De-Leveraging: How Much Should it Lower the Economic Forecast?

An audience member at one of my recent speeches asks how much of a drop in economic activity will occur due to de-leveraging and the end of stimulus programs.  Can we expect a double dip recession?

Good question.  I'm not expecting a really strong economic performance in the 2011 and 2012, but neither do I necessarily see another recession.  Let's talk first about de-leveraging.  It applies heavily to investment banks and hedge funds, but a lot of their activity was lending amongst themselves so that their bets were heavily leveraged.  That has already slowed a great deal, with little impact on Main Street.  (Main Street is more heavily impacted by the housing construction collapse and the fall in consumer confidence.)  Here's what corporate leverage looks like:

I could see corporations being a little more cautious, but they've already slashed capital spending pretty deeply.  I don't expect a major effort to pay down debt.

The real issue is with consumers.  Here's a picture of the long-term savings rate:

Note that there are plenty of short-term swings, but the longer term shifts take some time.  The drop from seven percent to two percent took nine years.  If consumers move their savings rate up at the same pace, they cut the growth rate of their spending by 0.56 percentage points per year.  Or, if real incomes are growing by 3 percent (long-run average), spending grows by 2.44%.  That would cut real spending by $46 billion in one year.  Seems manageable.

What of the withdrawal of stimulus?  Monetary stimulus will only be withdrawn if the economy is growing briskly.  The fiscal stimulus would get withdrawn if ....   Hmmm.  To get a scenariou with fiscal restraint, I need to envision the Republicans getting enough power to bring back gridlock.  If they got a majority on the House or the Senate, it could happen.  We'd be back to focusing on the blue dress (or whatever the modern equivalent is) and complaining that nothing gets done in Washington.  (Actually, I would not be complaining, but the New York Times and the Washington Post would be.)  So what's the odds that the Republicans stage a resurgence?    That asks for political speculation, which I'm going to avoid.

Would that gridlock, if it happened, mean a recession?  No, it would mean that we could grow our way out of the deficit.  If I hadn't seen it happen once in my lifetime, I would believe that it never could happen.

Anyway, double dip recession?  Possible, but I'm betting against it.

Comments

[Linda Keith]

Bill, just what is the definition of the savings rate that economists use? Is it the difference between after-tax disposable income and spending? What spending? Does that include pay-down of equity in the home (your entire housing payment)? Does it include everything you are putting into your 401(k) or other investments?

[Bill Conerly]

Linda, good question. The government defines savings as the difference between disposable (after-tax) income and consumer spending. It's a residual. The government does not count up all the ways you could save, but they end up in saving. As for paying down your home mortgage, it counts as savings because you use disposable income on something other than current consumer spending.

Best,
Bill

[Jerry Aalfs]

Does the increase in savings indicate that there will be a "pent up demand" for investments such as real estate?