Is the U.S. Economy So Bad It Can't Get Much Worse?


New and existing home sales are at drastic lows. Consumer sentiment is extremely weak. Auto sales in August hit a floor not seen in decades. The unemployment rate remains close to double-digits. It's easy to go on and on about some of the grim features of the current U.S. economy. In fact, things are so awful that you could ask: are things so bad already that they can't get much worse?

This claim was made by a Bank of America economist in a Bloomberg article on Thursday. It says:

The sectors of the economy that traditionally drive it into recession are already so depressed it's difficult to see them getting a lot worse, said Ethan Harris, head of developed markets economics research at BofA Merrill Lynch Global Research in New York. Inventories are near record lows in proportion to sales, residential construction is less than half the level of the housing boom and vehicle sales are more than 30 percent below five years ago.

His point is well-taken. Some of these figures are already so brutally low that it's hard to imagine that they could sink much further. And if the economy keeps even its current sluggish pace, then the U.S. won't double dip -- it will just endure a painfully slow recovery. But is Harris right -- are things so bad that it's actually unrealistic to imagine they could get much worse?

One way to determine this would be to look at sales data. But that's not enough. There are lots of moving variables that can affect sales like population, wages, taxes, etc. So let's look at the ratio of personal consumption expenditures to personal disposable income. That should provide a good measure of how willing consumers are to spend. The ratio serves as a sort of economic comfort indicator based on the amount of the money people have they can and are spending. If the ratio is already at a very low level historically, then the thesis above is correct, and it would be very unlikely to see it fall much further.

consumption to income ratio 2010-07.png

This is a trailing three-month average of the ratio, which helps get rid of some of the noise. As you can see, consumption spending-to-disposable income has fallen recently, but still stands at 0.907 -- well above its 2009 low of 0.894. That variance might not seem like a lot, but it's a difference of $130 billion in annual spending.

So how big a change is that in terms of the entire U.S. economy? Let's imagine that consumer confidence fell further and drove spending to match that 2009 ratio low, with everything else remaining constant since the end of the second quarter. That $130 billion decline in spending would bring down GDP by 0.9%.

You may notice from the chart that there's an even deeper low that was hit in 1992, when the ratio was at 0.892. If spending dropped to that point, GDP would decline by $155 billion and GDP would drop 1.1%. Certainly, such outcomes are clearly within the realm of possibility, if consumers felt renewed uneasiness about the economy.

And what happens if GDP declines due to consumption? Businesses would sense weaker demand and would respond with additional layoffs. That would then reduce GDP even further. The dominos could continue to fall after that, pushing consumer confidence down even more.

Of course, if such a negative GDP move persisted for a few quarters, then the dreaded double dip would be upon us. So things aren't so bad that a double dip is out of the question. But even if the U.S. did double dip, considering how weak the economy is already, the dip would probably be a relatively shallow one, compared to the deep GDP declines we saw in late 2008 through early 2009.

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