Shopped Out?

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I participated in a discussion in today’s WSJ’s (the free Econoblog) on consumer spending, titled Shopped Out?  My cohort in this was Dartmouth College Professor Andrew A. Samwick, author of Vox Baby. Andrew served as the chief economist
on the staff of the President’s Council of Economic Advisers in 2003 and 2004.

Its an explanation of why the consumer is almost — but not quite — tapped out, and the repurcussions of that.

Here’s the intro:

For at least the past decade, anyone who has bet against the resiliency and unending spending capacity of the U.S. consumer has decidedly lost the wager. Even through the recession of 2000-01, they hardly slowed their profligate ways. Sept. 11 managed to create a pause in spending — at least for a short time — but it was more than made up for in the ensuing quarters. Indeed, the careers of economists who have declared the U.S. consumer to be tapped out litter the countryside like corpses after a war.

There are early signs, however, that taking the other side of this bet is no longer a sure thing. We see a variety of factors suggesting that the consumer, while not yet exhausted, is slowly but surely moving in that direction. While it’s premature to declare the American consumer “shopped out,” I suspect it’s now quite late in the cycle. Barring a significant improvement in economic fortunes, including robust job creation and increased personal income levels, that exhaustion now looks inevitable.

It was a lot of fun doing this with someone the stature of Professor Samwick. I definitely learned a few things . . .

UPDATE 2: January 26, 2022
The originals seems to have disappeared from the internet; my 2005 text grab is after the jump.
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UPDATE September 6, 2005 6:30 am
To answer a recurrent comment and email about this:  It was written Sunday and Monday, before Katrina made landflall, the levees broke and the magnitude of the disaster was known or understood. The impact of the storm (see this) only exascerbates a deteriorating situation.

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Source:
Shopped Out?
Barry Ritholtz, Andrew A. Samwick
WSJ’s ECONOBLOG  August 31, 2005
http://online.wsj.com/public/resources/documents/econoblog08312005.htm

The free-spending U.S. consumer has been fueling economic growth for years. But with prices at the pump creeping ever higher and signs of a slowing housing market starting to emerge, will the credit cards finally be put away?

Retailers like Wal-Mart have been complaining for months that costly gasoline has been keeping more price-conscious shoppers away from their stores, and with gasoline and other commodity prices marching higher in the wake of Hurricane Katrina, the squeeze is likely to get tighter. Meanwhile, workers’ hourly earnings fell behind the pace of inflation in July, and personal saving levels have dwindled to 0%, leaving highly indebted consumers little financial cushion other than their homes — which many have already leveraged heavily.

So is the long national shopping spree finally winding down? WSJ.com asked bloggers Barry Ritholtz and Andrew Samwick to take the measure of the U.S. consumer.

What do you think? Is the consumer tapped out, and if so, what are the implications for the economy? Share your thoughts on your discussion board.

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Barry Ritholtz writes: For at least the past decade, anyone who has bet against the resiliency and unending spending capacity of the U.S. consumer has decidedly lost the wager. Even through the recession of 2000-01, they hardly slowed their profligate ways. Sept. 11 managed to create a pause in spending — at least for a short time — but it was more than made up for in the ensuing quarters. Indeed, the careers of economists who have declared the U.S. consumer to be tapped out litter the countryside like corpses after a war.

ABOUT THE PARTICIPANTS Barry Ritholtz is chief market strategist for Maxim Group, a New York investment bank. At Maxim, he maintains a market-timing model to determine risk using a combination of trend, market internals, sentiment measures and monetary issues within a broader macroeconomic framework. He received his bachelor’s in political science from Stony Brook University, and his graduate degree at Yeshiva University’s Benjamin N. Cardozo School of Law, focusing on economics and corporate law. He presents his macro perspectives on capital markets, the economy and geopolitics, along with some discussions of music and film at The Big Picture. Andrew A. Samwick is a professor of economics and the director of the Nelson A. Rockefeller Center at Dartmouth College. He is the author of Vox Baby, a blog about economics, politics, and current events. In 2003 and 2004, he served as the chief economist on the staff of the President’s Council of Economic Advisers. He has written extensively on a range of topics, including Social Security reform, taxation, pensions, saving, and executive compensation. Samwick received his doctorate in economics from the Massachusetts Institute of Technology and his A.B., summa cum laude, from Harvard University, also in economics.

There are early signs, however, that taking the other side of this bet is no longer a sure thing. We see a variety of factors suggesting that the consumer, while not yet exhausted, is slowly but surely moving in that direction. While it’s premature to declare the American consumer “shopped out,” I suspect it’s now quite late in the cycle. Barring a significant improvement in economic fortunes, including robust job creation and increased personal income levels, that exhaustion now looks inevitable.

The short list as to why a spending slowdown appears inevitable starts with energy. I’ll get to other issues beyond petroleum later, but we begin our discussion of consumer spending here:

While the same economists keep informing us how much smaller oil is as a percentage of gross domestic product than the 1970s, high energy prices still hurt consumers. I posed the question last week: Has oil reached the tipping point? (Even before Hurricane Katrina, it looked like a mild yes).

To answer that fully, we need to examine just how bad the gas pains are. Wal-Mart was the first indication, with its very price-sensitive clientele. But it’s impacting more than just low-income shoppers. We see an unusual increase in drivers using credit cards to manage gas costs. That’s hardly an encouraging indication.

Additional signs of slowing personal spending are manifest in weak back-to-school sales. The National Retail Federation noted a “dip,” blaming energy prices. This is consistent with an Opinion Research Corporation survey cited by ICSC.org. It showed that 58% of households are reducing their discretionary spending on clothing, shoes, jewelry and consumer electronics, as well as restaurants, spa and beauty services, and other nonessential purchases.

Even more dangerous is the shift in sentiment. You-know-what also gets the blame for the drop in consumer confidence. The danger, according to Oxford Analytica, is that “persistently low confidence undermines consumer spending.” And we are seeing signs that its not just the Wal-Mart shopper who feels pinched; even high-end consumer-electronic sales are showing signs of slipping next year.

Incidentally, unlike some of my Wall Street brethren, I’ve been bullishly discussing energy since December 2003 — so these aren’t the Chicken Little concerns of an oil johnny-come-lately (if I can mix my references like that).

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Andrew Samwick writes: There is no question that the currently high price of oil is squeezing U.S. consumers, and Barry’s points about the pinch it is taking out of retail trade are right on the money. I don’t see the phenomenon as short-lived, and I would expect there to be an adjustment to the makeup of the typical household’s purchases in the long term.

Whether that adjustment will actually translate into greater savings is a different matter. Barry is being too generous — the saving rate of U.S. households has been in a steady decline for a full two decades. Measured as share of disposable personal income, the personal saving rate from 2000 to 2004 averaged 1.8%, down from 3.3% between 1995 and 1999 and from 9.1% between 1980 and 1984. (Do your own comparisons here.) It may be oil that is the culprit today, but an excessive (and growing) reliance on consumption to fuel economic growth pre-dates the oil price increase by many years. And this is not just the growth of the U.S. economy — some of our major trading partners have been kept afloat through their exports to the U.S. in recent years.

Is the U.S. consumer tapped out? I’m still a skeptic. Everything about the economy surrounding U.S. consumers is focused on supporting their consumption. Financial innovations in credit markets, delivering financing terms with low down-payment requirements and low interest rates, have helped consumers stretch their incomes farther and farther. Misguided energy standards have encouraged cars to become light trucks and light trucks to become not-so-light trucks. Tax cuts delivered in a timely fashion have helped consumers manage through the recession and the slowly recovering job market. The concept of thrift is virtually gone from our national dialogue.

Perhaps more important than whether U.S. consumers are exhausted is whether they will respond to market signals when prices eventually turn to discourage consumption. The price of oil is one key price, but responses take time to evolve. (Though I enjoyed this list at Barry’s blog.) The dollar has been weakening for more than three years, with less effect than we might have expected. But the economists who have taken Barry’s bet previously and gotten it wrong may have predicated their views on the belief that interest rates would have to rise to curb spending. Until I see that, I’ll stick to Texas Hold’em.

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Barry writes: Allow me to clarify one issue: I have not found that the U.S. consumer has already run out steam. Rather, my specific question is, “Will they?” And if so, “Will they do so anytime soon?” I am in the camp that believes that it could actually happen sooner than many people expect — my guesstimate is for somewhere in the 2006-07 timeframe.

It’s a given that high energy prices hurt. But to reach the issue of whether the consumer is fading, we need to discuss several related issues: The first is real estate, and the second is consumer sentiment. I have been a longstanding advocate that this post-bubble recovery is an anemic, stimulus-driven one. Back out energy and real estate, and “there’s no there there.”

As of August 2005, recognition that real estate has been driving the economy is well developed. But six months ago, many economists were in stout disbelief. (I’ve been pounding the table on this issue since last year.) Credit for quantifying this goes to Asha Banglore of Northern Trust. Ms. Banglore was the first person to observe that more than 40% of post-recession private sector jobs were real-estate related. Since then, we’ve seen others recognizing this, most notably Merrill Lynch economist David Rosenberg, as well as Economy.com. Mr. Rosenberg noted that real estate accounts for nearly 50% of GDP gains — up from the typical 5%.

Why is this significant to consumer spending? As real estate begins to cool, it will have a very significant impact on employment, personal income and consumer spending. Housing-related employment will slow and then reverse. This includes real-estate agents, mortgage brokers, durable-goods manufacturers, homebuilders and even major retailers.

Note the impact of all of that above is before we even begin to discuss what happens if mortgage rates begin to rise in earnest. Since the Fed cut rates to half-century lows, consumers have been treating their homes as if they were ATMs. Monetizing home equity into consumer spending will come to a grinding halt if and when rates finally return to non-emergency levels. Once the entire refinance/refurbish/resell phenomena ends, you can kiss a huge amount of consumer spending, employment and GDP goodbye. And that’s not even talking about increased oil prices. Put them together, and you are looking at pretty powerful one-two punch. Its no coincidence that oil shocks typically precede recessions. High oil prices get the Fed nervous about inflation, and you know what happens when the Fed is skittish.

If energy prices don’t get ya, the Fed tightening will.

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Andrew writes: I thought you were a betting man — even the most guarded man in America proclaimed to the assembled masses in Jackson Hole on Saturday that “nearer term, the housing boom will inevitably simmer down.” There’s not much room for me to quibble with a guesstimate that U.S. consumers will run out of steam in the 2006-07 timeframe.

A day earlier, Chairman Greenspan also suggested that greater stability in the global economy has contributed to the historically high wealth-to-income ratios we are seeing in asset markets due to lower required compensation for risk. If consumers believe that their lower susceptibility to risk is permanent, then it makes sense for them to consume some portion of that increase in their wealth. This belief would also support a lower saving rate going forward, as the perceived need for precautionary balances is diminished. Maybe not to the extent we have seen, but at least the theory gets the direction of these movements right.

I’m not saying that I buy the premise that risk has actually declined, but more importantly, investors in almost all asset markets tend to confuse realized and expected returns during a phase like this. It happened in equity markets in the run-up to the collapse of 2000, and it is still going on in urban housing markets. If there were a structural adjustment that made an asset less risky, then investors would bid up the price of the assets immediately to a level justified by the lower required rates of return. But then a new crop of investors arrives on the scene, mistakes the recently high rates of return for high long-term expected rates of return, and bids up the prices even further. How much of this run-up in housing markets is a genuine reaction to fundamentals, how much is overreaction and whether households overspent even the rational increase in their permanent income are the questions that will find answers over your timeframe of 2006-07.

Is there a scenario in which the “inevitable simmering down” is orderly rather than catastrophic? Perhaps. In order to believe this, we would need to think of the resources now utilized in the housing sector as readily deployed into other sectors. For the past two years, I have been looking for a smooth handoff from consumption to investment spending to support GDP growth. In 2001 and 2002, nonresidential gross private domestic investment made negative contributions to GDP growth, while personal consumption growth explained more than 100% of GDP growth. In 2003, nonresidential investment made a positive contribution, but in the single digits. By 2004, and now into early 2005, the contribution is around 20% to 25%, which is close to the average contribution over the last 25 years. Some further growth in investment spending, coupled with some improvement in the international sector if oil prices at worst hold steady, could support respectable (if slower) GDP growth even if consumption cools a bit. Absent those developments, that one-two punch you describe will pack quite a wallop.

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Barry writes: Not a betting man? Anyone who attempts to forecast the behavior of random non-linear chaotic system, such as the stock market or the macro-economy, is by definition a gambler — or a fool. However, there’s a difference between being a smart gambler and a broke one. The key is having the patience to wait for an excellent hand before pressing a large bet.

In the present metaphor, that means not only waiting for the right cards, but keeping a sharp eye out for a “tell” from the other players as well. You alluded to what my “tell” at this table is — market and consumer sentiment. Teasing out what might cause a sharp shift is more art than science. The key, from an investor’s perspective, is trying to time when sentiment will turn distinctly negative.

When analyzing sentiment, it helps to keep in mind the context. The present re-inflationary expansion is modest, stimulus driven, and real estate dependent. Somewhat contradictorily, it is both consumer driven and taking place during wartime. These are an unusual confluence of factors, to say the least.

It would be a mistake to think that only real estate or the high price of oil may be what perturbs the consumer: To track sentiment, we must also consider other factors that might impact them:

• The war in Iraq, with less than a majority of Americans now supporting it, also impacts sentiment.

• Government debt is increasingly getting attention. A widely carried Associated Press story reported that the indebtedness of every American is now $145,000. That’s the “tab for the long-term promises the U.S. government has made to creditors, retirees, veterans and the poor.” The consumer is just starting to figure out the true level of their debt.

• The current-account deficit continues to be problematic. Americans spend approximately $2 billion more per day on imports (primarily clothes, cars and electronics) than the rest of the world spends on our goods and services. That imbalance is unsustainable; it will end when we either sell more goods to others, or throttle back our own spending dramatically. Which do you think is the more likely scenario?

• Lastly, there’s the problem of “data disconnect”: There is a tension between consumers and the apparent good economic news that has been dominating the news. We know there’s a disconnect between the positive headlines and the approval rating for the president’s handling of the economy. One explanation why is the tendency for government data to be positively biased. That helps to explain why there is a rising negativity, despite good headlines. This implies the BLS/BEA releases are simply not capturing the true state of the economy.

• As Andrew correctly pointed out, even Alan Greenspan has finally come around to recognizing, however belatedly, the impact of increased liquidity. What the Chairman neglected to mention was that weak wage increases are pushing buyers to use 40-year mortgages; this even as “the median price fell for the third consecutive month” and have dropped in five out of the seven months of 2005. On a year-over-year basis, the median price of a single-family home was down 4.1% this past month. This is the largest monthly decline since early 1991.

The combination of high energy prices combined with the end of the easy refi money may be a serious one two punch. Add to that big expenditures for discounted GM vehicles, and you have the makings of a wobbly consumer. I will be closely watching how this holiday shopping season goes: If it’s more difficult for retailers than expected, we will have unequivocal confirmation that the consumer has — finally — exhausted themselves.

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Andrew writes: Turning now to the micro level, I am sure many people are wondering, “How do we explain the behavior of the American consumer?” I would like to use this installment to discuss some recent ideas from the academic literature on household saving.

I will start with a theory advanced most eloquently by a former mentor of mine, Christopher Carroll, who is now a professor at Johns Hopkins. According to his Buffer-Stock Theory, the typical household’s saving behavior can be described as the interplay between impatience, the desire to borrow against future income if the latter were not subject to uncertainty, and prudence, the need to save against future uncertainties. If consumers are sufficiently impatient, then they will save only to maintain a target level of wealth, or a buffer-stock, against near-term fluctuations in income. Some research that Chris and I did suggested that the typical consumer was in fact so impatient that saving for retirement would not commence until retirement was only a decade or so away. Sound like anyone you know?

The decline in personal saving that I alluded to earlier may be the result of impatience growing in the population or finding more opportunities to express itself in capital markets, like the newfound liquidity of housing. Target saving in a buffer-stock model also helps explain why households have been so willing to cash out their capital gains-as long as the buffer stock is intact, impatience suggests a strong desire to consume unanticipated increases in wealth. I think that’s a reasonable description of what we’ve seen as of late.

Is there any way we can help consumers behave in a less impatient manner? For this, we turn to the research of David Laibson, a professor at Harvard specializing in behavioral economics and its application to issues of consumption and saving. David’s work began with the observation from psychological studies that consumers suffer from a time inconsistency problem — they are willing to commit today to begin saving tomorrow, even if they might change their minds as tomorrow arrives. Their impatience is only a near-term phenomenon — they expect to be patient in longer-term decisions. An immediate implication was that illiquidity was a desirable feature of a savings account, since it helped enforce that commitment. This shows why greater access to home equity may be a mixed blessing.

David’s more recent work (with several co-authors) has focused on ways to set up 401(k) plans so that workers actually save in them. For example, it matters quite a bit as to whether new workers at a firm are automatically enrolled in the 401(k) plan or have to make an election to join. Automatic enrollment generates higher participation. The plan’s default contribution rate and investment allocations also matter — many employees seem to follow them without much additional thought. The clear lesson from this body of work is that we should look for every possible mechanism to make it easy on consumers to commit themselves to a long-term savings plan with fairly high savings rates.

In my view, only then does prudence or thrift have a fighting chance against impatience.

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Barry writes: At last, we come to an area of mutual interest and agreement between the good professor and I: The myth of the rational economic participant. There’s a lot that devolves from that simple yet overlooked premise.

Hard as it is to imagine, only a few years ago classical economics didn’t acknowledge that humans engage in behavior far away from rational — despite all the obvious proof we encounter daily. The evidence of our irrationality, poor judgment and capacity for self-delusion is quite astonishing. From the innumeracy that keeps the gaming industry profitable (was it Mark Twain who said “gambling is a tax on the stupid”? He could just have easily been referring to the economically irrational), to those of cigarette smokers (fully aware of the economic and health consequences of their habits) to even the simple failure of 25% of U.S. drivers who elect not to use seatbelts (despite overwhelming evidence of their efficacy) — we are hardly the rational creatures economists used to make us out to be.

We see evidence of this in recent economic data. Household debt is now at historical highs. Despite interest rates being at half-century lows, a surprising percentage of new mortgages — 36.6% as of March of this year — are adjustable-rate mortgages. Perhaps I am confusing irrationality with plain ol’ foolishness. And it’s not just mortgages — despite credit-card interest rates remaining on the high side, this type of debt has risen even more than mortgages! That’s simply inexplicable.

Several commentators have pointed out that household debt isn’t all that high relative to assets. The problem with that analysis is that these asset values are all volatile and subject to market forces. Debt wasn’t that high relative to equity assets in the beginning of 2000, nor was it that high in Holland during the height of the tulip craze. In the event asset values correct, real debt will remain stubbornly high. Asset-to-debt ratio is hardly a reassuring metric.

The bottom line is that our own analytical risk engines are, in fact, quite inadequate. That’s why the efficient market theory is (finally!) starting to fall into disrepute. At best, the market is kinda-eventually-sorta-mostly-almost efficient.

These are helpful issues to keep in mind when trying to suss out how the consumer will react to any one of numerous economic scenarios in the future.

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Andrew writes: I think the myth is of the pervasive rational economic participant. But that is little consolation in unsteady times, as both the rational and the irrational co-exist in markets. Usually, that works to the advantage of the rational participants — a fool and his money are soon parted. But should the bottom fall out, it may be everyone’s bottom, rational and irrational alike.

In finishing up our session, I’d like to revisit two of the areas that we have addressed as threats to the sustainability of consumption and economic growth. The first was oil. CNN reports today that some experts see the price of retail gasoline topping $4 per gallon in the wake of Hurricane Katrina’s damage to the Gulf Coast. I think the White House is right to tap the Strategic Petroleum Reserve, but it seems fairly certain that this risk to consumption and growth just got much bigger.

The second was debt burdens of households. Every quarter, the Federal Reserve reports on the debt service and financial obligation ratios of households. These are ratios of estimated payments to disposable income, and “financial obligations” include lease, rental and tax payments associated with residences and vehicles in addition to the mortgage and consumer debt in the debt-service measure. In the first quarter of 2005, the debt-service measure stood at 13.40%, its highest level in the 25 years of available data. The more comprehensive measures are also near their highest levels, though all measures have been fairly flat since the end of the recession.

There are two key risks associated with debt service. First, it is not evenly distributed among households. Renters, for example, have financial obligation ratios nearly twice those of homeowners. Since the ratios are to disposable income, low-income households are almost surely at greater risk. Second, continuing the theme of one-two punches that Barry and I seem to like, rising interest rates are going to hit both the asset and liability side of household portfolios. Since the value of an existing house depends on what a prospective buyer can afford to pay, rising interest rates will put downward pressure on the value of existing homes. But rising rates will also increase the cost of debt service on existing mortgages if they are adjustable — rather than fixed-rate — loans. Not a pretty place to be, unless income growth picks up.

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What do you think? Is the consumer tapped out, and if so, what are the implications for the economy? Share your thoughts on your discussion board.