Also see our Economic Commentary which supplements the Laufenberg Economic Quarterly and primarily focuses on more recent economic developments.

Greece has been in the news recently. In 2010 Dan wrote an essay on Greece and the European Union which you may find interesting and still relevant. Go here to read it.

This page is designed to offer you my perspective on economic fundamentals, ranging from business cycles to yield curves. It will provide more detailed economic analysis than is generally available in the Quarterly. For the most part, the essays provided here will attempt to discuss timely fundamental issues related to the forecast but are expected to have a longer shelf life than the content on either the Quarterly or Commentary pages. I hope that over time you will consider the information on this page as a source of reference when debating economic issues in the future.

Daniel E. Laufenberg, Ph.D.


Factors that drive consumer spending
(August 13, 2012)

In the U.S., a strong consumer generally translates into a strong economy, given that nearly 71 percent of gross domestic product (GDP) is personal consumption expenditures (PCE). One aspect of the current expansion I find especially frustrating is that PCE growth has been slower than even my below-normal forecast. Several factors have been offered to explain this development, including sluggish job growth, the so-called “fiscal cliff,” house prices, and the debt crisis in Europe just to mention a few. To better understand the outlook for PCE growth and in turn U.S. economic growth, it may be worthwhile to discuss these various factors and how they may or may not influence consumer spending decisions. The bottom line is that all of the factors mentioned above most likely have had an impact on PCE but not to the same degree. And for the most part, the factors that seem to matter most are becoming more positive, or maybe I should say less negative, which should bode well for PCE growth over the remainder of this year and into 2013.

To begin the discussion of consumer spending, I think it is appropriate to start with a consumption function. After all, anyone who took an economics course in high school or college probably learned something about the consumption function, if only a mention. As a reminder, the consumption function is generally expressed as:

C/P = a + b·Y/P,

where C is PCE and C/P is real consumer spending (PCE adjusted for inflation). Also, a, is the level of real PCE when income is zero, b is the marginal propensity to spend out of income, Y is income, and Y/P is real income.

The idea that consumption is a stable function of income was given its first full and clear statement by John Maynard Keynes, in his General Theory of Employment, Interest, and Money. However, it is easy to find others who had come close to stating the same idea earlier, including Alfred Marshall. The point is that today most economists, regardless of their theoretical leanings, agree that consumers need income to spend. Where they may disagree is what other factors should be included in this function, whether it is stable over time, and whether factors other than income may be more important in longer term.

For my purpose here, I will limit my discussion to the variables that may influence real PCE over the forecast horizon, which is less than two years. This discussion will rely heavily on the general form of the consumption function illustrated above, where the primary determinant of real PCE is real income. First, real PCE, which is the dependent variable in the consumption function, is defined to include spending on both goods and services. The goods component includes spending on durable goods and nondurable goods, while the services component includes spending on shelter, medical care, and numerous other services.

Second, the only determinant in the consumption function expressed above is real income (income adjusted for inflation). Exactly what measure of real income should be used is somewhat controversial in itself. In particular, should it be real personal income before taxes, after taxes, or maybe real personal income less transfer payments, just to mention a few. For empirical purposes, I tend to favor real disposable personal income, which is an after tax, inflation-adjusted measure of consumer income. It is worth noting that this measure of income does not include capital gains of any kind, even though capital gains taxes are a component of the tax exclusion. It is also worth noting that personal income includes more than just wages and salaries; other items included in this measure of income are other employee compensation (which includes contributions to all types of private pension plans), proprietors’ income, rental income, interest income, dividend income, and personal current transfer receipts (which includes benefits from Social Security but not private pension plans).

The coefficients in the consumption function are very important to the analysis. The intercept of the function, a, is the level of spending when income is zero. It represents the basic needs of consumers for survival. This term is most likely determined by things like the aging of the population, population growth, or structural shifts in spending patterns, none of which typically change dramatically in the near-term. For that reason, it is probably reasonable to assume that the variable a in the consumption function is constant for a particular forecast but not necessarily for all future forecasts. If this is the case, then the change in real PCE is proportional to the change in real income.

However, it is unreasonable to think that the marginal propensity to consumer, b, could be constant over any period given the host of variables that most likely influence it even in the short run. Of course, the key to forecasting is not whether the marginal propensity to consume is constant but rather whether it is predictable. I contend that this coefficient is predictable within reason and that the broadly defined factors to do so include the following:

  • Interest Rates: Lower interest rates may encourage households to borrow to finance some types of consumption expenditures (such as automobiles and furniture). In effect, lower interest rates make it less expensive for consumers to borrow from future income in order to spend today. When this happens, current consumer spending represents a larger share of current income; the result is that the marginal propensity to consume increases. But lower interest rates have another aspect to them; that is, they also lower the return on debt obligations and bank accounts, which means that interest income suffers. On balance, real disposable personal income is not as high as it would be but a larger share of current income is likely to be spent, all else the same. The net impact on consumer spending depends on which effect—the borrowing effect or the income effect—is stronger. Higher interest rates work in the opposite direction.

  • Consumer Confidence: If people have more confidence about the state of the economy, they are more likely to boost their spending. However, because this extra spending is not the result of extra income, it must come from saving. As such, consumption increases and saving decreases. A drop in consumer confidence works in the opposite manner. But confidence can reflect a lot of different things and is very complicated to predict. If interest rates are low and expected to remain there because it is the appropriate policy stance to accelerate economic growth, then it would most likely boost confidence. However, if interest rates are low and expected to remain there because the economy is not expected to recover, then it would most likely reduce confidence. In other words, expectations play a huge role in determining the net effect of this factor on consumer spending decisions.

  • Wealth: An increase in wealth motivates the household sector to increase consumption and decrease saving at the same level of income. Wealth is defined to include the value of all assets owned by households less any liabilities. For example, the equity that homeowners have in their houses is part of wealth. Also, any stocks, bonds, or cash held less margin debt is wealth, as well as the net value of other physical assets. According to the latest Flow of Funds data from the Federal Reserve Board, the household sector’s net worth was $62,865.6 billion at the end of the first quarter 2012, up $2,009.1 billion from a year earlier. This compares with gross domestic product of $15,595.9 billion and personal income of $13,357.8 billion in the second quarter. If consumers feel wealthier, they are more inclined to save less and spend more of their current income. Obviously, home equity lines of credit and mortgage refinancing are easy ways for consumers to monetize some of this wealth and do so with the only tax-favored interest expense available to households. A decrease in wealth works in the opposite direction.

  • Taxes: Exactly how taxes affect spending also depends very much on expectations. This is consistent with the “permanent income hypothesis” of consumer spending, which suggests that consumers change their spending based on what they perceive to be changes in their permanent income rather than changes to current income. If the income change is perceived to be temporary, it tends to be saved rather than spent. In other words, even though real disposable income goes up, the marginal propensity to consume may fall. Thus, exactly how much a cut in taxes increases consumption depends on whether it is perceived to be permanent or temporary; that is, if it is perceived as permanent, it is more likely to be spent. Unlike the other factors, a cut in taxes most likely increases both consumption and saving, but not always to the same degree. Again, the mix between spending and saving will depend on whether the tax cut is perceived as permanent. That being said, no tax change should ever be considered permanent, given the frequency with which Congress changes the tax code. For that reason, we should not use the tax code to stimulate spending but rather to pay for government services that policymakers deem appropriate. Of course, if the majority of citizens disagree with the judgment of policymakers with regard to what services the government should provide, then we do not reelect them. Or do we?

The bottom line is that several factors may influence consumers’ decisions to spend, including expectations of whether each of the factors is temporary or perceived as permanent. Consumer confidence may capture some of this effect but not all of it, which is why interest rates, wealth and taxes all play a role as well.

In addition, the factors mentioned above do not have the same influence across all components of PCE, such as durable goods, nondurable goods and services. As shown in Chart 1, services represent the largest component of PCE, accounting for roughly 64 percent of total consumer spending. The second largest component is nondurable goods, which accounts for about 22 percent of PCE. Also, even though it may not feel like it, all three components of real PCE have rebounded from the depths of the recession of 2008-9. Indeed, the levels for each of the three components of real PCE were at all-time highs in the second quarter. The issue is that it took three years of recovery to get there. In other words, the recovery in spending has been slower than hoped but certainly not disastrous.

With this in mind, I return to the original items that are so often mentioned as possible restraints on real PCE so far this year, such as sluggish job growth, the so-called “fiscal cliff,” house prices, and the debt crisis in Europe. The first item is sluggish job growth. This argument may have had some merit before the latest revisions to real income, but not any longer. According to the latest estimates from the Bureau of Economic Analysis, real disposable personal income grew 3.4 percent at an annual rate in the first quarter and 3.2 percent in the second quarter. In contrast, real PCE grew 2.4 percent in the first quarter and only 1.5 percent in the second. Clearly, consumers acquired the wherewithal to spend at a faster pace in the first half of 2012 than they apparently did.


The conclusion is that the marginal propensity to consume fell. And it is very likely that most of the other concerns listed were in play. For example, the fiscal cliff implies that future taxes are likely to be higher, leading consumers to be more cautious about spending decisions. Hence, any tax cut now is perceived to be temporary. Recall that is it permanent income that may drive spending trends.

Another example is the ongoing slump in house prices, which has made it difficult for consumers to take advantage of the low cost of borrowing currently available. After all, if households have little or no equity in their houses, their ability to refinance or to use home equity lines of credit is limited. In this case, the uptick in the marginal propensity to consume owing to lower interest rates is much smaller than in the prior decade. Moreover, lower interest rates for an extended period of time also will have an adverse effect on disposable personal income growth through the interest income component, adding to the restraint on spending.

The final concern is the debt crisis in Europe. Exactly how this item has affected consumer spending is unclear. The best I can determine is that the concern about Europe and what it might mean for the U.S. economy has contributed to the low level of consumer confidence. Obviously, less confidence means less spending if the drop in confidence is meaningful. However, even in this case, so long as real income continues to grow, the adverse effect from low confidence is very temporary.

If we look at growth rates of the various components of real PCE (see Chart 2), it is clear that all three have lagged past performance to some extent. Also, it is interesting to note that spending on durable goods, even though it is the smallest component of PCE, is the most volatile. As such, an economic recovery that is driven primarily by consumer spending on durable goods is not a very reliable or sustainable recovery. At some point, it would be helpful if spending on nondurable goods, but even more importantly, on services start to show stronger gains. I remain convinced that recent gains in the stock market and improvement in house prices (wealth effect), along with further gains in real disposable income, will accelerate spending growth on services and sustain spending growth on goods.


The conclusion is that it took far longer than usual for real PCE to recover from the last recession, reflecting the severity of the 2008-9 recession, as well as the sluggishness of the recovery. The downside risk is that spending growth is so slow that it leaves little room for the U.S. economy to withstand a policy or price shock of any sort. On the other hand, the upside is that slow spending growth reduces the risk of inflation bottlenecks, even food inflation, from derailing the current expansion anytime soon. The implication is that the current expansion may survive longer than I had expected originally because of slower-than-expected consumer spending growth early in the recovery.


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For the current economic forecast, as well as other analysis and commentary, please visit the Stonebridge Capital Advisors website.

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The views expressed here reflect the views of Daniel Laufenberg as of the date referenced. These views may change as economic fundamentals and market conditions change. This commentary is provided as a general source of information only and is not intended to provide investment advice for individual investor circumstances. Past performance does not guarantee future results.

Current Perspective

2012 Economic Perspectives

Factors that drive consumer spending
August 13 , 2012

House prices: the bottoming process continues
March 8 , 2012

Equities and the political calendar
-- February 7, 2012

2011 Economic Perspectives

Is the great American job machine finally broken?
-- December 6, 2011

Recession fear, not fact
-- September 4, 2011

Core inflation: a policy guide more than a policy target
-- May, 2011

Help not wanted?
-- Feb, 2011

Special Report: Health Care Legislation:
Essay No.1 - Costs
Essay No.2 - Revenue
Essay No.3 - Budget Deficits

2010 Economic Perspectives

Causes of the financial crisis revisited
--November, 2010

A less robust U.S. Economy longer term
--August, 2010

Greece: A test of Europe's resolve to remain united
--May, 2010

The U.S. jobs machine restarting at a slower pace
--February, 2010

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