Wednesday, November 4, 2009

The Recession and the ‘Paradox of Thrift’

Copyright, The New York Times Company
One bit of conventional wisdom about this recession is that it was caused, or at least significantly worsened, by a “ paradox of thrift”: Consumers suddenly ceased to be willing or able to spend like they once did. An alternative interpretation puts the labor market at ground zero, and sees the spending decline merely as a reaction to the labor market.

Was spending or the labor market the fundamental driver in this recession? Causality is always hard to disentangle, but one fact is worth noting: Consumer spending fell much less than did the labor market.

The chart below displays inflation-adjusted private consumer spending, alongside hours worked in the labor market (the product of employment and hours worked per employee), for each month of this recession.

Each series is displayed as an index, with its value at the start of the recession (December 2007) set to 100. Consumer spending normally trends up more than employment does, so I have adjusted for that by removing prior trends from consumer spending and work hours.

For example, a value of 95 for real consumer spending in September 2009 means that inflation-adjusted consumer spending in September 2009 was 5 percent below what it would have been had it continued its previous trend since December 2007.

Consumer spending fell significantly during the months of 2008, a drop that sorely hurt manufacturing and other industries. But labor fell at least as much for the first nine months of 2008, and fell a lot more since then.

Through September 2009, work hours were 11 percent below trend, while consumer spending was “only” 5 percent below trend.

The economic news first started getting widespread attention in September 2009 when Lehman failed and credit markets froze. Since that time, consumer spending only fell only two percentage points further below its trend while labor fell another eight.

While it is conceivable that a few percentage points’ decline in consumption could cause a many-fold reduction in work hours, it seems more likely that the reduced consumer spending was mainly a reaction to layoffs and hours cuts. The roots of this recession go a lot deeper than the paradox of thrift.

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