The Recession – Short Term Pain, Long Term Gain?

by Justin Weinger on August 10, 2008

Here’s the bad news: this recession – yes, we are in a recession – is going to last a long time and will likely lead to a great deal of pain in the short-term. But, there is some good news: the long term changes and gains brought about by this recession are going to be phenomenal.

First things first – let’s talk about how we got here and why is it going to be so bad. The answer, in one word, is debt.

Much of the economic expansion of the last twenty years has been driven by debt – namely, people living beyond their means, spending money they don’t have to buy things they don’t need. Americans have gradually moved away from their financial roots — which are based in saving money — and in 2005 and 2006, Americans actually spent more money than what they earned.

Take a look at the following chart, which is courtesy of the United States Department of Commerce, and shows the dramatic decrease in the rate at which Americans have been saving their money:

This recession is going to change all of that, which is both good and bad news.

Nearly three-quarters of the American Gross Domestic Product (GDP) is comprised of consumer spending. Therefore, any drawback in spending will cause a sizable dent in our economic growth. For example, for every 1.33 percent pull back in consumer spending, there should be a 1 percent decrease in GDP. (Keep in mind GDP could still go up or down based on other non-consumption factors such as manufacturing.)

So, if consumers cut spending by 7% to return to the average savings level between 1960 and 1980, we can expect a roughly 5.25% decrease in the GDP over the coming quarters. That’s a pretty significant fall especially considering this past quarter the GDP grew at 1.9% on an annualized basis yet the unemployment rate jumped to 5.7%, the highest level in nearly four years.

Here’s another telling chart, which shows just how much credit spending – which excludes home equity loans – has jumped in the past 20 years:

Think credit spending had something to do with the great economic expansion of the last 25 years?

So, what does it all mean? As credit dries up, people will actually have to pay money that they currently have in order to make purchases. Want to buy a brand new plasma screen TV and redo the kitchen? Hopefully you’ve got some money in your checking or savings account, because the credit avenues previously available to you via easy to get credit cards or home equity loans are either going to be non-existent or far too costly to use.

Naturally, this means we would see a reversal in the two above charts, as the savings rate increases while consumer credit decreases.

In the short term, this return to responsibility is probably a bad thing for our economy. As debt becomes harder to get, people will cut back on their consumption. Both of these things will place significant pressures on corporate revenues and profits. In turn, this will lead to much higher unemployment. As jobs become less secure and harder to find, people will cut back on their consumption even more, placing even more pressure on corporate revenues and profits. As you can see, this is economic downward spiral would be hard to get out of and would likely cause financial hardship for many families.

But, at some point it will end, and we will be smarter and better off for having learned our lessons.

In the long term, this return to fiscal and financial responsibility is a good thing. People will go back to living within their means. They’ll save for retirement, and have enough money to put a sizable down payment on a home, not need to finance their next car purchase, etc. These changes will help to stabilize the economy and strengthen the dollar. The government will be less likely to have to step in and bail out major financial institutions and put even more debts on their balance sheet and burdens on their tax payers.

So, while it may feel gloom and doom now and for the next year or two (or maybe longer) know that better days are ahead.

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