As Finances Mend, Will Consumers Spend?

The Federal Reserve recently released first quarter data on household finances. These show continued and welcome improvement. Stronger balance sheets reflect improved real estate prices, rising stock prices, and continued higher rates of household saving. Household finances still lack the strength they exhibited in the early 1990s, before the great debt boom got under way. But they have improved enough to offer a firm basis for future consumer spending and, consequently, a durable, if still sluggish, general economic recovery.

There are, of course, innumerable ways to gauge financial health. At the macro level, the most broad-based and straightforward would track the ratio of all assets to all liabilities. For American households, this measure has improved by almost 24% over the years since the dark days of 2008. Back then, assets stood at a near all-time low of only 5.1 times liabilities.1As of this year's first quarter, they were 6.3 times the size of overall liabilities. In addition to the elevated savings rates, this improvement reflects gains in several areas. The value of real estate on household balance sheets has risen 3.9%, the value of cash and cash equivalents has risen 12.9%, and an 88.8% jump in value of equity assets on household balance sheets has propelled a 33% jump in the value of all household financial assets. The broad assets-to-liabilities ratio has also benefited from a 5.1% decline in overall liabilities. Most of this improvement reflects a drop in mortgage debt, which has fallen by 10.9% since 2008, mostly from foreclosures. But the general caution households have shown about the acquisition of any new debt has also contributed.

The striking feature about this improved financial picture is how it compares over a longer time frame. This measure shows that household finances have more than recaptured the ground lost in the 2008 financial collapse and 2006–09 recession. The level of household assets to liabilities is better today than any time since 2001. It is only 5.6% weaker, in fact, than it was in 1993,2before the debt boom gained momentum. If recent trends continue, the ratio, and what it implies about financial health, will take only one or two years more to regain the level it commanded before the American consumer yielded to the siren song of excessive debt. This situation is extremely encouraging. The picture is more mixed, however, with other gauges of financial strength, in particular the crucial comparison of household debt to income, a gauge where the great stock market gains of the past four years count less in the calculation.

To be sure, the ratio of total household liabilities to aftertax income has improved markedly. As of first quarter 2013, annual aftertax income equaled fully 90% of all outstanding household liabilities, about 24% better than the 2007's low of 73% at the peak of the debt boom. Longer-term comparisons, however, look less impressive. In 1993, before the debt bubble began to inflate, annual aftertax income was 12% higher than the value of total household liabilities. This comparison is less impressive than the straight asset-liabilities comparison because household aftertax incomes have shown much less dramatic gains than household assets, stocks in particular. Indeed, between 2007 and first quarter 2013, aftertax household income has only grown by an average of 2.4% per year during that period.3Even though income growth has accelerated of late, the trends of these recent years of improvement still imply that it will take another six years for American households to bring this critical gauge to where it stood in 1993, if it ever gets there.

Still, if there is room for improvement, the gains in financial health during the last five years are sufficient to have changed the game, as they say. American households are no longer financially precarious, certainly not the way they once were. Their current financial base should easily support consumption growth at least in line with income growth, something that should sustain the present economic recovery, albeit at a still sluggish pace. If the past couple of years are any indication, such a posture should allow average real consumption growth of 2.0–2.5% a year, which, though it is less impressive than in past recoveries, can ensure a durable recovery.

If households get too comfortable, however, and turn again to debt, they could undermine this relatively pleasant prospect. Consumption growth based in debt and in excess of income gains would quickly undermine past financial rebuilding and so the economy’s ability to sustain a recovery. A debt-based rise in consumer spending might accelerate overall economic growth for a time, but then it would lose momentum, as it loses its financial base, and perhaps even turn downward. The 8.3% annualized surge in installment debt, recently reported by the Fed for May, might raise concerns that households have returned to such older, unsustainable patterns. Against this fear, however, is the sustained caution households have shown lately about debt over so many months and quarters. That pattern makes the May surge look more anomalous than anything else, leaving likelihoods that favor contained moderate consumption growth and so moderate economic growth for an extended time to come.

© Lord Abbett

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