In the recovery from this crisis, the evolution of private consumption is a matter of keen interest. This is not surprising. Private consumption constitutes the largest share of GDP. In the US, private consumption has, in recent years, been about 70% of GDP. Even in Germany, where savings rates are high, private consumption constitutes almost 60% of GDP. Moreover, consumption growth has implications for global trade and investment. As such, the pace at which G7 consumption growth will revive is critical to the speed of world GDP growth.
But there is a further, perhaps more subtle, interest. Prior to the onset of the crisis, there was considerable concern about widening global imbalances. The US current account deficit had reached historically-high levels and this deficit was being financed by large German, Japanese, and Chinese surpluses. The risk that these balances would ultimately unwind in a disorderly manner was a source of considerable policy apprehension. In particular, if the sizeable required depreciation of the US dollar were disorderly, the fear was that the global economy could be severely destabilised.
In the end, events took a different course and the crisis had other sources – in the US housing bubble, subprime mortgage lending, the opacity of financial markets, and the inability of global banks to withstand the rapid discounting of their assets (DeLong 2008).
Some would argue that the housing bubble fed the tendency towards over-consumption, which, in turn, was mirrored in the US current account deficit (Feldstein 2008). But the immediate response to the crisis was an appreciation, not depreciation, of the US dollar. Thus, although the virulence of the crisis was not due to the correction of global imbalances, the imbalances have regained centre stage in recent months (Cline and Williamson 2009).
Our analysis suggests that, in the short-run, income uncertainty will dampen consumption growth in the G7 countries, constraining global growth as a consequence (Mody and Ohnsorge, 2010). Any cyclical improvement in imbalances, we suggest, could be short lived. Over the more medium term, structural differences between countries play a persistent role in driving consumption and savings decisions, and hence global imbalances. Our perspective on global imbalances is admittedly a partial one. It leaves out considerations of private investment and public savings and expenditures. We also do not consider China and the Middle East. The main claim of our research is that consumption trends in the G7 economies have significant short-term and long-term implications for the global imbalances.
Short-term influences on consumption growth
The short-term drivers of consumption growth are related to the precautionary motive for saving – a motivation accentuated at times such as this when income uncertainty is high. An increase in unemployment over the previous year is associated with significantly lower consumption growth, appearing to proxy not just for risk but also for expected future income. Higher GDP volatility – as recently experienced – is similarly associated with a sizeable reduction in consumption growth. These results are consistent with Carroll (2001) and his interpretation of Friedman’s (1963) permanent income hypothesis. Households place a large emphasis on precautionary savings and the “permanent income” that guides their current spending is the expected level of income in the “very near-term.”
Precautionary behaviour is also implied by the finding that households tend to set target levels of wealth to act as buffers in bad times. Our results show that the cumulative differences in household wealth over time are a source of significant cross-country differences in consumption growth. But, since wealth changes from one year to another within a country are small, typically the size of the annual consumption variation on this account is limited. But when, as now, the loss of financial wealth is substantial, the effects are evidently larger and the current drop in wealth will likely have persistent effects. Our results suggest that a period of slow consumption growth lies ahead as households rebuild their financial buffers to their threshold levels.
The longer term
Despite annual changes in a country’s savings rate, large differences persist across countries. The angst in the US on account of its falling savings rates is long-standing (Summers and Carroll 1987) – the fact, however, is that US savings rates have been lower than those of Germany for nearly each of the last 40 years (see Figure 1). Similarly, although recently falling, Japanese savings rates have also been traditionally high. These differences across countries reflect deeper roots that reassert themselves regularly to influence the dynamics of consumption.
Figure 1. The long-term differences is savings rates
Recently, Barro and Ursúa (2008) have emphasised the link between a greater likelihood of catastrophic risk and a higher level and variance of the equity premium. Weitzman (2008) argues that where structural parameter uncertainty about “bad” events is high, a “fear factor” will generate a high and more volatile equity premium. Figure 2 shows the Barro and Ursua estimates. Japan and Germany historically have had high equity premia volatility, high equity premia, and very low risk-free rates – whereas the US lies at the other end of the spectrum. We find that along with short-term economic risks reflected in rising unemployment and a more volatile GDP dynamic, a historically-high volatile equity premium has been associated with lower average consumption growth in recent decades.
Figure 2. Long-run equity premium, real Treasury Bill yields, and stock market volatility (per cent)
Finally, the demographic structure matters. Where the working-age population supports more dependents consumption growth is lower. Again, Japan and Germany have higher savings rates on account of their aging populations, while the US, with its younger population, has lower savings rates.
Put together, the results show (Figure 3) that recent higher GDP volatility in Japan and Germany, and their traditionally greater “fear” factor plus population structures lead to lower-than-G7-average consumption growth. In general, the US does better on these measures and has higher-than-G7-average consumption growth.
Figure 3. Contribution to predicted real consumption growth (deviation form G7 average, in percent)
In the short run, the high level of economic uncertainty will act as a significant dampener on growth. Since this is likely to happen everywhere, consumption in the G7 economies is unlikely to be the engine that revives global growth.
Writing in the context of the Great Depression, Keynes (1937) was quite clear that consumption was unlikely to lead a recovery. Ultimately, investment would be the source of recovery. But investment, he went on to note, was highly sensitive to a deep form of uncertainty. The factors that influence the rate of investment, he concluded, were “most unreliable” since they were “influenced by our views of the future about which we know so little” (p. 221). Thus, at a time when consumers are restrained by the uncertainties and fears that we have discussed, investors could be all the more reluctant to step forward.
The differing pace and timing of consumption moderation also has implications for the evolution of global imbalances. With the US experiencing a sharper rise in unemployment and, perhaps, more widespread loss of financial wealth than elsewhere in the G7, the relative rise of the US savings rate is helping narrow global imbalances. But the findings of this paper also caution that with a likely earlier recovery in the US, this impact could be short-lived. Moreover, long-term differences – in economic and financial volatility and in demographic structures – have been an important source of the imbalances and could soon reassert their prominence.
Transfers and tax cuts are intended, as components of stimulus packages, to raise real household income. But just as important for consumption behaviour may be the stability of the economic environment. Though the sense of crisis has passed, the financial crisis and GDP gyrations have introduced continuing uncertainty. Households will accumulate savings to rebuild buffers for periods of unemployment or reduced income. Hence, much of the transfers or tax relief may feed increased savings rather than stimulate consumption.
For sustained rebalancing of the global economy, it may be insufficient to focus on consumption growth, which is driven by persistent forces. Investment behaviour may be more important for global rebalancing of growth. However, the role of public policy in stimulating investment is not straightforward, and probably requires very country-specific answers. Some surplus countries may have obstacles to investment in excessive red tape. Some deficit countries may have distortions in public policies that encourage excessive investment in housing markets, like mortgage tax credits.
Disclaimer: The authors are respectively with the International Monetary Fund and the European Bank for Reconstruction and Development. The views expressed here are their own and do not represent those of the IMF or the EBRD, the managements or their Boards.
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Carroll, Christopher D (2001), “A Theory of the Consumption Function, with and without Liquidity Constraints”, Journal of Economic Perspectives, 15(2):23-45.
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Friedman, Milton (1963), “Windfall, the ‘Horizon’, and Related Concepts in the Permanent-Income Hypothesis”, in: Measurement in Economics, Stanford University Press.
Mody, Ashoka and Franziska Ohnsorge (2010), “After the Crisis: Lower Consumption Growth but Narrower Global Imbalances?” IMF Working Paper 10/11.
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