Household Reaction to the Financial Crisis: Scared or Scarred?

Abstract

The current financial and economic crisis has been characterized as the worst since the Great Depression. While the crisis may be bottoming out, its effects may linger for quite some time. After all, the Great Depression left an entire generation of Americans scarred by their experiences. Times were good, the stock market was booming, and then suddenly it all fell apart. The stock market collapsed, firms went bankrupt, jobs disappeared, large numbers of banks failed and confidence in the economy withered. Many Americans faced poverty and a desperation they never expected.For many Americans today, the similarities are frightening. Household net worth has plummeted, the unemployment rate has soared, foreclosures and bankruptcies have risen sharply and banks are failing. In response, the personal saving rate has risen significantly as many households have cut back spending. However, it is too early to tell how persistent these responses will be. It wasn’t just the depth of the Great Depression that affected subsequent behavior, it was its persistence. The economy didn’t bounce back. Had the downturn been sharp, but relatively short, people would have been scared and suffered economic and emotional pain. They would have had to try to rebuild their wealth and their lives, but this would have been made easier by a recovering economy. Thus, it is less likely that they would have been scarred so deeply that many of the survivors retained a lifelong fear of experiencing another Great Depression, causing them to become more financially conservative, wary of taking on debt and distrustful of financial markets.How will Americans respond to the current crisis? It is hard to gauge the outcome because we do not have a similar recent experience that can be used as a benchmark. Certainly, we have experienced recessions, and even a wave of bank failures in the late 1980s and early 1990s, but they didn’t persist. On the other hand, Japan experienced a malaise that rivaled the Great Depression in length, but not in depth, yet still created its own “Lost Generation.” Thus, the present financial crisis is an unprecedented experience for the current generation. Free-spending and optimistic Americans accumulated massive amounts of debt. Of course, they had growing incomes and wealth they thought (or at least hoped) would enable them to meet their obligations and still have a comfortable retirement. However, as the values of the assets they had used as collateral collapsed, and many lost the jobs that generated the income from which they were making their debt service payments, defaults and foreclosures became widespread. Confidence in financial markets, and the economy more generally, evaporated for many, only to be replaced with uncertainty about future prospects, both for their families and the economy overall. Many Americans will cut their spending sharply out of necessity, others out of fear of what the future holds. Saving rates have already risen substantially. Thus, we are facing the “paradox of thrift” as households try to rebuild their net worth, with the reduced spending likely to delay and weaken recovery from the “Great Recession.” With consumer expenditures accounting for about two-thirds of GDP, severe cutbacks in household spending could prolong our economic malaise, increasing the risk of a more permanent retrenchment of consumer expenditures. But the current uncertainty also will hold back business investment spending, further restraining recovery. With widespread projections that high unemployment and low house prices will be with us for an extended period, as well as the rise in problem loans at banks that will restrain their willingness and ability to provide credit, it is unlikely that the dramatic rise in loan delinquencies, home foreclosures and bankruptcies will soon abate by a meaningful amount.Unfortunately, we face the possibility of being caught in a vicious circle. The cutbacks in consumer and business spending are likely to contribute to a more anemic recovery. A slower recovery, in turn, will likely deepen and prolong the weakness in consumer and business spending, further undermining the recovery. The longer the malaise in economic activity continues, the more likely that diminished spending persists, adversely affecting future economic growth and the standard of living.