Consumption and the Great Recession Mariacristina De Nardi, Eric French, and David Benson Introduction and summary the second-worst rebound observed in the data followed The Great Recession of 2008–09 was characterized by the 1974 recession and lasted just over one year. We the most severe year-over-year decline in consumption find that this persistence is reflected most in the sub- the United States had experienced since 1945. The components of nondurables and especially in services. consumption slump was both deep and long lived. It Our main findings from the analysis of the micro- took almost 12 quarters for total real personal con- data are as follows. First, expected nominal income sumption expenditures (PCE) to go back to its level growth declined significantly during the Great Recession. at the previous peak (2007:Q4). This is the worst drop ever observed in these data, and In this article, we document key facts about aggre- this measure has not yet fully recovered to pre-recession gate consumption and its subcomponents over time levels. Second, the decline exists for all age groups, and look at the behavior of important determinants of consumption, such as consumers’ expectations about Mariacristina De Nardi is a senior economist and research their future income and changes in consumers’ wealth advisor; Eric French is a senior economist and research advisor; positions related to house prices and stock valuations. and David Benson is an associate economist in the Economic Then, we use a simple permanent-income model to Research Department of the Federal Reserve Bank of Chicago. The authors thank Richard Porter and an anonymous referee determine whether the observed drop in consumption for helpful comments and Helen Koshy for editorial advice. can be explained by these observed drops in wealth and income expectations. © 2012 Federal Reserve Bank of Chicago We begin our data analysis by using macroeco- Economic Perspectives is published by the Economic Research Department of the Federal Reserve Bank of Chicago. The views nomic data to study the behavior of consumption and expressed are the authors’ and do not necessarily reflect the views its subcomponents. We then use microeconomic data of the Federal Reserve Bank of Chicago or the Federal Reserve from the Reuters/University of Michigan Surveys of System. 1 Charles L. Evans, President ; Daniel G. Sullivan, Executive Vice Consumers to study nominal expected income growth President and Director of Research; Spencer Krane, Senior Vice and inflationary expectations. President and Economic Advisor; David Marshall, Senior Vice Our main findings from the macrodata are the fol- President, financial markets group; Daniel Aaronson, Vice President, microeconomic policy research; Jonas D. M. Fisher, Vice President, lowing. First, the Great Recession marked the most macroeconomic policy research; Richard Heckinger,Vice President, severe and persistent decline in aggregate consump- markets team; Anna L. Paulson, Vice President, finance team; William A. Testa, Vice President, regional programs, Richard D. tion since World War II. All subcomponents of con- Porter, Vice President and Economics Editor; Helen Koshy and sumption declined during this period. However, the Han Y. Choi, Editors; Rita Molloy and Julia Baker, Production large drop in services consumption stands out most, Editors; Sheila A. Mangler, Editorial Assistant. Economic Perspectives articles may be reproduced in whole or in relative to previous recessions. Second, while the de- part, provided the articles are not reproduced or distributed for cline was historic, the trends in consumption and its commercial gain and provided the source is appropriately credited. subcomponents leading up the recession were not Prior written permission must be obtained for any other reproduc- tion, distribution, republication, or creation of derivative works substantially different from past recessionary periods. of Economic Perspectives articles. To request permission, please Third, the recovery path of consumption following contact Helen Koshy, senior editor, at 312-322-5830 or email the Great Recession has been uncharacteristically weak. [email protected]. It took nearly three years for total consumption to re- ISSN 0164-0682 turn to its level just prior to the recession. In contrast, Federal Reserve Bank of Chicago 1 education levels, and income quin- FIGURE 1 tiles. Relative to previous recessions, Level of real personal consumption expenditures those with higher levels of income and education are more pessimistic billions of 2005 dollars coming out of this recession than 10,000 their poorer and less-educated counterparts. Third, expectations 8,000 for real income growth have also declined, and the decline in expected 6,000 real income growth is more severe when personal inflation expectations 4,000 are used instead of actual Consumer Price Index (CPI) inflation. Fourth, 2,000 expected income growth is a strong predictor of actual future income 0 growth. Since expected income 1962 ’70 ’78 ’86 ’94 2002 ’10 growth is a very important determi- Note: PCE is personal consumption expenditures. nant of consumption decisions, the Source: Haver Analytics. observed drop in expected income has the potential to explain at least part of the observed decline in FIGURE 2 consumption. Nominal PCE to nominal GDP ratio during recessions since 1962 In the context of a simple perma- nent-income model, we find that the PCE – GDP ratio negative wealth effect (coming from 0.72 decreased stock market valuations 0.70 and housing prices) and consumers’ 0.68 decreased income expectations were 0.66 big factors in determining the ob- 0.64 served consumption drop. In fact, 0.62 we find that in this model, the ob- served drops in wealth and income 0.60 expectations can explain the observed 0.58 drop in consumption in its entirety, 0.56 depending on what we assume about 0.54 1962 ’68 ’74 ’80 ’86 ’92 ’98 2004 ’10 future income growth beyond the time horizon covered by the Reuters/ Notes: PCE is personal consumption expenditures; GDP is gross domestic product. Shaded areas indicate recession periods as defined by the National University of Michigan Surveys of Bureau of Economic Research. Consumers data set. Source: Haver Analytics. Reinhart and Rogoff (2009) have stressed the similarities be- tween the current financial crisis and many earlier ones shows a flattening out of the consumption growth rate stretching across centuries, continents, and economies. in 2008–09. The fact that this pattern is clearly visible, These crises entailed large declines in real housing even over a period of almost 50 years, highlights the prices, equity collapses, and profound declines in out- severity and persistence of the Great Recession and put and employment. They emphasize the importance the very slow recovery that is following it. of balance sheet repair. We complement their research Figure 2 shows that consumption growth outpaced by emphasizing the role played by consumers’ income gross domestic product (GDP) growth through past expectations, as well as wealth effects. recessionary periods. The nominal PCE–GDP ratio has increased in each recession since 1962. In contrast, Macrodata: Total real PCE during the Great Recession, it increased more modestly. Figure 1 displays the level of real PCE from 1962 Since the latest recession, this ratio has either fallen to 2011:Q3. Even over this long horizon, the chart or stagnated. Thus, as a share of GDP, consumption 2 1Q/2012, Economic Perspectives has been hit harder than in previous FIGURE 3 recessions. Normalized real PCE levels over recession periods Petev, Pistaferri, and Eksten (2011) document that while real per peak level = 1 capita consumption declined mono- 1.20 tonically until the middle of 2009, 1.15 real per capita disposable income 1.10 was relatively stable and its decline was significantly smaller. This stabil- 1.05 ity in per capita income is explained 1.00 entirely by a strong increase in gov- 0.95 ernment transfers to households, as wages and financial income fell. The 0.90 increase in government transfers was 0.85 partly due to higher take-up rates 0.80 for unemployment insurance and −16 −14 −12 −10 −8 −6 −4 −2 0624 8 10 12 14 16 food stamps and partly due to the quarters since peak increased generosity of means-test- 1973:Q4 1981:Q3 2001:Q1 ed programs enacted by the federal 1980:Q1 1990:Q3 2007:Q4 government (such as extended un- employment benefits and increases Note: PCE is personal consumption expenditures. Sources: Haver Analytics and authors’ calculations. in food stamps and emergency cash assistance). Given that these transfers are means tested, they primarily help poorer households. Consistent with FIGURE 4 this finding, we find that in the Real total quarterly PCE growth over 2008–09 Reuters/University of Michigan versus previous recessions since 1974 Surveys of Consumers, the drop in quarterly growth (annual rate) income expectations for the next 6 12 months among poor households was smaller than that among all 4 other households. 2 Figure 3 compares the time path of real PCE over several recession- 0 ary time periods, where the level of PCE is normalized to 1 at the busi- −2 ness cycle peak (as defined by the National Bureau of Economic −4 Research, NBER) prior to each −6 recession. The NBER dates for −16 −14 −12 −10 −8 −6 −4 −2 0624 8 10 12 14 16 the recessions’ peaks are 1973:Q4, quarters since peak 1980:Q1, 1981:Q3, 1990:Q3, Average of previous recessions 2001:Q1, and 2007:Q4. 2007:Q4 Figure 3 highlights that in the 2008–09 recession, consumption Note: PCE is personal consumption expenditures. dropped 3.4 percent from peak to Sources: Haver Analytics and authors’ calculations. trough (six quarters after the peak) and was slow to increase afterward. This pattern contrasts with every other recession since Figure 4 displays the time path of the real PCE 1974.