Huh? Consumers Are Spending Again?

President Barack Obama and his economic advisors pushed hard for nearly $800 billion in additional federal spending and tax cuts to prime the economy because consumer spending had fallen off a cliff. The only way that the economy could recover, they argued, was by increasing aggregate demand through massive infusions of money into the economy. New data suggest their forecasts of what was needed to bring economy out of recession were about as inaccurate as the ones forecasting the recession–off by wide margins.

According the Washignton Post, then President-elect Obama gathered his economic team in Chicago before taking office to discuss the economy and what was needed to stem the economic recession.

Then, on Dec. 16, the staff assembled to hear Christina Romer, Lawrence H. Summers, Timothy F. Geithner and others describe an economy in a state of near-free fall.

Romer, an MIT-educated economist, took on the role of selling Obama on the need for a much larger fiscal stimulus package than had been proposed.

She had charts, graphs and a sheaf of ominous economic indicators — “numbers we’d all been looking at our whole lives,” another senior adviser said, “and had never seen anything like before.”

Just three months earlier, as the global reach of the subprime mortgage crisis came into view, economists talked about the need for a fiscal stimulus of as much as $150 billion. In internal conversations, the Obama transition team had concluded that the amount would have to be much larger.

On this day, Romer, Summers and others outlined a package of public works spending, unemployment benefits expansion and tax cuts more than four times that size. The economy was contracting at an annual rate of 6.5 percent, the fastest since 1982.

During her presentation, Romer told Obama that Americans had yet to have their “holy [expletive]” moment over the economy, a phrase she had borrowed moments earlier from the more profane David Axelrod, Obama’s senior political adviser.

The most recent data from the U.S. Bureau of Economic Analayis cast serious doubt on the wisdom of that advice. While the economy appears to have contracted by 6.1 percent (Gross Domestic Product on an annualized basis) from January through March 2009, a higher rate of contraction than expected, the bright spot was a dramatic increase in consumer spending!

Real personal consumption expenditures increased 2.2 percent in the first quarter, in contrast to a decrease of 4.3 percent in the fourth. Durable goods increased 9.4 percent, in contrast to a decrease of 22.1 percent. Nondurable goods increased 1.3 percent, in contrast to a decrease of 9.4 percent. Services increased 1.5 percent, the same increase as in the fourth.

What’s going on here? For one, perhaps, this recession is a lot more conventional than many economists thought. As the housing bubble burst, and the financial markets became locked in the uncertainty of the subprime mortgage crisis, consumer spending took a nose dive. Households had to re-evaluate what their spending priorities were and what they could afford. Notably, this was a time when employment remained pretty high (unemployment rates were still very low historically), so incomes were still steady. Now, having re-set their priorities, consumers have started spending again. (Unemployment was 8.5 percent in March, high but below the levels of the 1982-83 recession.)

Naturally, private business sector spending would be expected to lag as they adjust to fewer people coming in their doors to buy goods and services. The first quarter data bear this out as well:

Real nonresidential fixed investment decreased 37.9 percent in the first quarter, compared with a decrease of 21.7 percent in the fourth. Nonresidential structures decreased 44.2 percent, compared with a decrease of 9.4 percent. Equipment and software decreased 33.8 percent, compared with a decrease of 28.1 percent. Real residential fixed investment decreased 38.0 percent, compared with a decrease of 22.8 percent.

This is perfectly understandable and boringly conventional. Businesses need to get rid of excess inventories so they can begin stocking the items consumers really want absent the distortions of bubble markets and easy money. With the real-estate market is a bonafide recession, and consumer’s spooked by high consumer debt and uncertain mortgages, businesses had to re-assess the consumer market. They naturally pull back before putting stuff back on the shelves again.

In other words, this recession is doing what every recession should do–re-calibrate the economy based on the real wants of consumers. It’s an adjustment, made bigger and more visible by the extraordinary housing bubble that really threw household spending for a loop. Now, things are getting sorted out.

Bottom line: Expect third quarter results to show an even stronger economy, even if the overall GDP numbers are still flat or a little down.

Lesson: All this re-jiggering happened before the stimulus package was passed and well before any meaningful dollars began to trickle into the economy. (On this, see previous blog posts here and here.)

Reason Foundation’s complete bailout and financial crisis coverage can be found here.

Samuel R. Staley, Ph.D. is a senior research fellow at Reason Foundation and managing director of the DeVoe L. Moore Center at Florida State University in Tallahassee where he teaches graduate and undergraduate courses in urban planning, regulation, and urban economics. Prior to joining Florida State, Staley was director of urban growth and land-use policy for Reason Foundation where he helped establish its urban policy program in 1997.