Consumption and the Great Recession

Abstract

Introduction and summary The Great Recession of 2008-09 was characterized by the most severe year-over-year decline in consumption the United States had experienced since 1945. The consumption slump was both deep and long lived. It took almost 12 quarters for total real personal consumption expenditures (PCE) to go back to its level at the previous peak (2007:Q4). In this article, we document key facts about aggregate consumption and its subcomponents over time and look at the behavior of important determinants of consumption, such as consumers' expectations about their future income and changes in consumers' wealth positions related to house prices and stock valuations. Then, we use a simple permanent-income model to determine whether the observed drop in consumption can be explained by these observed drops in wealth and income expectations. We begin our data analysis by using macroeconomic data to study the behavior of consumption and its subcomponents. We then use microeconomic data from the Reuters/University of Michigan Surveys of Consumers (1) to study nominal expected income growth and inflationary expectations. Our main findings from the macrodata are the following. First, the Great Recession marked the most severe and persistent decline in aggregate consumption since World War II. All subcomponents of consumption declined during this period. However, the large drop in services consumption stands out most, relative to previous recessions. Second, while the decline was historic, the trends in consumption and its subcomponents leading up the recession were not substantially different from past recessionary periods. Third, the recovery path of consumption following the Great Recession has been uncharacteristically weak. It took nearly three years for total consumption to return to its level just prior to the recession. In contrast, the second-worst rebound observed in the data followed the 1974 recession and lasted just over one year. We find that this persistence is reflected most in the subcomponents of nondurables and especially in services. Our main findings from the analysis of the microdata are as follows. First, expected nominal income growth declined significantly during the Great Recession. This is the worst drop ever observed in these data, and this measure has not yet fully recovered to pre-recession levels. Second, the decline exists for all age groups, education levels, and income quintiles. Relative to previous recessions, those with higher levels of income and education are more pessimistic coming out of this recession than their poorer and less-educated counterparts. Third, expectations for real income growth have also declined, and the decline in expected real income growth is more severe when personal inflation expectations are used instead of actual Consumer Price Index (CPI) inflation. Fourth, expected income growth is a strong predictor of actual future income growth. Since expected income growth is a very important determinant of consumption decisions, the observed drop in expected income has the potential to explain at least part of the observed decline in consumption. [FIGURE 1 OMITTED] [FIGURE 2 OMITTED] In the context of a simple permanent-income model, we find that the negative wealth effect (coming from decreased stock market valuations and housing prices) and consumers' decreased income expectations were big factors in determining the observed consumption drop. In fact, we find that in this model, the observed drops in wealth and income expectations can explain the observed drop in consumption in its entirety, depending on what we assume about future income growth beyond the time horizon covered by the Reuters/ University of Michigan Surveys of Consumers data set. Reinhart and Rogoff (2009) have stressed the similarities between the current financial crisis and many earlier ones stretching across centuries, continents, and economies. …