When Markets Crash: Part Two

30 Jun

When Markets Crash: Part Two

The Economic Impact of Market Recessions

Synopsis:

  • The personal savings rate hit a historic 33% in April, (according to) the U.S. Bureau of Economic Analysis.
  • How does the savings rate impact the economy?

It is not uncommon for consumers to cut back on spending during recessionary times. Typically fear, uncertainty, or job loss drive these changes in behavior. However, during the recent pandemic we have seen a spike in the personal savings rate that is of unprecedented levels. According to the U.S. Bureau of Economic Analysis, the personal savings rate hit a historic 33% in April. Compare that number to 7.6%, which was the average personal savings rate for 2019, and you can see why this number raised some eyebrows.

This figure is a useful indicator that economists follow to learn about Americans’ financial health, and to help predict consumer behavior and economic growth. The U.S. Bureau of Economic Analysis defines personal savings rate as the percentage of people’s disposable income that they save instead of spending. It is calculated as the amount of income left after people spend money and pay taxes. What does that mean for the average American?

To answer that, it is important for us to first visit how money flows through the economy. We will use a simple water analogy to help illustrate this point. The size and flow of the river can serve as a representation of how a person or company’s money moves through the economy. Think of a large river – say the Colorado River – it represents a widget factory in a small town. Rivers are formed by the culmination of much smaller waterways all flowing to the same spot. Think of these trickling brooks as the average consumer. While a single consumer may not have a large impact, the cumulative effect of a lot of these “small streams” can compound and eventually come together to form a larger waterway. So as consumers collectively purchase ‘widgets’, their spending effectively helps create the larger river that represents the factory.

Just as a river is formed by smaller waterways coming together, so too can a river fork or split off to create secondary streams. Think of this as how the widget factory pays its employees. The employees-turned-consumers then spend their money to buy goods. The company that produces those goods then needs to spend its profits to pay employees or buy raw products from other companies. Money comes in as consumers buy goods, then goes out to pay employees, who turn around and spend those dollars at other companies, and the cycle continues.

So, what happens when the economy sees a dramatic spike in the personal savings rate like we did earlier this year? Enter the Hoover Dam. Except in this scenario, the Hoover Dam was not a multiyear project with a team of engineers and scientists planning and studying its potential effects. Nope, in this case it suddenly dropped into the middle of the Colorado River overnight. While saving money is important for long term plans and goals (i.e. retirement), such an unprecedented spike seemingly instantaneously causes dramatic challenges for the economy. Water (money) is no longer continuing to flow downstream, and this has a compounding effect on other businesses and consumers. The widget factory is no longer buying goods to manufacture, they are forced to reduce hours or lay off employees. This in turn hurts the local economy, as those workers can no longer shop at their favorite stores, enjoy leisure activities, or order takeout.

The burden of this phenomenon is typically not shared equally. The lowest income earners tend to be hit hardest by the economic impacts, since most of their income goes to pay for nondiscretionary goods (i.e. rent and groceries). Whereas the wealthiest tend to have the most freedom for discretionary spending and many of those options are unavailable during the pandemic. With little to no travel possibilities, restaurants at reduced or no capacity, and other entertainment options shut down during the pandemic it is difficult to find ways to pump money back into the river that is our economy. To make matters worse, we find that many low-income earners tend to work in these industries hit hardest during the pandemic thus, extending the vicious cycle.

This explains the urgent push for some politicians and economists to help reopen the economy as soon as possible. With so many American families struggling to afford even basic necessities, and many jobs at risk of permanent loss there is understandable concern. The hope would be for a vaccine or other effective treatment for the virus to help put some of this fear to rest. In the meantime, we will need continued support from politicians, medical experts, and business owners to help ensure people receive the assistance they need.