Are We Approaching The End Of The Binge In US Consumer Debt?

Changes in household income and spending since 1960

By Daan Joubert

 

It is widely accepted that deficit spending on household budgets is an essential factor in the sustained performance of the US economy, as measured by the GDP. Consumer credit and the use of the house as an ATM to generate cash for home-owners have run at levels that contribute much and sometimes most of reported quarter on quarter growth in the GDP. If consumers should begin to suffer debt exhaustion in their pursuit of more credit with which to fuel their desire to live the good life, this will have an adverse effect on US GDP – resulting in a decline in growth that would become the first in a series of cascading dominos throughout the US economy.

 

It is therefore of widespread interest, in particular for foreign investors in the US, to have some idea how long American consumers can continue to add more debt to their already impressive load of household debt. Taking on more debt is how many households afford the desirable luxuries that tempt them with low prices and easy finance, while for many others it is he only way they can afford the essentials of existence. While desire on the one hand and spiraling costs of the essentials of life – food and energy paramount among them, yet not receiving much attention ‘out in the cold’ outside the ‘core’ CPI – drive the pursuit of more debt, there comes a day when the ability to afford and take on more debt hits a ceiling. The question is, Where lies that ceiling?”

 

Official figures on disposable income of US households and the corresponding change in spending that are released month by month are both given as percentages. It is striking that more often than not, over a long time, the month on month percentage increase in spending is greater than that for the increase in income. An initial reaction is to ask, “How long can American consumers continue to increase the amount they spend by more than the increase in their income before their money runs out – so that the ability to increase debt is reduced and people have to begin and make do with what they have left of their incomes to take home.

 

After some pondering it sinks in that if the absolute increase in spending is less than the increase in the amount earned, after deductions, there is no problem. If I earn $1000 and spend $800 and my income increases by 4% ($40) while my spending increases by 5% ($40), then I still break even, so that the difference in the percentages is misleading.

 

But is this really so in real life? Is disposable income of US households so much greater than their consumer spending that it negates the apparent excess of spending go on?

 

These questions prompted a study where, initially, month on month changes in consumer spending relative to changes in disposable income, measured in dollar terms (using data from the St. Louis Fed), were charted. The variations in these two series proved to be so volatile that it was difficult to interpret in terms of trends. Even when variations were calculated as year on year changes, the volatility was too high to make much sense of the chart. Building cumulative totals of spending and income and comparing the ratio of the totals worked much better.

 

Therefore, in this report, cumulative year on year increases in consumer spending are compared to cumulative year on year increases in disposable income. The base period for the data is January 1960, but the chart is only generated from December 1974. The later date results in sufficient history to support meaningful conclusions. Secondly, it lies in the period of stagflation that caused Volcker to raise interest rates above 20% – a step that successfully addressed the problem of inflation at that time and by 1982 established a foundation for the long term US bull market that finally peaked in 2000.

 

1974 was also 6 years before Reagan moved into the White House. The subsequent focus on supply side measures changed the basic assumptions in US economics and most likely set the stage for what we find in conclusion in this analysis.

 

 

Exploring the chart

The chart displays, from the end of 1974, what percentage of the cumulative increase in disposable income of US households since 1960 immediately left the household purse in pursuit of a high standard of living, as indicated by the cumulative increase in consumer spending. Note that the analysis is not examining total income to total spending, a more widely accepted way to look at household finances, but at a ratio of cumulative year on year changes in these totals.

 

 

During the early 1970’s, US inflation prompted Americans to spend more, rather than to save. Then, when stagflation became the issue, this changed, as we will see. By looking at increases in spending relative to increases in income since 1975 – rather than at the absolute values of income and spending – we are in effect examining what American households are doing at the margin with improved cash flow into the household budget.

 

A premise of the analysis is that under normal circumstances households have balanced budgets; fixed commitments and living expenses are (mostly) covered by income. When disposable income increases, people can decide what to do with the extra cash – they can save all or a part of the increase or they spend all of it.

 

The result of this decision, as it was made over time, for all US households, is revealed by the chart of the ratio between ‘cumulative increases in consumer spending’ and the ‘cumulative increases in disposable income’ over the period of 46 years since the start of the data set in 1960 (the chart only displays the data as from the end of 1974).

 

 

Cumulative increases in spending relative to cumulative increases in income

 

 

During the early seventies there was a sharp increase in the amount of additional income that was spent and not saved or invested. One can surmise that as inflation had picked up from the middle 60’s, it made little sense to save additional income and have the value eroded by rising inflation. Further, people probably reasoned that an item that costs $100 today may well be $120 in the not too distant future; therefore it is tempting to buy it now rather than look on as its price gets marked up every so often.

 

For the brief comments that follow, the initial letter of the paragraph refers to the place on the chart where a change in trend had taken place:

 

A – during the period of stagflation having a job became uncertain, which in due course caused households to curb their spending, or so one can speculate from the fact that the fraction of new income that was spent during this period remained constant; and then  . . .

 

B –  . . . during the late 70’s and into the early 80’s when Volcker brought interest rates to above 20% in his conquest of inflation, it became attractive to think of saving more of the additional income. The ratio of income to outgo over this period of high rates dropped to the lowest point on the chart. The fraction of increased income being retained was large enough to lower the ratio of accumulated fresh spending to the increase in income since 1960 from near 89% to only slightly more than 84% – a significant feat.

 

C –  It is often mentioned that in 1982 the 16-year sideways drift on Wall Street ended with the start of the bull market that extended into 2000. We see that the positive change in Wall Street’s fortune kicked off with some increased spending by households, but they quickly got cold feet and cut back on their spending again.

 

D – However, by 1985 a new, longer lasting spending spree took the ratio to a new high in 1986/87; the euphoria of a bullish equity market (a fore-runner of the ‘famous’ “wealth effect”?) clearly brought on spendthrift tendencies. This over-exuberant spending spree had to have been a key factor underlying the October 1987 Panic on Wall Street (which is now only remembered by the ‘old-timers’ in the markets).

 

E – With the Dow falling by 23% on the first day of the Panic, later to record a loss of more than 50%, rediscovery of the principle of “saving for a rainy day” was no surprise. From 1987 through 1992 the ratio gradually declined, showing that an increasing fraction of income was not being spent. In due course, this lack of spending surely contributed to the recession of the early 90’s; the one that brought Bill Clinton into the White House, winning the vote with the slogan, “It’s the economy, Stupid.”

 

 F –His election inspired economic confidence, as spending immediately took off again in a new “I want that now!”-spree that helped to kick-start the boom economy of the 90’s – and took the ratio to a new high; by 1994, 92% of accumulated new income since 1960 had been spent. Then the rate of increase in the ratio tapered off, but did not really stop its upward trend. In 1997, events in SE Asia –the Asian Tigers turning into kittens and with problems also surfacing in South America and Russia – proved central bankers were not as omnipotent in their ability to govern the ‘new economies’ of the 90’s as the public and they themselves had come to think. American households were frightened enough by what was happening to think it prudent to reduce their rate of spending – which took the ratio back to its support line. One should however be careful not to seek the full reason for the decline in the ratio in a stress reaction to untoward overseas events. The late 90’s was a period of great prosperity in the US – just think how much has been written about the ‘wealth effect’ arising from the bull market in equities and bonds and early signs of a new bull market in property. Income from all sources was rising steeply; foreign imports were having a deflationary effect on prices and it was not necessary to spend all this new cash to live the good life.

 

G – After the scare of 1997/8 had dissipated, with the ratio essentially flat right into 2003, consumer spending took off again. The ratio leveled off as 2000 (Y2K?) crept over the horizon. This cooling down of the urge to empty the shelves in the shops may have been in the back of Greenspan’s mind when he pumped up liquidity in the run-up to the Millennium change. However, before a new spending spree was triggered, the Dow and Nasdaq hit tops to turn lower and acted as a reality check to keep spending mild and contained. Then 9-11 happened to further dampen any inclination to go and hit the shops armed with fresh credit cards. Then, by 2003, interest rates had fallen to record lows, the Chinese were getting into their stride and the almost consistent reduction in the prices of electronics and other goodies coming from Asia had shoppers queuing to take home new large TV’s, CD players, DVD’s, fancy home theatres and all manner of computer stuff – US manufactured motor cars, SUV’s and many other items were on permanent special offer, with terms never seen before. Demand sky-rocketed and in due course so too did the ratio of increased spending over income.

 

H – The acceleration in the ratio after 2003 broke upwards out of the wedge-shaped pattern that had developed over more than 20 years. By April 2006, US households had spent almost 98% of all additional income they had received since 1960. A well-known saying when someone is putting everything on the line, is that one is “Going for broke”. This seems an apt phrase to describe the enthusiasm and intensity behind the spending spree that has virtually exhausted all accumulated household wealth of the past 46 years. It is clear that to have achieved this ‘feat’ – requiring just 3 years to proceed from having spent 94% of the accumulated increase in income of more than 4 decades to nearly 98% of the income spent – called for a concerted and united effort to buy everything in sight.

 

 

Discussion

It is unclear whether this state of the ratio – so close to 100%, where all accumulated net income of 46 years had been spent, much of it since 2000 – is a sign that debt exhaustion is about to hit domestic America. There are too many imponderables along the way.

 

It is nevertheless interesting to find such a good correlation between the ratio and factors that affect trends in the US economy. While it is not possible to say whether unity, 100%, is going to prove a significant level for the ratio, it is quite clear that the recent trend from the 94% level – in slope and in duration – is only matched by the spending spree starting in 1985 and running through to just before the Panic (and Crash!) of 1987.

 

It is equally clear that the trend of at least the past 30 years is unsustainable over the long term. Sooner or later new spending has to be curbed and this time around – from such a lofty height in the ratio – the correcting trend and the economic pain that goes with it can be expected to be more severe than any of the preceding corrections.

 

How severe, time will teach us.

 

 

Conclusion

American households have, in a steadily accelerating spending spree, now spent almost all of the increase in household income of the past 46 years. It implies that, nationally and should the trend remain intact, the US household sector is on the verge of going bankrupt. Of course, many household have saved a good part of their income over the years. These households are counter-balanced by those that have sunk deeply into debt in order to keep the spending flag flying high.

 

These households are very poorly prepared to weather any financial headwind, let alone a significant rise in interest rates. Roll on the end of June and the FOMC meeting. If the decision is to raise rates, the effect on a large segment of the US economy could be most interesting – settling for a phrase that would appeal to a Chinese philosopher.

 

 

Invitation:

The author has produced the first issues of a newsletter that combines technical analysis of important market variables and financial instruments with a fundamental perspective.

 

The time horizon is longer term and the focus is international. The intended readership is investors who manage all or part of their funds, or who closely oversee what their fund managers are doing; investors who need a ‘window’ on future possibilities, in order to identify both opportunities and threats while they are still coming over the horizon. 

 

Initially and for quite some time the letter will be free. If you are interested in receiving the letter, send an email to this address:        chartsym@#mail.com                          

NB: Replace the ‘#’ in the ISP-name with a ‘g’.

 

daan joubert

 

© June 2006  All rights reserved