Why sluggish income growth continues to drag on the U.S economy

The U.S. economy is driven largely by total consumption expenditure of its domestic populace, in fact some 70% and evidencing how, in contrast to Asia, exports are a relatively small part of its economy. This bald statistic explains why many economists place a great deal of importance around assessing the health of the U.S. consumer. If consumers do have money to spend, then the health for the U.S. economy is expected to be generally good but if consumers do not have cash to spend, sooner or later the U.S. economy will enter recession.

With aggregate demand assuming such importance as depicted above, it is no surprise that staunch Keynesians developed a model in order to delineate a plan of intervention whenever the economy derails. Their basic idea is to smooth the business cycle by increasing government expenses when the economy is overheating and by decreasing them at the first signs of cooling – it’s fair to say that Ed Balls is no doubt a Keynesian but one who forgets the second half of this!! The multiplier effect is thus supposed to result in each dollar spent growing in a multiplied fashion throughout the economy.

Besides the use of fiscal policy to increase growth, Keynesians also advocate a decrease in the interest rate level. As interest rates decrease, then not only does investment increase due to the lower borrowing costs, but it also, as the theory goes, increases due to the higher spending generated by consumption. Keynesians see the level of present consumption as an inter temporal choice between consumption today and consumption in the future (saving).

When interest rates then rise, consumers save a larger part of their income, while doing the opposite when the interest rate declines. Under the current economic environment, one would be forgiven for expecting consumers to spend each dollar in income they have and through the multiplying effect so generate investment and growth. Sadly this is not happening in the U.S…

With consumption being a central issue for government policy, and with it being dependent largely on personal income, in particular disposable income, governments should look at ways of increasing this income to guarantee that consumers have the necessary funds to spend; otherwise, even if the savings rate is low, their final consumption expenditure would thus be flat.

It is interesting then that according to the latest economic data reported by the U.S. Bureau of Economic Analysis (BEA), GDP grew at an annual pace of 3.2% during the fourth quarter and almost exclusively due to consumer spending. Real personal expenditure increased 3.3% and was the main force behind the growth. That’s the good news.

Unfortunately, a closer look at the numbers reported shows a problematic reality that is cause for concern… While consumers are increasing their expenditure, this has largely been through borrowing, as this is growing faster than the increase in disposable income. Consequently, much of the increase in GDP is a direct consequence of a declining savings rate, which will quickly turn around at the first sign of smoke. As these numbers are a picture of the past rather than a real time frame then my guess is that this is already happening and consumption is once more slowing. Bad news for the U.S economy…

Real disposable income actually grew 0.7% in 2013, the slowest pace since the end of the financial crisis in 2009, and this was also the second consecutive annual decline. In fact the pace observed compares with the pre-crisis cooling instead of showing the health of the initial years of the 2000s. With a crisis in the emerging markets and the main global equity indices going down, it won’t take long for consumer confidence to start decreasing further. In the first phase, consumption expenditures will be brought down to earth, that is, grow at the same pace as income (at most) and which is not growing at all. Then, this reduced consumption along with the negative contribution coming from reduced government spending and from reduced exports, will likely result in deteriorating GDP growth during the year. What does this mean? That’s right a braking in QE tapering and likely re-ignition under precious metals prices…

Filipe R Costa