Are U.S. Households Living Beyond Their Means?

• Author: Chris Faulkner-MacDonagh/Martin Mühleisen
• Position: Economist/Deputy Division Chief in the IMF's Western Hemisphere Department
• Pages: 36-39

Consumer spending, household wealth, and real estate prices in the United States

Page 36

The boom in consumer spending, now in its 12th year, has weathered many adverse shocks that have hit the U.S. economy in recent years, including terrorist attacks and heightened security concerns, a sharp decline in equity prices and the 2001 recession, and a series of corporate and financial scandals. Throughout, resilient household demand has not only sustained domestic growth but has also played a key role in supporting the global economy.

Some observers, however, have viewed the surge in consumer spending with apprehension. The personal saving rate has fallen to historic lows, consumer debt levels have risen, and the household home equity ratio has dropped to an all-time low. This has led to concern that the rise in private consumption may not be sustainable and that a subsequent weakening could throw the recovery off track. Fears have especially been expressed that consumers could be exposed to a collapse of what many view as a housing "bubble" in the United States, given the spectacular increase in real estate prices in some markets.

So are U.S. consumers living beyond their means? Examining the evidence based on background work for the IMF's 2003 Article IV consultation with the United States-the annual round of discussions on macroeconomic and structural policies-this article finds that U.S. households are in a better financial position than they may appear.

Page 37

Why household spending is strong

The strength of U.S. consumer spending is closely related to increases in personal incomes and wealth. Households have benefited from the rise in housing and stock markets over the past decade, with net housing and equity wealth rising by $3 1/4 trillion and $2 #/4 trillion, respectively, between the end of 1995 and the second quarter of 2003. Other components of financial wealth-primarily cash and bond holdings-also rose strongly, by $6 1/2 trillion, bringing the total increase in personal wealth to about 120 percent of GDP during this period. As shown in Chart 1, there has been a close inverse relationship between household net worth and the personal saving rate, consistent with the permanent income hypothesis, under which household expenditures respond principally to changes in long-term wealth rather than short-term fluctuations in income.

In addition, consumer spending has been supported by expansionary macroeconomic policies over the past three years. A series of tax cuts has contributed to a $230 billion decline in personal income tax payments to the federal government, and government spending has increased. The economic forecasting firm Macroeconomic Advisers estimates that federal, state, and local fiscal stimulus added 1-2 1/2 percentage points to growth every year during 2001-3.

The effect of monetary policy has also been significant. Action by the Federal Reserve to lower the federal funds target rate from 6 1/2 percent in 2000 to 1 percent in 2003-a 50-year low-has spurred successive waves of mortgage refinancing, releasing substantial financial resources to fund consumer spending. This has been facilitated by innovation and improved risk management in U.S. financial markets, broadening household access to credit and providing consumers with greater flexibility in managing balance sheets.

In addition to mortgage refinancing, households have borrowed from other sources to finance consumption purchases, including higher credit card debt and short-term personal loans. Debt ratios have steadily increased since the mid-1990s, reaching a record high of 115 percent of disposable income in mid-2003 (see Chart 2). Although the increase in private...