Economic Update: Why a U Shape Recovery and What That Means to U
-9.11.2009
Why a U Shape Recovery?
If you listen to Bloomberg, CNBC, or just about any financial news story, you might hear economists and others talk about a V or U shape recovery. Each describes the manner in which the economy will exit from the current recession. Briefly, a V recovery suggests that the nation will exit the current recession quickly, and a U shape implies that the economy will hit a bottom and then experience slow growth for an extended period of time.
I have been suggesting for quite some time that the recovery will follow a U shape. Even though the economy is probably near the end or actually may have even exited the recession, we will continue to experience a tough slog. It will still feel like a recession.
So why the U shape?
Gross domestic product (GDP) depends on consumption spending, investment, government spending, and net exports. The consumer makes up 70% of the nation’s economy or GDP. Hence, the rapidity of the recovery will strongly depend on the consumer. We will likely see progress with government spending, investment spending due to stimulus-induced construction spending, and an improvement in exports. However, due to the hibernation of the all powerful consumer, a U shape recovery is in the cards.
There are a couple of key indicators that might lead one to believe that this indeed will be the case. This week, the Federal Reserve released the monthly report on consumer debt, and revealed that consumer debt shrank by $21.6 billion, versus an expected decline of $4 billion (See Figure 1). That is a staggering difference. Yesterday, the Financial Times reported that this decline in consumer debt was the steepest since World War II.
So why is this so significant? In 1980, 80% of consumption was financed with wages and salaries. In other words, spending was largely dictated by the level of one’s take home pay. In 2008, only 65% of consumption was financed by wages and salaries. Did spending decline as a result? No. Consumption spending continued to increase, and this additional spending was financed by consumer debt, including debt made possible by home equity.
So given the staggering declines in consumer debt, we can only conclude that spending might also decline or certainly stagnate (See Figure 2). The flip side to declines in spending is that the personal savings rate is increasing (See Figure 3). Households must now save to replenish the wealth destruction tied to declines in the stock market and home values. Any discretionary component from wages and salaries will go toward savings, and not necessarily consumption spending.
Some believe that this increase in savings rates is cyclical, suggesting that this is only occurring due to the current recession. I tend to side with the school that these changes in consumer behavior will be permanent. The household has been shocked, and will be determined to not return to the spending excesses that were linked to wealth created by an all time high in the stock market, and the housing bubble.
So what does all this mean from an everyday business standpoint? First, if your customers typically pay with credit, you need to think of creative solutions that will allow you to retain your customer base. The supply of credit may be available, but your customers may not have the stomach to take on the additional debt. Secondly, you may need to think of new or revised lines of goods and services that are priced accordingly. Customers will be searching for value. Businesses that know how to tap into this new frugality will do quite well. Finally, customer service will take on a whole new meaning. Superior customer service will allow you to retain your customer, and maintain higher profit margins.
All businesses and industries are different. And the pointers above may not necessarily apply to your particular industry. The point of this column is that the consumer, the driver of the US economy, is going to be more selective in their spending, and will finance this spending with less debt. Understanding these changes will allow you to maintain your competitive edge.
New Unemployment Claims Update
New unemployment claims continue to fall. Yesterday, the Labor Department reported that new claims for unemployment fell by a substantial 26,000, and this was better than expected. As claims continue to fall, we should continue to see a moderation of employment losses. Due to the reasons stated above, gains in employment will not necessarily equate with significant strides in consumer spending.
Suggestions
If you have any suggestions on future columns or research about specific industries or other economic data, please send me an email at udufrene@ius.edu.
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This information is provided by
Uric Dufrene.
Uric Dufrene, Ph.D. holds the Sanders Chair in Business in the School of Business at Indiana University Southeast. He conducts research on local and regional economic trends, and teaches corporate finance at the undergraduate and graduate levels. He previously served as dean of the School of Business.
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