The Financial Crisis and Consumption

The U.S. consumption boom of the mid-2000s and the decline in the U.S. personal savings rate since the early 1980s have been linked to increases in the availability of consumer credit and the liquidity of wealth. More recently there has been much concern that declines in wealth—particularly housing wealth—coupled with the tighter availability of consumer credit will give rise to a prolonged period of declines or subdued growth in consumer spending. Nevertheless, rigorous time series linkages among these factors and the saving rate have not really been established, partly owing to a lack of data availability and endogeneity issues. Moreover, just as many analysts did not foresee the financial crisis, most macroeconomists failed to predict the large fall-out of the crisis on U.S. consumption, mainly because their models did not properly account for the impact of credit and liquidity constraints, which were eased during the prior boom and reversed during the current financial bust. Aside from the impact on household spending via income, the financial crisis is having credit and wealth effects on consumption via three channels, as illustrated in Figure 1, which limits visual clutter by omitting the reverse transmission from lower economic activity back to housing and mortgage markets, consumer spending, bank balance sheets, other asset prices and credit spreads. By depressing the macroeconomic outlook and raising uncertainty, the crisis has depressed stock and corporate bond prices, thereby affecting consumer spending via a stock/bond wealth effect, which can be tracked with conventional wealth measures. A second channel is through depressing the effective demand for housing, which, in turn, has a large impact on home prices and housing wealth.1 A third channel of the crisis transmits via the banks' capital losses arising from credit losses. This damage has curtailed the ability of lenders to extend credit, and has generally raised the counter-party and solvency risk posed by many.

To a large extent, the impact of the credit crunch on house prices is gauged by housing wealth estimates; similarly, the impact of credit losses on consumer credit availability can be Lower Demand for Housing Weaker Consumption ↓Home Prices & Wealth Mortgage, Housing, & Leverage Crisis Lower Capital of Financial Firms Consumer Credit Standards Tightened ↑ Counter-Party Risk, Debt & Equity Mkts Hit Figure 1: Credit/Wealth Channels of How Mortgage, Housing, & Financial Crisis Hit U.S. Consumption Outlook, ↑ Risk, ↑ Risk Aversion ↓Stock & Corp Bond Wealth, Slower Consumption Reversal prior easing of mortgage standards Effect macroeconomic backdrop/credit crunch credit losses where financial shocks & innovations alter normal links,download.