Thesis: Understanding Why Consumer Spending Declines During a Recession

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¶ … Consumer Spending Declines in a Recession

Consumer spending significantly declines in a recession in a cyclical pattern, gaining or reducing velocity depending on the interpretation of market conditions by businesses, financial institutions, governments, all impacting the consumers' confidence. At the center of what can accelerate a recession is widespread pessimism often exhibited as fear on the part of consumers. This can freeze an entire nation to stop spending, which just accelerates a recession. Consumer spending declines rapidly in a recession as a result (Changmock, 2008). The intent of this analysis is to evaluate why consumer spending drops so rapidly in a recession, evaluating the each factor and then relating them all to how the cycle can be turned around to attain economic equilibrium and growth.

State of Problem and Background

Each recession the U.S. And global economies have experienced have different catalysts that transform them from am economic slowdown to two or more quarters of contracting Gross Domestic Product (Abberger, Nierhaus, 2008). The definitions of recessions vary yet all share the attributes of a contracting amount of currency in banks 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 makes the recession the global economies are experiencing today so server has been the massive reduction in lending capabilities of global institutions given the collapse of the banking system and the fall of dozens of financial institutions (Deloitte Research, 2009). When lending to corporations and homes begins to drastically decline there is a longer-term and permanent impact to the unemployment rate of each nation impacted by the economic downturn (O'Reilly, 1992). This in turn fuels the cycle as consumers who don't follow the intricacies of economic policy do pay attention to one figure, and that's the unemployment rate (Elliman, 2009). In effect the unemployment rate becomes a proxy for the confidence level consumers have in the broader economy as a whole (Changmock, 2008).

What is also noteworthy about the existing recession which began by many estimates in the Fall of 2007 is the fact that traditional monetary policies that worked to turn around the U.S. And global economies no longer are as effective as they once were (Chamberlin, 2009). Keynesian economic theory had been the foundation of American economic policies 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 there is less faith in this approach to economies than had been in the past (Deloitte Research, 2009). As banking systems in the U.S. And elsewhere edge towards nationalization the sentiment of consumers continues to one of anxiety and lack of trust over what the entirely new banking system will be for them personally and for their long-term investment, the anxiety and fear that is the fuel of recessions continues (Changmock, 2008). Breaking this cycle of fear is however just part of the resolution of a recession; it's much broader than the emotions of consumers which act as a catalyst of spending declines (Abberger, Nierhaus, 2008). As this recession is based on significant reductions in lending capabilities and the en masse consolidation of the financial sector, which some are calling a collapse, the need for more effective, coordinated fiscal policies between nations is critically important. The ability to move entire nations beyond the drastic declines many have seen in their GDP is at the center of the economic policy strategies needed to stop a recession for worsening (Deloitte Research, 2009). The next section of this report, data presentation, analysis and findings discusses the cycle of how recessions perpetuate themselves and this analysis concludes with recommendations on how to correct them.

Data Presentation, Analysis and Findings

As a recession by consensus definition is a reduction in GDP for two or more quarters (Abberger, Nierhaus, 2008) the many leading indicators make it clear to consumers, governments and businesses that economic contraction is well underway. Slow-down in capital equipment expenditures (Deloitte Research, 2009) have marked previous recession while the current one has been centered on the massive loss of capital as a result of the subprime lending practices of bundling fraudulently given loans with creditworthy ones, with the net result being loan-based investment funds collapsing due to lack of fund performance over time (Abberger, Nierhaus, 2008). Yet this was just a single catalyst; in fact the multiplicative effects of subprime lending began to occur early in this recession in the mid-2007 timeframe when net borrowing by households and companies plunged 55%, representing nearly $1.4 trillion in funds (Farrell, Lund, 2009). This immediately placed consumers into a situation of not having the borrowing power to purchase new home, durable goods, and consumer electronics and also forced businesses to drastically reduce their expansion plans for new plants, equipment and construction. The net effect of this massive contraction of borrowing capability, coming on the heels of one of the most lax lending periods in American and global financial history, was to expose extensive debt overhangs of both consumers and businesses (Changmock, 2008). With credit tightening rapidly and liquidity of cash becoming scare quickly, consumers began to also drastically cut back on purchases (Walzer, 2009) further fueling the reduction in available funds to invest. It is no wonder that the illegal activities of Bernie Madoff and others began to surface during this time; their schemes and illegal businesses thrived in an environment where investors in their illegal and ridiculously high rate of return-based programs could get funds loaned to them to invest. Madoff regularly promised investors over 60% returns, which were clearly outside the theoretical boundaries of what was possible (Bernard, Boyle, 2009).

Consumers stop spending in this recession because they lost faith and trust in financial institutions and quit investing in the stock market as they no longer trusted the Securities and Exchange Commission (SEC) to protect their investments. This is one of several factors, and the SEC was no longer seen as trustworthy after the Madoff Scandal had been reported to them years earlier and they ignored it (Bernard, Boyle, 2009). As a result of this reduction in consumer spending the net returns on 401Ks plummeted by an average of 30% in 2008 (Deloitte Research, 2009).

In addition to the lack of trust in financial institutions and increasing wariness of how the government is managing the economy, consumer disposable incomes are also hit with inflation, or rising costs from oil, gas, and the many supply chains that are dependent on these sources of energy to operate effectively (Clauson, Kaufman, 2009). As a recession constricts the flow of capital for investment, the costs of fuel increase thereby driving up the costs of food, gasoline, textiles and many other goods that rely on their supply chains for fulfillment (Clauson, Kaufman, 2009). As consumers see these costs increasing they continue to reinforce their spending declines, thereby continuing the recession as a result. The net effect of all this is the reduction in discretionary consumer spending which just adds to the cycle over time and further makes recovery difficult as governments must face the challenge of turning around GDP at an aggregate level while also contending with the factors causing inflation. Fuel price increases are actually a leading indicator of recessions as they impact consumers fit, and then are multiplied through supply chains, eventually driving up the costs of delivering goods and services over time (Clauson, Kaufman, 2009).

Based on an analysis of bank lending practices since 2000 to corporations it is clear that this recession is more severe, global and immediately impacting consumers' ability to gain credit as a result. This is the primary catalyst of this recessions' impact on the reduction of spending by consumers -- there simply is not enough cash to lend, and when it is lent, the terms are either only for those with exceptionally strong credit or at interest rates that make the loan unprofitable for the borrower. Figure 1: Time Series Analysis of Outstanding Bank Lending To Corporates, illustrate the time series data analysis by nation.

Figure 1:

Time Series Analysis of Outstanding Bank Lending To Corporates

Source:

(Deloitte Research, 2009)

The immediate effects of this on households across the U.S., UK, and European nations can be seen in Figure 2: Time Series Analysis of Outstanding Bank Lending To Households. Clearly the lack of available funds to loan stresses even the most resilient personal financial budget as the figures shown in Figure 2 are also having a multiplicative effect on savings rates and investment. Of these two, consumers' lack of trust in investments at the onset of this recession has just exacerbated it (Changmock, 2008).

Figure 2: Time Series Analysis of Outstanding Bank Lending To Households

Source: (Deloitte Research, 2009)

Conclusion and Recommendation

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… [END OF PREVIEW]

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