Recently we blogged on the Obama administration’s proposed American Recovery and Reinvestment Plan, noting that several big-ticket elements of the Plan appeared to have little or nothing to do with achieving its two stated goals — reducing unemployment and restoring economic growth. Subsequwntly we blogged on the advance macroeconomic statistics released showing a 3.8% decline in annualized Gross Domestic Product for the fourth quarter of 2008. Personal consumption and (especially) business investment are significantly lower.
Reviewing the stimulus proposals to date show that they do not address the fundamental forward-looking change that has occurred in the past several months.
Consumers believe they have experienced a significant reduction in permanent income. The stimulus proposals are supposed to promote household borrowing and spending. However, the apparent decline in permanent income leads households to reduce consumption in favor of savings or debt reduction (which is the same thing).
In today’s Wall Street Journal, economist Bert Ely raises a concern that banks are being pressured to make more loans at a time when households (and businesses) do not want to borrow:
[T]he drop in stock-market and house prices has made millions of families feel poorer and led them to save more than in recent years. It has also encouraged them (especially Baby Boomers approaching retirement) to pay off debt. They don’t need more debt.
More broadly, many of the most creditworthy neither need to nor want to borrow right now. Richard Davis, CEO of U.S. Bancorp, recently said that he is seeing the demand for loans diminish at his and other banks “from people and businesses spending less and traveling less and watching their nickels and dimes.”
“Feeling poorer” is the same thing as sensing a decline in permanent income:
The permanent income hypothesis (PIH) is a theory of consumption that was developed by the American economist Milton Friedman. In its simplest form, PIH states that the choices made by consumers regarding their consumption patterns are determined not by current income but by their longer-term income expectations. The key conclusion of this theory is that transitory, short-term changes in income have little effect consumer spending behavior.
Measured income and measured consumption contain a permanent (anticipated and planned) element and a transitory (windfall gain/unexpected) element. Friedman concluded that the individual will consume a constant proportion of his/her permanent income; and that low income earners have a higher propensity to consume; and high income earners have a higher transitory element to their income and a lower than average propensity to consume.
In Friedman’s permanent income hypothesis model, the key determinant of consumption is an individual’s real wealth, not his current real disposable income. Permanent income is determined by a consumer’s assets; both physical (shares, bonds, property) and human (education and experience). These influence the consumer’s ability to earn income. The consumer can then make an estimation of anticipated lifetime income.
If Friedman’s hypothesis is correct, consumer spending will not be restored to pre-financial crisis levels unless and until permanent income is restored. Ely suggest why this will not occur by trying to expand credit:
Lenders moreover have tightened lending standards, correcting an excessive laxness that contributed to our financial mess. Zero or very low down-payment mortgages are out, as are “covenant light” corporate loans. Likewise, lenders have trimmed credit-card limits and cut the amount of money available under home equity lines of credit as home values have declined.
And contrary to the “lend more” message broadcast from inside the Washington Beltway, bank examiners are criticizing weak loans and forcing banks to tighten lending standards. Bankers are caught in a vise between politicians and examiners.
What is required to restore lost permanent income? Administration proposals for federally-funded infrastructure projects, technological improvements in the electricity grid, and the extension of broadband to rural areas all might have net social benefits, but they are highly unlikely to raise permanent income. To the extent that households recognize that the cost of these projects must be paid through future taxes, they are sure to reduce permanent income. Spending on renewable fuels probably does not have net social benefits because previous spending appears not to have done so. These programs also look unlikely to restore permanent income, and they may reduce it even further. (Unless a persuasive case for market failure can be constructed, the same is true for renewable-fuel regulatory mandates.)
There are three sources of lost permanent income: (1) unemployment, which affects a small but rising percentage of households; (2) equity in residential real estate, which has taken a beating over the past year and continues to do so; and (3) stock ownership, including both conventional investment and investments in pension and retirement plans. Unemployment is buffered by unemployment compensation, but there is little to dampen lost asset values in real estate or equities.
Permanent income probably will remain depressed until the average value of owner-occupied homes and broad stock indexes recover to pre-financial crisis levels. For homeowners who increased consumption based on higher intuitive estimates of permanent income including “bubble-based” real estate prices, and in many cases funded the additional consumption by borrowing against that equity, permanent income recovery may be impossible. For these households, consumption must decline consistent with more reasonable expectations about permanent income. There is no solution for their condition save redistributing wealth to them from those who did not think bubble-based real estate prices were genuine.
But the act of performing that redistribution would reduce the permanent income of the involuntary donors to the redistribution program, with concomitant reductions in their consumption. For this reason, it is highly unlikely that redistribution can achieve economic recovery.