Adjusting to a higher US savings rate

29 June 2009 - The outlook for the US economy is improving.  An examination of the economic data reveals that green shoots outnumber yellow weeds - - but not by a huge margin.  The shape of the recovery remains uncertain though it would be reasonable to exclude a traditional v-shaped rebound.

Past cycles have conformed to the aforementioned shape.  However, the current downturn has been anything but normal.  We have experienced the combination of a severe housing crash and a banking bust, leaving behind many elements of weakness in the system that will take time to resolve.
Inevitably, after the excesses of the previous boom and some badly-burned fingers in the ensuing recession, one would expect a degree of caution in the behaviour of banks, households and firms.  It may be a while before animal spirits have revived.

The financial state of the banking system is not nearly as robust as the authorities have made out.  There has been a concerted attempt to make them look healthier than they are by changing the rules and hoping that market conditions will recover rapidly enough to allow a genuine improvement in their finances.

In the meantime, banks are likely to be careful about extending credit and adding to their loan losses.  Even when the economy gets more traction, banks will continue to be more stringent about making loans to households and small businesses than they were in the previous boom period.  So households will no longer have access to easy borrowing or be able to tap into home equity to shore up their spending, recalling that these were two important sources of spending power in the past.

Both house prices and the stock market have declined dramatically from their peak, wiping out a big chunk of household net worth.  Rationally, they need to increase their savings rate in order to rebuild their assets, which will of course mean that consumption growth has to be curbed.

There is some evidence, based on surveys done by consumer-related companies, of a more frugal mindset developing among American consumers.  In the past, they have been famous spenders with some of the lowest savings rate among developed economies.  So, switching to the new orientation will be hard as it represents a new experience but, at the same time, they have to take account of the realities.

The latest economic report shows that personal income grew at a substantial 1.4% pace in May.  But this was largely due to government transfer payments via the stimulus programme.  The job market remains weak, which means that salary growth will continue to be under pressure.  Meanwhile, the savings rate rose to 6.9% and is expected to remain high.  This has raised concerns that economic growth will be seriously held back by households’ propensity to save at a higher rate.

It should be noted that repairing household balance sheets is a healthy process and is beneficial for the economy in ensuring stable long-term growth.  And the adjustment to a higher savings rate is unlikely to cause the economy to fall back into recession if it occurs gradually rather than abruptly.

Nor does it follow that the US is condemned to have an exceptionally low growth rate for years to come because of households’ reduced propensity to consume.  It is quite possible for other components of aggregate demand to grow at a more rapid pace, compensating for slower consumption growth.

For now, government spending is the main driver, but it will have to be scaled back in the future as the debt load rises dramatically.  Of the two other main components of demand, namely business investment spending and exports, the latter can have a more significant role in both boosting growth in the US and reducing global imbalances.

Rising US exports would, of course, go hand in hand with higher imports by the rest of the world.  And this requires an open trading system and policies by foreign governments that are conducive to higher consumer and business spending.

For example, China has a significant trade imbalance with America.  Higher Chinese imports along with business spending and consumption growth would help to reduce the gap.  One problem, however, is that even though domestic demand growth in China may rise rapidly and policymakers may place few overt restrictions on imports from the US, Chinese appetite for the mix of products available from the US could be limited.  Many of the technology-related products that the Chinese would like to buy are restricted by the Americans for “security” reasons.

But in a multilateral trading system, this bilateral problem could be alleviated to some extent by the US increasing its exports to other countries from which China can then raise its imports.  In any case, if the slowdown in American consumption growth is not offset by higher spending elsewhere overall growth could be lower in both the United States and at a global level.