What about the personal saving rate?

One thing that worries me about the current economic unpleasantness is how the personal saving rate plays into the downturn and the possibilities of recovery in the near term.

The personal savings rate is calculated by the Bureau of Economic Analysis (http://bea.gov) as personal income, less taxes, less personal outlays, divided by disposable personal income. To me, its not so much a measure of how much households save for the future.  It's more a measure of how much of each paycheck gets spent (i.e. the "average propensity to consume").  If households are, on average, living completely paycheck to paycheck, then the personal saving rate will be zero. If they spend less than they earn, then the personal saving rate will be some positive percentage.

The reason the personal saving rate is important is that it, along with personal income levels, determines the size of consumer spending (called personal consumption expenditures or PCE by the BEA), and consumer spending makes up approximately 70% of Gross Domestic Product.

Now for the scary part.

If you look at the personal saving rate for the last twenty years you will see that in 1988-1992 it was pretty solidly in the 7% range, which is pretty close to its long term average, but then starting in the mid nineties its started to drop until finally in 2005 it hit a low of 0.4%.  That means that over that period US households shifted, on average, from spending only 92.7% of each paycheck to 99.6% of each paycheck.  While on a percentage basis its just 7 percentage points, in dollars its huge: 7% of the 2008 personal disposable income equals 744.6 billion dollars, or about 5.2% of GDP.

So, what happens if US households revert to the historical average personal saving rate of around 7%?  By my amateur calculations there will be a minimum contraction in GDP of 5.2% (just subtracting the reduced consumer spending from today's GDP), before counting multiplier effects and without counting any knock-on reduction in personal disposable income from lost jobs, which means in reality the GDP drop would probably be substantially higher.

This indicates to me that if people stop living paycheck-to-paycheck we are going to have a deep contraction of GDP, and we will not return to previous GDP levels for a few years at least. And once again, that before counting feedback and multiplier effects (declining GDP and declining personal income).

Once I started worrying about the personal saving rate the questions in my mind became:

1. Why did households start living paycheck-to-paycheck in the first place?
   
2. Are households pulling back from living paycheck-to-paycheck, and if so, why?
3. What are the odds of households going back to living paycheck-to-paycheck soon enough to avoid a long recession?

Why did households start living paycheck-to-paycheck in the first place?

My thesis is that the personal saving rate collapsed in the period 1988 to 2005 in part because US households bought in (literally) to the story of a stock market that reliably returns 10% and housing prices that reliably rise year after year.  According to this source equity ownership among US households rose from 29.6% in 1989  to 56.9% in 2005. This was primarily fueled by the explosion in participation in 401k plans.  Households saw their 401k statements, and their home equity, growing briskly over time, and were constantly being told by multiple sources that a long term 10% annual return on stock market investments was a sure thing.  In this environment of swelling 401ks and home equity values saving $7 out of every $100 seemed kind of dopey and old fashioned.  The smart thing to do was to stop saving so much of each paycheck and instead "put your home equity to work for you" by borrowing against it to finance consumption, and trust that a combination of reliable stock appreciation and home value appreciation would take care of retirement savings.  I distinctly remember reading articles a few years back about how the declining personal saving rate was nothing to worry about in terms of Americans saving for the future because the appreciation in the stock market and housing meant that Amercan's wealth was growing faster than ever despite the reduction in personal saving.

The other factor that I theorize helped the personal saving rate collapse in the period 1988 to 2005 was the explosion of ways for consumers to borrow.  One reason to not live paycheck-to-paycheck is that if your life can get ruined if you get caught out by some large unexpected expense like a car dieing, or a major repair.  However, as credit cards and home equity loans became much easier to get, the smart thing to do became to stop saving for a rainy day, and instead just draw on a home equity loan or credit card to get you through any rough patches.  There were certainly many experts advising consumers to do just that in the last few years. I theorize that essentially what happened was that many consumers because to view their home equity and the availability of easy unsecured credit as defacto cash in the bank (i.e. very liquid money available for spending on little or no notice).  Once these consumers started seeing easy credit and home equity as the equivalent of cash the need for actual cash savings vanished.  If you poke around you can find financial advice from circa 2005 essentially advocating this view, and certainly there were a raft of ads around then from home equity lenders promoting the view that home equity should be "put to work" by borrowing against it for consumption.

There is some support for this theory in a May 2006 paper from the St. Louis Fed "Cross Cultural Personal Saving Rates" where they found "The personal saving rate usually declined more in countries where access to domestic credit grew faster."

The decline of the personal saving rate is discussed in detail in "The Decline in the US Personal Saving Rate: Is it Real and is it a Puzzle" from the November/December 2007 edition of the Federal Reserve Bank of St. Louis Review. They run through all the theories for the decline.  The first theory (stock and housing appreciation) is mentioned but discounted on the basis that it is not adequately supported by empirical evidence. Oddly, my second theory is not mentioned.  The paper discusses the increase of availability of credit, but only through the mechanism of actual borrowing being used to increase consumption.  There doesn't seem to be any mention of my theory that just the availability of easy credit can inspire people to spend more of their paychecks even if they don't actually borrow anything. In the end, the authors conclude that no existing theory can explain the decline in the personal saving rate and so its a puzzle.  Maybe my second theory of easy credit as a substitute for an emergency fund is one of the missing pieces of the puzzle?

Are households pulling back from living paycheck-to-paycheck, and if so, why?

The personal savings rate has shot up to 3.6% in December 2008. And the reasons seem pretty simple: Credit is harder to get, 401k balances have been decimated, people have much less home equity, jobs are evaporating at near-record levels, and, perhaps most significantly, some of the foundational myths that supported the lifestyle of living paycheck-to-paycheck have been busted:

• The stock market has a long term average return of 10% in the long term. Busted.
• There has never been a national decline in housing prices so home equity will always grow. Busted.
• Its always easy to just borrow to get through emergencies. Busted.

For all these reasons living paycheck-to-paycheck just doesn't look so smart any more.  In addition to the busted myths, there are some new factors the promote increased personal saving:

• High rates of job losses increase the need for an emergency fund, especially in light of tightening consumer credit.
• People who are upside down in their houses must have a substantial emergency fund to avoid complete ruin by unexpected expenses or job losses.  There are a number of reasons for this:
• Before the real estate bubble burst a middle class person who lost their job could go on a nationwide job search, which minimized the probability of extended unemployment.  People who are upside down in their homes don't have this option (actually given the slowness of the real estate market relocation for a job is hard for everyone now).
• If you are upside down in your house, the chances of getting credit to tide you through a rough patch are pretty slim.
  

What are the odds of households going back to living paycheck-to-paycheck soon enough to avoid a depression?

In my mind this is the big big big question that everything turns on. If the personal saving rate peaks at 3.6% and then reverts back to near zero in the next few months, then it seems possible for the economy to recover in the next year or two because consumer spending will recover.  If the personal saving rate keeps climbing for the next year or two, then no amount of bailouts and/or stimulus will bring GDP back to its previous level because (1) healthy credit markets don't matter if people just don't feel like borrowing to live paycheck-to-paycheck anymore, and (2) there are no plans in the works for a stimulus package big enough to replace the lost spending from a 7+% increase in the personal saving rate.  Increased personal saving will cause GDP to fall, which will reduce personal income, which will, combined with the personal saving rate, reduce consumer expenditures, which will reduce GDP, in a cycle that will continue until the personal saving rate is forced back to zero (like it was in the Great Depression) because personal income has fallen so far that on average households have to live paycheck-to-paycheck just to procure the basics.  To avoid an very long depression, the personal saving rate has to fall back to near zero before GDP has contracted substantially. Once GDP (and personal income with it) has contracted substantially it will be too late for a reduction in the personal saving rate to save the economy because the damage will already be done.

If getting the personal saving rate back to near zero in the near term is key, what are the chances of getting American consumers to go back to living paycheck-to-paycheck in the next 12-18 months? I mentioned above about how some of the myths that support living paycheck-to-paycheck have been busted: The myth of the perpetually growing stock and housing values and the myth of perpetually available easy credit.  As long as the average household no longer believes in these myths its going to be really hard to get them to spend every penny of every paycheck, especially the baby boomers.  There are a lot of baby boomers out there in their mid to late fifties who had been living paycheck-to-paycheck who have just seen their 401k plans lose 30-40% of their value, and much, if not all, of their home equity evaporate.  And they are all reading about record unemployment levels.  If you were in their shoes would you continue to live paycheck-to-paycheck, with retirement maybe 8 years away? Some will, undoubtedly, but its the average that is important, and its hard to imagine that on average the baby boomers will continue living paycheck-to-paycheck in the coming months.

To me the important question is just how busted are these myths?  At the moment I suspect the reputation of these myths has only been damaged, but not completely destroyed, for many people.  There are probably many people who expect that we will soon return to "normal."  However, with each passing month without a recovery the reputation of these myths will continue to dim.  Although the media doesn't yet mention it often, the stock and real estate markets in Japan never did recover after their real estate bubble popped in 1990 (The Japanese stock market was still well below its peak 17 years later in 2007, and Japanese real estate prices declined for 15 consecutive years). As time passes without a recovery, the Japanese lost decade experience may tend to be seen as more and more relevant and telling, and the cultural consensus may shift more and more against the myths required to support living paycheck to paycheck. Some support for this theory that the personal saving rate tends to rise after a real estate bubble bursts can be found in the Japanese "Lost Decade."  According to a May 2006 paper from the St. Louis Fed "Cross Cultural Personal Saving Rates" the Japanese personal saving rate jumped after their 1990 crash, and then slowly climbed for almost 9 years.