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By Michael Mandel COVER STORY PODCASTThe long-awaited, long-feared consumer crunch may finally be here. That might not mean an economywide recession, but the pain for American households will be deep.
In recent years the U.S. mostly has seen narrowly focused downturns, where a few sectors are hit hard while the rest of the economy and financial markets remain relatively unscathed. In the dot-com bust of 2001, for example, tech companies and stocks took it on the chin, while consumer spending and borrowing sailed through without a pause. This time the positions will be reversed, as consumers tank while much of the corporate sector stays on track.
It's been a glorious run for the consumer. In the past 25 years, Americans have kept shopping through good times and bad. In every quarter except one since 1981, consumer spending rose over the previous year, adjusted for inflation. The exception was the first quarter of 1991, and even then the decrease was a mild 0.4% dip.
The main fuel for the spending was easy access to credit. Banks and other financial institutions were willing to lend households ever increasing amounts of money. Any particular individual might default, but in the aggregate, loans to consumers were viewed as low-risk and profitable.
The subprime crisis, however, marks the beginning of the end for the long consumer borrow-and-buy boom. The financial sector, wrestling with hundreds of billions in losses, can no longer treat consumers as a safe bet. Already, standards for real estate lending have been raised, including those for jumbo mortgages for high-end houses. Credit cards are still widely available, but it may only be a matter of time before issuers get tougher.
What comes next could be scary—the largest pullback in consumer spending in decades, perhaps as much as $200 billion to $300 billion, or 2%-3% of personal income. Reduced access to credit will combine with falling real estate values to hit poor and rich alike. "We're in uncharted territory," says David Rosenberg, chief North American economist at Merrill Lynch (MER
), who's forecasting a mild drop in consumer spending in the first half of 2008. "It's pretty rare we go through such a pronounced tightening in credit standards."
Don't expect the spending to come to a screeching halt, however. Remember the stock market peak in early 2000? It wasn't until a year later that tech spending fell off the cliff and the sector didn't hit bottom until 2003. The same delayed impact holds true here. The latest retail sales numbers, which showed a soft 0.2% gain in October, suggest that spending may hold up through this holiday season.
Next year, though, will be much tougher. The consumer slump may be deep and long-lasting, and the political implications could be enormous. "There's growing evidence that the economy will become a dominant, if not the dominant issue of 2008," says independent pollster John Zogby. "It's even to the point where the numbers of people who say Iraq is the No. 1 issue are starting to decline."WIDE-OPEN CREDIT WINDOWTruth is, economists have been complaining about excessive borrowing and spending since the early 1980s. Journalists began writing about consumers being "tapped out," "profligate," and "spendthrift." Magazines and newspapers regularly ran stories about debt-ridden Americans not being able to buy holiday presents for their kids.
But no matter how many times economists predicted the demise of the consumer, the spending continued. The latest data from the Bureau of Economic Analysis show that the personal savings rate—the share of income left after consumption—fell from 12% in 1981 to just over zero today. And debt service, which is the share of income going to principal and interest on debt, kept rising. Those numbers aren't dead-on accurate: The data has been revised endlessly, and the BEA includes outlays on higher education as consumption rather than saving, which would seem odd to families who have socked away thousands of dollars for college.
But the story line is clear. Consumers' outlays have outpaced the growth of their income for a long time. Lenders learned how to judge risk and expand the pool of potential borrowers—and the party was on. "The most important factor has been that it is easier to borrow," says Christopher D. Carroll, a Johns Hopkins University economist.
While many companies struggled in the 2001 recession and afterward, American consumers just kept borrowing. "In 2001-02, the credit window was open for anyone who had a pulse," says Merrill's Rosenberg.FEWER TRIPS TO THE MALL?Not this time, though. "The consumer is retrenching, bigtime," says Richard Hastings, economic adviser to the Federation of Credit & Financial Professionals. "It's starting to get to the point where people are achieving levels of debt that are getting uncomfortable."
The question, though, is just how much consumers will restrain their free-spending ways. Research by economist Carroll suggests that every $1 decline in house prices lops about 9 cents off of spending. The current value of residential housing is about $21 trillion, according to the Federal Reserve. So if home prices fall by 10%, as many people expect, that would lead to roughly a $200 billion hit to spending over the next couple of years. A 15% tumble in home prices would produce a $300 billion pullback in spending, or about 3% of personal income.
That accords well with calculations by BEA economists. They figure that households took out $340 billion in cash from mortgage and home-equity financing in 2006. That source of funding could largely disappear over the next couple of years.
Three percent—that doesn't sound like a lot. Look a little closer, though, and it's a bigger hit than it seems. The reason is that much of what the government counts as consumer spending is not directly controlled by households. For example, the $1.7 trillion in medical costs is counted as consumer spending, but 85% of that is spent by the government and health insurers, not individuals. And $1.5 trillion in "housing services" is listed as part of consumer spending, but for homeowners it really just represents the value of living in a home rather than any spending they can change. It's mainly a bookkeeping convention, not a real outlay.
So that 2%-3% decline in income directly hits the wallet and the discretionary purchases that households actually control. One logical place for cutbacks is apparel. Autos will be hit. Another target could be luxury items, a surprisingly big part of discretionary spending. Pamela N. Danziger, president of Unity Marketing in Stevens, Pa., conducts a quarterly online survey of adults earning $75,000 a year and up. She found that people who make more than $150,000 have been unaffected, but the rest are cutting back on luxury goods such as fashion accessories. "They are taking a very cautious attitude," says Danziger.A LIFT FROM EXPORTSWill the consumer crunch spread to the rest of the economy? Conventional wisdom is that consumer spending makes up 70% of gross domestic product. While technically true, that figure is deceptive, because so much of what Americans buy these days is made overseas. Compared with the early 1980s, which was the last time consumers cut back, much more of what Americans buy is made abroad. Today, imports of consumer goods and autos run about $740 billion a year. That's fully one-third of consumer spending on goods outside of food and energy. As a result, most of the spending cutbacks won't cost Americans their factory jobs—those factory jobs have mostly fled offshore anyway. Workshop China, in contrast, will get hurt.
What's more, it's still a low-rate world for most nonfinancial corporations, which have access to relatively cheap funds for expansion and capital investment. Asia and Europe are continuing to expand, with German and French growth accelerating in the third quarter. Exports of aircraft and other big items are likely to rise, too, supplying the U.S. economy with an extra lift. In other words, globalization has made consumers less central to the American economy.
Still, the consumer recession will hit some parts of the economy harder than others. Particularly at risk are retailers, who have already seen sharp declines in their stock prices since the extent of the subprime crisis became clear. Nordstrom (JWN
) shares, for example, fell from 52 in September to as low as 32 before rebounding. On Nov. 14, Macy's (M
) cut its sales forecast for the fourth quarter, sending its stock down to $28 a share from $43 in July. "Retailers are looking to pare inventories," says Rosenberg.
Not everyone thinks American shoppers are tapped out. Consumers have about $4 trillion in unused borrowing capacity on their credit cards, enough to keep spending afloat, points out Stuart A. Feldstein, president of SMR Research in Hackettstown, N.J., which studies consumer loan markets.
But executives from Capital One Financial (COF
), Bank of America (BAC
), Discover Card (DFS
), Washington Mutual (WM
), and others have told investors in recent conference calls that they are using more caution in extending credit. Chief Financial Officer Gary L. Perlin of Capital One, the nation's No. 5 card issuer, says he believes last year's historically low defaults by credit-card holders were partly driven by the real estate boom, particularly in previously hot housing markets such as Arizona, California, and Florida. Those benefits also have seemed to run out. As a result, says Perlin, Capital One is tightening lending standards and limiting credit lines.
More rate cuts by the Fed can cushion the impact of the consumer cutbacks but not avert them altogether. It's best to think of this as the end of a long-term spending and borrowing bubble, where the role of policy is to keep the inevitable adjustment from turning into panic. "The Fed's job is to keep us all calm and reasoned," says Carroll.
Everyone now seems to be coming up with remedies. At a Nov. 8 congressional hearing, Fed Chairman Ben Bernanke suggested legislation that would temporarily add liquidity to the jumbo loan market. And the possibility of a consumer slump already has Presidential candidates and their staffs looking ahead. "Potentially, the next subprime crisis is the issue of credit-card debt," says Austan D. Goolsbee, economic adviser to Democratic hopeful Barack Obama and a professor at the University of Chicago Graduate School of Business. The Illinois senator's view, says Goolsbee, is that the U.S. needs to improve oversight in the credit-card market. Republican candidate Mitt Romney suggests eliminating taxes on savings and investment by low- and middle-class families, a move that could help make up for a tougher credit environment.
The politicians can say what they want. Recession or no, Americans had better get ready to tighten their belts.Join a debate about Christmas spending during the crunch
With Peter Coy in New York and Dawn Kopecki and Jane Sasseen in Washington