We have often written about the dramatic increase in leverage that took place from the early 1980s through 2007. Commercial and investment banks doubled their leverage, or more, from historical levels. Over the same period, consumer debt as a percentage of GDP doubled from approximately 50% to 100%. Pundits have suggested that, with personal consumption expenditures at roughly 70% of GDP, US economic growth will remain moribund until consumers once again ratchet up their spending. While it is true that a healthy consumer is an important component of a healthy economy, largely missing from the conversation has been a discussion of just what constitutes a healthy consumer and what represents a healthy level of personal consumption as a percentage of GDP.
Gross Domestic Product is the sum of private and public consumption, investment, and net exports. During the Great Depression domestic investment and international trade collapsed, leaving GDP almost entirely a function of personal consumption and government expenditures. Throughout the 1930s personal consumption expenditures accounted for more than 70% of GDP, reaching a high of 83% in 1933. With the onset of WWII, personal consumption expenditures dropped dramatically, bottoming at 49.4% of GDP in 1944 while government expenditures skyrocketed, peaking at 47.9% in the same year.
The Great Depression and WWII left US consumers starving for goods and services. After more than 15 years of pent-up demand, personal consumption expenditures exceeded 65% of GDP in all but two quarters from the 1st quarter of 1947 through the 3rd quarter of 1950, peaking at just over 68% in the 4th quarter of 1949. However, it would not reach that level again until the 3rd quarter of 1999. From 1951 through 1984 personal consumption expenditures averaged 62.35% of GDP, but climbed steadily higher over the subsequent 17 years. It has averaged 69.86% from 2001 through the first half of this year. At current levels, personal consumption expenditures as a percentage of GDP is two standard deviations above its mean level of the last 60 years (Chart 1).
Not surprisingly, government expenditures were low and net exports high as a percentage of GDP in the aftermath of WWII. On an absolute basis, US government expenditures declined each year from 1945 through 1947. With much of Europe and Asia in ruins, the US became manufacturer to the world. However, by the early 1950s net exports had declined significantly, generally ranging from modestly negative to modestly positive from 1950 through the mid 1970s. From the early 1980s through 2005, with the exception of the period from 1988 to 1992, the US trade balance steadily deteriorated (Chart 2).
Generally, domestic investment has bounced between approximately 13% and 19% of GDP over the last 60 years. However, after reaching 17.72% of GDP in the 1st quarter of 2006, it has declined in each subsequent quarter with the exception of the 2nd quarter of 2008. It fell dramatically in the first two quarters of 2009 and now stands at 11.02%, more than three standard deviations from its long-term average (Chart 4).
After the recession in 1982, financial institutions and consumers spent 25 years levering their balance sheets. As they did so, consumption grew steadily as a percentage of GDP. Household debt doubled as a percentage of GDP as consumers barrowed to sustain lifestyles their income couldn’t support. As financial institutions de-lever, consumers will be forced to do so as well. As such, consumption as a percentage of GDP is likely to decline as consumers spend less, pay down debt, and save more. Despite the challenge this poses to economic growth in the near-term, healthier consumer balance sheets are imperative to the long-term health of the US economy. Personal consumption expenditures as a percentage of GDP are likely to decline to a more sustainable level, which we suggest is closer to 64-66% than 70%.
Meanwhile, domestic investment has declined to post-WWII lows as a percentage of GDP and is now three standard deviations below its mean level of the last 60 years. This represents a collapse of epic proportions. Businesses have drawn down inventories each of the last six quarters, massively so over the last two. By the 2nd quarter of 2009, real residential investment had declined 56% from its peak reached in the 4th quarter of 2005. Meanwhile, real investment in equipment and software has declined more than 21% over the last six quarters. We believe that government initiatives have thwarted what would have been a collapse of the US economy. As the economy recovers, domestic fixed investment is likely to increase substantially over the next several quarters.
Real imports peaked in the 3rd quarter of 2007 and have since declined more than 20%. Over the same period real exports are down just over 9.50%. As a result, net exports, while still negative, have risen dramatically over the last three years and the US trade deficit has been more than halved. Global growth will likely to be led by emerging economies over the subsequent three to five years. This, in conjunction with US consumers saving more and spending less, is likely to result in further improvement in the US balance of trade. While it is unlikely to turn positive, the trade balance will likely remain significantly smaller than it had been from 2002 through 2008.
This brings us back to our initial discussion of the components of GDP: GDP = Consumption (personal consumption expenditures + government expenditures) + Domestic Fixed Investment + Net Exports. The consumer needs to become a smaller portion of gross domestic product if the US is to develop a truly sustainable economic recovery. But for a given level of GDP, if personal consumption expenditures decline as a percentage of GDP, one or more of the other components must increase. Despite the fiscal stimulus, it is not necessarily apparent that government expenditures will dramatically increase as a percentage of GDP. That is because state governments, which have massive holes in their budgets and appear likely to cut programs and spending, comprise two thirds of total government spending. Even if overall government spending significantly increases as a percentage of GDP, this is only a short-term solution.
A healthy long-term solution to plugging the hole that will be created by reduced consumer spending as a percentage of GDP is savings-driven growth in the domestic investment. Altering the consumption/savings/investment mix within the US economy such that we consume less, and save and investment more will result in healthier consumer balance sheets and a more competitive, and sustainable, economic model. This is not a choice, but rather a requirement, if America plans to compete in the global economy of the 21st century.