The Effect of the Financial Crisis on Ordinary Lives

I’ve gotten a couple questions along the lines of: What do the crisis, the recession, and the recovery (of the banking sector) mean for ordinary people? I don’t think there’s any systematic way to answer this question, so I will simply offer some observations and guesses.

The material standard of living will not improve much for a while. Median real household income in the U.S. had already been stagnant for a decade, peaking in 1999 and spending all of this decade slightly below that level. The current recession is sure to drive that number down. Unemployment is up around 10% and seems likely to continue rising (unemployment is a lagging indicator, since businesses will first give existing employees more hours before they hire new workers), which will constrain wage growth (which was already constrained, presumably by globalization, for quite some time).

Median real household net worth, which did increase significantly in the last several years, is probably back down to 1990s levels, based on a little analysis of the Fed’s Survey of Consumer Finances. For that to go up, housing prices have to up again. On that question, take a look at housing prices in historical perspective. We’re probably 30% down from the peak, but there’s no fundamental reason why housing prices have to stay where they are or go up from here. The other thing that could help out household net worth would be a rising stock market. That’s plausible, since the lower the level of the market the more likely it is to go up (all other things being equal). But I’m enough of a believer in efficient markets to think that you can’t expect more than the historical real rate of return (about 6%) – which would imply that the S&P 500 would reach its 2007 highs around 2021. (That’s assuming a 2% dividend yield and 4% real annual increase in the index itself.)

What about that economic recovery? I’m no macroeconomic forecaster – I believe some people build models with hundreds or thousands of variables – so take this for what it’s worth. Although the economy may start growing later this year, it is at a relatively low level – it will probably have contracted something like 4% when all is said and done. Now according to ordinary models, when the economy has contracted that much, there are built-in mechanisms that cause it to grow faster than its usual trend rate. For example, businesses have spare capacity, and employees can’t demand higher wages, so the marginal cost of production goes down (businesses can produce more stuff without having to invest in new factories); and if costs are lower, businesses can either lower prices to stimulate demand, or they can make higher profits with which to expand. Similarly, if the economy is slow, people and businesses aren’t investing, so there is lower demand for money, so the price of money (interest rates) falls – to the point where people start borrowing and investing again.

The question is whether we can count on these mechanisms, and there is reason for skepticism.

The idea that you can stimulate consumption by reducing prices or by increasing income presumes a rational consumer who is balancing the utility of money against the utility of the stuff he can buy. Lower the price of the flat-screen TV enough, or give the consumer more income, and he will buy it. However, I suspect that the recession has changed at least some households’ attitudes toward consumption in a discontinuous way. People have always used certain shortcuts in mental accounting; money falls into various buckets, each of which is managed according to different rules. The rapid increase in the savings rate implies that people are putting a lot more money into the “do not consume no matter what” bucket, which is not responsive to ordinary economic incentives. Put another way, the productive side of our economy may be able to climb back to its potential output, but that depends on somebody buying all that stuff – and it will be a long time before China can pick up that slack.

So if I had to guess, I would imagine we’ll see moderately high unemployment for several years, reinforced by political opposition to more fiscal stimulus and by the increasing weight given to the national debt. One consequence of the recession and the huge increase in the budget deficit (and also of the last eight years of large budget deficits) is that we can’t even get universal health coverage without a majority of the political spectrum insisting it has to be deficit-neutral. In those circumstances, it seems highly unlikely that there will be political willingness to spend money for something so mundane as reducing unemployment.

What about all these bank profits? In the short term, I don’t see bank profits particularly helping or hurting ordinary people. We certainly aren’t enjoying any of them (except insofar as we own bank stock, but the median American has relatively little stock, and it’s already fallen 35% in value). But nor are they likely to trickle down, unless you have a house in the Hamptons to sell. The banks are making a lot of money on things like fixed income trading and equity underwriting; apparently a major source of profits for the leading investment banks was underwriting equity being issued by other banks to fill their capital holes. All this cash rushing in is being used to shore up bank balance sheets to protect them against the ongoing devastation in both residential and increasingly commercial mortgages. (See Bloomberg on the need for greater provisions against bad loans; hat tip Calculated Risk.) If the banks can make money fast enough to compensate for the toxic assets they never got rid of – which is the administration strategy – then that is good in that it reduces the risk of another financial system panic. But I haven’t seen much evidence that banking profits are being used to expand lending into the real economy.

In the longer term, of course, the recovery of the banks will put the financial system exactly back where it was ten years ago, only with a few fewer banks (that is, more concentration). Hopefully we’ll also have a Consumer Financial Protection Agency, which should help protect people from particularly unsuitable financial products. Regulators will be a little more on their guard, and may have a few more powers at the margin. But the basic outlines of the system will be the same.

About James Kwak 133 Articles

James Kwak is a former McKinsey consultant, a co-founder of Guidewire Software, and currently a student at the Yale Law School. He is a co-founder of The Baseline Scenario.

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1 Comment on The Effect of the Financial Crisis on Ordinary Lives

  1. We are all dead, just waiting to fall over. The first strong breeze that comes through this economy will cause a tree fall of epic proportion. There is weakness as far as the eye can see or the rational mind can conceive.

    The dinner party is over and now we fight over how we split the tab. There will be little hunger for another dinner until we pay for the last feast and work off this flab around our middles. Go gently into the night and try to find cover in the shadows until this thing blows over, it will take a good deal of time and destroy a good deal of people.

    These days will be remembered and not in a good sense.

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