of this time, including credit card, auto, and home improvement debt. The debt retirement (plus the improvement in financial markets after 2009) produced a remarkable recovery in household net worth, even as the economic recovery proceeded at what can only be described as an anemic rate. From lows in 2008, net worth expanded more than 23% to the end of 2012 (the last available measure). Net worth, now, is almost back to the all-time highs of 2007; it stands at an impressive 5.6 times disposable income—quite an improvement over the low of 4.9 times in 2008, but, admittedly, still well below the all-time high of 6.6 times registered in 2005.
In 2012, however, another change began to take shape. Households apparently have decided to slow their financial rebuilding. Thankfully, they are not returning to their spendthrift ways of 2005, 2006, and 2007. Such a move—though it would create a surge in consumer spending and, consequently, in the economy—would hurt household finances and, consequently, would lose momentum quickly. The resulting need to rebuild balance sheets would then cut into spending and likely prompt another bout of recession. It might seem on the surface that people have returned to their old, unsustainable ways. After all, savings rates early this year fell toward a mere 2.5% of disposable income. But this dip is likely only temporary, a reaction to the savings surge to over a 6% rate that accompanied an equally temporary income surge late in 2012. In this context, this latest drop in savings rates looks like an effort to even the savings rates out to the 3.5% on which households had settled earlier in 2012.3
To sustain their savings rate, households should expand their spending going forward about in tandem with their income growth. Still, their balance sheets should continue to improve. Savings at 3.5% of disposable income would still go toward debt reduction and asset acquisition, just at a slower pace than occurred between 2009 and 2011. The pace of income and spending growth could, of course, pick up if hiring trends accelerate, but even if hiring growth remains at the slow 1.6% annual rate of the past couple of years, income can expand faster than the simple head count would imply. Growth in labor compensation—about 2% a year for the past couple of years, according to the Department of Commerce—would enlarge incomes above and beyond the rate of jobs creation. Business’s tendency to use overtime more than in the past (probably to avoid additional hiring) would do the same. The average workweek, already up almost 3% from its lows, suggests that many hourly workers are already getting time and a half. That figure could rise still further.
Such factors have allowed wage and salary income to rise annually by 4–4.5% during the past couple of years,4 even as employment growth has disappointed. Though hardly a boom, spending growth in tandem with that income expansion could keep the economy on its admittedly modest expansion path. But there is more that might actually permit spending to outpace income growth, at least marginally, and still avoid a deterioration in household finances. Past de-leveraging, as well as declining interest rates, has reduced the burden of debt service. According to the Federal Reserve, the average American household presently dedicates just a bit more than 15% of its aftertax income to debt service, interest, and principal, including mortgages. That burden has fallen from about 20% in 2007. What is more, the burden will likely continue to fall, since the Fed also reports that more than a third of the country’s mortgages have a rate above 5%. With this extra fillip to spendable income, nominal consumption could expand at about 4.5–5% a year, even as households sustain their 3.5% savings rate, modestly improve their finances, and sustain the recovery such as it is.

Milton Ezrati , is a partner, senior economist and market strategist at Lord Abbett & Co. LLC. This commentary originally appeared on the firm’s website.