Monday Morning: Consumer saving is trouble for economy

The economy appears to be delicately balanced on a razor’s edge.

Nudged one way, it may begin to recover strongly. Nudged another, it could fall into a double-dip recession, or even into stagflation.

And unfortunately, increased consumer saving – which in normal times we want more of – may be a key driver for the economy slipping into recession mode.

There are indications the economy began to recover in late 2002 and in January.

James W. Paulsen, Minneapolis-based chief investment officer at Wells Capital Management Inc. of San Francisco, points out some of those signs in the March issue of his firm’s newsletter, Economic and Market Perspective.

First, the unemployment rate fell 0.3% in January to 5.7% “on the largest non-farm monthly job gain since November 2000,” he says.

In addition, there has been a persistent downward trend in initial unemployment claims, he notes. Furthermore, household disposable income rose 8% in 2002, “one of its fastest growth rates in the last 15 years,” Mr. Paulsen notes.

Then there are corporate earnings reports.

About 60% of corporations that reported fourth-quarter earnings met or exceeded Wall Street estimates. More significantly, among companies in the Standard & Poor’s 500 stock index, top-line sales grew by 4% in 2002, compared with a decline of 4% the previous year.

manufacturing blitz

The most significant recovery in the corporate economy, Mr. Paulsen says, has been in the manufacturing sector.

Manufacturers’ new orders are up 2%, compared with an 8% drop a year ago. And inventory building is starting to kick in. From last April, business inventories have risen each of the last eight months.

“A renewed business willingness to stock the shelves … may be a sign confidence is finally returning and may soon lead to greater employment and capital spending,” Mr. Paulsen notes.

However, one of the above figures is a conundrum. If household disposable income grew so strongly, why is consumer spending not stronger?

According to Paul Kasriel, director of economic research at Chicago’s Northern Trust Corp., real consumer spending grew marginally less in 2002 – 2.5% – than it did in 2001, when it rose 2.79%.

The shortfall is due to increased personal saving. Indeed, the personal saving rate rose to 3.9% in 2002, from 2.3% in 2001, Mr. Kasriel says. And during the fourth quarter of 2002, the figure was an exuberant 4.3%, compared with 0.8% in the year-earlier period.

The key reason for the increased saving is that consumers’ net worth fell for the third consecutive year, he says. “Households are increasing their saving rate because their retirement nest eggs have grown significantly smaller in the last three years.”

saving up, up and away?

Because of the historic relationship between net worth and income, Mr. Kasriel expects the consumer saving rate to increase to 5.5%.

Unfortunately, Mr. Kasriel’s savings projection could mean bad news for Mr. Paulsen’s economic optimism, because if personal disposable income doesn’t grow strongly, consumer spending might not increase in 2003 and could even drop as consumers save more.

And consumer spending is a key driver of the economy. Weak consumer spending would hit all of Mr. Paulsen’s positive indicators.

Even worse, the budget deficits of state governments will lead to tax increases in many states, slashing disposable consumer income. Without significant federal income tax relief, consumer spending is likely to decline even more.

Which way will the economy fall from the razor’s edge? That depends in large part how much federal tax relief individuals get to offset the state and local tax increases they have been hit with, and how quickly they receive it. It also depends to a lesser extent on the resolution of the Iraq crisis.

A quick, significant federal tax cut would enable consumers to continue to increase saving without cutting spending. And a quick, relatively painless resolution of the Iraq situation would no doubt boost the stock market, helping to rebuild damaged net worth and ease the pressure to save.

We want more personal saving in this country, but just not now.

Now we need consumption to prevent the economy from falling off that razor’s edge into renewed recession or worse.

Mike Clowes is editorial director of InvestmentNews and sister publication Pensions & Investments.