Can Americans Stop Spending?

Spending is out, saving is in. We buy Hyundais, not Hummers, and bungalows, not McMansions. We dine out less and pay cash when we do. We take "staycations." But have we really changed as people? Is frugality just this year's fad diet, or have we, like the generations that grew up in the Great Depression of the 1930s or the Great Inflation of the '70s, been truly altered by economic trauma? The answer seems to be: Yes, we probably have.

Right now, as we lick our financial and career wounds and poke our 401(k) statement with a stick to see if it’s still breathing, we see positive behavioral trends: The savings rate hovers just over 5 percent, up from negative 2.7 percent in 2005. We’re borrowing less, partly because easy credit no longer exists. Our overconsumption has stopped for the moment, and we’re trying to become better financial citizens. But isn’t that what always happens in crises? People get scared straight — until the threat disappears and the old urges return. That’s why economists and historic data suggest that we will be different, but only for a very short time. Here’s what we see:

We will be better financial citizens ... for a little while

Jeremy Grantham, legendary investor and founder of global investment firm GMO, predicted in his May 2009 letter to investors “seven lean years” of frugality and paying down debt. Before the crisis, he points out, the U.S. had about $50 trillion in perceived wealth supporting $25 trillion in debt, a 2-to-1 ratio. Then whoosh, the economic meltdown erased between $20 trillion and $23 trillion, dropping our perceived wealth to less than $30 trillion while the $25 trillion in debt remained. We’ll need to slash that debt by half just to get back to 2-to-1, and, as Grantham writes, that’s “still enough to deliver a life-changing shock for hundreds of millions of people.”

However, one powerful economic trend suggests the debt paydown will only last as long as the hard times. The “wealth effect” states, in theory, that for every dollar a person gains in wealth, he will spend 7 cents more. For every dollar lost, he’ll spend 7 cents less. According to Jay Zagorsky, Ph.D., an economist from Ohio State University, the wealth effect has dictated savings through history: “After nine of the last 10 recessions since World War II, when people felt poorer, the savings rate increased for three to five years and then dropped off as economic expansion returned and they felt richer.”

And after that 10^th recession? That was 1991, and for the years that followed, says Zagorsky, savings rates plummeted because stocks did our saving for us. And therein lies one of society’s big problems: We include capital gains in the definition of “saving.” But if your house gains $10,000 in value, for example, and your stock portfolio climbs by $5,000, have you really “saved” $15,000?

That’s the main reason we’ve been such lousy financial citizens and why history suggests we’ll revert back to that level of citizenry a few years after this recession recedes.

Take action: Absolutely, positively continue saving. Set up automatic transfers from checking to savings, and don’t touch that cash. Resist the urge to overspend, especially when you hear things like “70 percent of the U.S. economy is consumer spending.” The fact is, consumer saving is important to the economy as well, says Gian Luca Clementi, Ph.D., assistant professor of economics at NYU’s Stern School of Business. “The corporate health of the United States depends on our saving because it is crucial for investment. There can be no investment unless we save.” When asked if he thinks we might return to the 15 percent savings rate of the mid-’80s, Clementi replies, “Never.” Take that as a personal-savings challenge, for a wall of cash can block almost any future life crisis.

We will borrow a lot less

While an increase in the savings rate may not make it past the next presidential election, disdain for “investment” houses and wild loan-to-home-value ratios will last a lot longer. Yale Economist Robert Shiller predicts that the same thing will happen to real estate speculation that happened to stock speculation in the 1920s. “This crisis will at least somewhat reduce our speculative enthusiasm for real estate. Remember that in the 1920s, it was considered smart to buy stocks on margin. After the Depression, however, people have regarded that as very erratic or risky behavior. I suspect that the idea of buying a second home with a heavy mortgage might be looked down on as well.”

Take action: Invest in the stock market, not real estate, to see long-term appreciation going forward. “Homes have not been a great investment unless they serve you well as a home,” says Shiller. “The longest home-price history is for a neighborhood in Amsterdam that goes back to 1627. You’d think, Wow, if I could’ve bought one of those houses in 1627, I’d be rich now. Wrong. It’s the same [inflation-adjusted] price as it was back then. People have missed a very important principle of economics: When an asset can be created by building, the price will have to track construction costs in the long run. Some people say, ‘Well, land is limited.’ But, actually, builders keep building new communities, so land isn’t really a resource constraint. I think a temporary construction bottleneck — a resource constraint — allowed this bubble to happen. Prices should really come down to construction costs, and those haven’t been going up in the long run.”

We will behave rationally in the face of irrational events

Looking back on the real estate bubble and back further on the tech-stock mania, it’s easy to see nothing but “irrational exuberance” and pathological greed. But Clementi says it was the prices, not the people, that were nuts. “People were responding in a rational way to prices that did not reflect fundamentals. An example: Let’s say someone thinks they need to save half a million dollars for retirement, and suddenly they see that their house is worth half a million dollars. They think, Well, I’m done.” It was a mistake to think that prices were here to stay, but it wasn’t crazy.

Take action: Remember the past. “History shows we have a short memory,” says Clementi, “In a few years people tend to forget about painful things they went through even though they’ve watched their lives unravel.” But don’t just remember the financial beating you took during the crisis. Remember that being a good financial citizen requires discipline, even to the point of taking actions that look irrational in the context of current events. Following the crowd is generally a bad idea.

We’ll redefine our concept of “wealthy”

When Pimco’s Bill Gross addressed the Morningstar convention in Chicago recently, he told an interesting story about how our culture has changed: “Fifty years ago, I was 15 years old. I was talking to my parents about golf and country clubs. They said, somewhat resentfully, that the only way you could be a member was if you were an airline pilot, a doctor, or a car dealer. This past weekend, the only people that were shanking balls into the lake were investment bankers, mortgage brokers, and investment managers. There were no airline pilots.” Gross is right, of course, and his point is further illustrated by two numbers that have dominated the media landscape in the past 18 months: $250,000, which has been defined as “wealthy” according to the Obama administration as far as tax hikes go; and “trillion,” which, as a dollar amount, has never gotten so much casual airplay in any era. Our concept of these two numbers will forever be altered by their role in the crisis recovery. Why? Ask a resident of a major metropolitan area who makes $250,000 if they feel wealthy, let alone have enough to join a country club. And watch if the public flinches the next time a trillion dollars is mentioned in financial-policy debates.

Take action: Define wealthy for yourself by defining your single long-term life goal. Whether you want to sail around the world in your 40s or start a small cupcake business in your 60s, defining the realistic amount of money it will take to attain that goal is job one. Job two is saving the cash. Do that all by yourself and, no matter what your net worth, you’ll feel wealthier than a trillionaire.

We will still be gamblers

Shiller wrote in Animal Instincts about how the prevailing card game of our culture through the Depression and World War II was bridge, a team game based on strategy that was rarely played for money. Our favorite card game now? Texas Hold ’em, a spectator sport played for big money and based on deception and all-in bets. Gambling in general has grown in popularity and acceptance throughout our culture over many years. “The philosophy that whatever consenting adults do is OK has become a democratic principle,” observes Shiller. “It’s also a cultural change in who we admire and think is smart. We’ve started to think of Donald Trump as our real estate genius. He has no compunction about investing in casinos.” Alas, Shiller doesn’t see the Trumpification of our culture changing much.

Take action: Adopt new demigods. While flashy types like Trump and Jim Cramer get all the press, quiet geniuses like Shiller, Grantham, and Nassim Nicholas Taleb, author of The Black Swan, all predicted our financial downfall — and none of them use a gambling approach to investment. Read up on their work. Oh, and stay the hell out of casinos, too. Is it a coincidence that Bill Gates, Warren Buffett, and Charlie Munger play bridge? Probably not.

Our leaders will finally get it (maybe)

Note to President Obama and Congress: You will have a major hand not only in how the U.S. is governed, but also in what kind of people we will become. Why? Because, Shiller says, history has shown that consumers base their decisions on your policies and your example. “The government has done some really dumb things,” he says. “One of them is encouraging everybody to buy a house on a high level of margin. It was considered patriotic and American. President Bush went on his Saturday radio addresses extolling that home ownership had risen to new levels. He was so happy. But it was just not very well thought out.”

Take action: Be the leader you’d like Washington to be. The math is simple: Spend less than you take in and pay down your debts coldly and methodically — and when they’re gone, apply that discipline to future saving. “[A president should say] ‘As your president, I want you to be careful about your family balance sheet and not overexpose yourself to what are really risky markets,’” says Shiller. “Bush didn’t say that. And now what do we see? Twelve million households under water.”

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