Saturday, February 02, 2008

When The Music is Over...

Since 2005 the national savings rate has slipped into negative territory. Though some people more conservative than myself has been sounding the alarm bells, this one statistic isn't exactly telling when viewed by itself. In the 1980's the average American family saved 10% of their gross income each year which lead to an accumulation of wealth in cash savings during the early part of 1990's. As the stock market started to pick up many families moved more and more assets into the market and the accumulation of wealth began to multiply more quickly.

As this wealth began to multiply more rapidly, the savings rate started to decline. There is nothing wrong with this - people were simply adjusting their spending of earned income (the savings rate is earned income less money spent from any source) up because their savings invested began to grow more rapidly than in the traditional savings account. In essence if you combine the savings plus paper investment growth - Americans' were getting the effect of a bigger an bigger raise each year. However because of the strict measurement of savings rate this couldn't be calculated and created the effect of a seeming decrease in savings rate.

Even after the tech bubble, paper wealth was still above levels it would have been had it remained in savings accounts throughout the 1990's. Next with the coming of easy access to credit based during 2001-2006 spurred another part of the American portfolio - their home value. With the stock market in the dumps, housing values were picking up the slack and again the household wealth was increasing which continued to keep the savings rate in low to negative territory.

As people used their houses as piggy banks and cashed out on every increasing values in their homes, they were using their house to boost their spending. Nothing is wrong with this necessarily as long as housing or stock market wealth continued to increase.

So fastforward to 2008 - with easy credit gone, and the housing market is set to either decline or stagnate for the next few years while we absorb the excess of the frenzy, we can't continue to cash out our homes. Well, we can just turn to our equity wealth now to keep up our lifestyle, right? Not so fast - the market which has been growing since just after 2002 is nearing the late stage of one of the longest bull markets. Moreover in order to build wealth in the market we need to have money to put into the market, not take it out.

The real problem is that America's lifestyle has grown accustomed to levels which would necessitate spending more than we earn. As long as we have wealth to continue to liquidate this isn't a problem, but over the last 7-8 years we've exhausted much of this wealth. Will American's continue to exhaust their dwindling wealth or worse run up more debt in order to maintain their lifestyle? If they do we can expect an economy that grows more and more slowly until a point where people are forced to come to terms with their outsized spending and adjust it downward.

When this adjustment comes the question will be - will we have run ourselves so deep into debt that we are now forced to use a portion of our income on interest payments? If so, the negative savings rate if it is -0.5% this past year will be compounded by whatever interest rate America is paying - thereby giving a good estimate to the decline in consumer spending. If this interest rate is 6% we can expect a 6.5% decline in disposable income which will create considerable drag on the economy - and this assuming people don't save a dime. If households do the responsible thing and try to save some income on top of this 6.5% drag we're looking at an even larger temporary drag on the economy.

If Joe Consumer gets to this point, what is likely to happen in the long run. Its likely retirement investment will be curtailed to pay current debt - meaning he will work longer...wait didn't I hear about the retirement age increasing...perhaps we're already in some stage of this scenario?

Is this doomsday? Probably not, but its certainly not a rosy scenario and signals a medium term sluggishness which will have varying effect on the economy. The music is over...time to go home get a good night sleep and get ready to work long and hard to pay for the party.