Consumer Spending Declines During a Recession: Causes and Fixes

Introduction

Consumer spending significantly declines in a recession in a cyclical pattern, gaining or reducing velocity depending on how businesses, financial institutions, and governments interpret market conditions — all of which affect consumer confidence. At the center of what can accelerate a recession is widespread pessimism, often exhibited as fear on the part of consumers. This fear can freeze an entire nation and cause people to stop spending, which in turn accelerates the recession. As a result, consumer spending declines rapidly during a recession (Changmock, 2008). The purpose of this analysis is to evaluate why consumer spending drops so rapidly in a recession, examining each contributing factor and then exploring how the cycle can be reversed to attain economic equilibrium and growth.

State of Problem and Background

Each recession the U.S. and global economies have experienced has had different catalysts that transform an economic slowdown into two or more quarters of contracting Gross Domestic Product (Abberger & Nierhaus, 2008). The definitions of recessions vary, yet all share certain attributes: a contracting supply of capital in banks available for lending and investing, a reduction in consumer confidence, and, as a result, higher levels of unemployment and eventually higher levels of inflation on products (Abberger & Nierhaus, 2008). What made the recession that global economies experienced so severe was the massive reduction in the lending capabilities of global institutions following the collapse of the banking system and the failure of dozens of financial institutions (Deloitte Research, 2009). When lending to corporations and households begins to drastically decline, it produces a longer-term and lasting impact on the unemployment rate of each nation affected by the economic downturn (O'Reilly, 1992). This in turn fuels the cycle, as consumers who do not follow the intricacies of economic policy nonetheless pay close attention to one figure: the unemployment rate (Elliman, 2009). In effect, the unemployment rate becomes a proxy for the confidence level that consumers have in the broader economy as a whole (Changmock, 2008).

Also noteworthy about the recession that began by many estimates in the fall of 2007 is the fact that traditional monetary policies that once successfully reversed U.S. and global economic downturns were no longer as effective (Chamberlin, 2009). Keynesian economic theory had been the foundation of American economic policy for over half a century, yet with the liquidity crisis and the eventual collapse of much of the commercial banking system in the U.S. and globally, faith in this approach diminished considerably (Deloitte Research, 2009). As banking systems in the U.S. and elsewhere edged toward nationalization, consumer sentiment shifted to one of anxiety and distrust over what an entirely new banking system would mean for them personally and for their long-term investments. The anxiety and fear that fuel recessions continued to spread (Changmock, 2008).

Breaking this cycle of fear is, however, only part of resolving a recession — the problem is broader than the emotions of consumers, which act merely as a catalyst of spending declines (Abberger & Nierhaus, 2008). Because this recession was rooted in significant reductions in lending capabilities and the large-scale consolidation of the financial sector — which some described as a collapse — the need for more effective, coordinated fiscal policies between nations became critically important. The ability to move entire nations beyond the drastic GDP declines many experienced lay at the center of the economic policy strategies needed to prevent the recession from worsening (Deloitte Research, 2009).

Data Presentation, Analysis, and Findings

As a recession is defined by consensus as a reduction in GDP for two or more consecutive quarters (Abberger & Nierhaus, 2008), the many leading indicators make it clear to consumers, governments, and businesses that economic contraction is well underway. Slowdowns in capital equipment expenditures (Deloitte Research, 2009) have characterized previous recessions, while the recession beginning in 2007 was centered on the massive loss of capital resulting from subprime lending practices — specifically the bundling of fraudulently issued loans together with creditworthy ones, causing loan-based investment funds to collapse due to sustained underperformance (Abberger & Nierhaus, 2008).

Yet the subprime mortgage crisis was only a single catalyst. The multiplicative effects of subprime lending began to surface early in this recession, around mid-2007, when net borrowing by households and companies plunged by 55%, representing nearly $1.4 trillion in funds (Farrell & Lund, 2009). This immediately placed consumers in a situation of insufficient borrowing power to purchase new homes, durable goods, and consumer electronics, while also forcing businesses to drastically reduce expansion plans for new plants, equipment, and construction. The net effect of this massive contraction in borrowing capability — arriving on the heels of one of the most permissive lending periods in American and global financial history — was to expose extensive debt overhangs carried by both consumers and businesses (Changmock, 2008). With credit tightening rapidly and liquid cash becoming scarce, consumers began to drastically cut back on purchases (Walzer, 2009), further reducing the funds available for investment.

It is worth noting that the illegal activities of Bernie Madoff and others began to surface during this period. Their schemes thrived in an environment where investors in their fraudulent, unrealistically high-return programs could obtain loans to fund those investments. Madoff regularly promised investors returns exceeding 60%, which were clearly outside the theoretical boundaries of what was possible in any legitimate market (Bernard & Boyle, 2009).

Based on an analysis of bank lending practices since 2000, it is clear that this recession was more severe, more global, and more immediately damaging to consumers' ability to obtain credit than prior downturns. This is the primary catalyst of the recession's impact on consumer spending: there simply was not enough cash to lend, and when credit was extended, the terms were either restricted to borrowers with exceptionally strong credit histories or offered at interest rates that made the loan unprofitable for the borrower. Figure 1 (Time Series Analysis of Outstanding Bank Lending to Corporates) illustrates this contraction by nation (Deloitte Research, 2009).

The immediate effects on households across the U.S., UK, and European nations are illustrated in Figure 2 (Time Series Analysis of Outstanding Bank Lending to Households). The lack of available funds to lend strained even the most resilient personal financial budgets, with multiplicative effects on savings rates and investment activity. Of these two consequences, the erosion of consumer trust in investments at the onset of the recession particularly exacerbated its severity (Changmock, 2008).

Conclusion and Recommendations

Global governments have entire divisions and ministries of economists focused on these issues, yet it is very difficult to modify GDP rapidly, as it is an aggregate measure of all economic activity in a nation. What needs to happen is that economic stimulus aimed at savings and investment — not necessarily nationalization of financial institutions — must be pursued. There is an important distinction between the two: with nationalization comes the assumption of risk by a government that will naturally be among the most risk-averse actors, and therefore unable to capitalize on the growth-oriented thinking that economic recovery demands.

A financial strategy focused on restoring greater levels of trust in financial institutions through tighter regulation, combined with the development of programs to free critical resources such as oil and gas from inflationary pressure, is essential to preventing a recession from being prolonged. Stabilizing these two factors — supporting GDP growth and controlling inflation — is what can restore trust in an economy and help it turn around. There are no quick fixes to a recession; rather, the same gradual spiral that creates one must be navigated in reverse to lead a country out of it.

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