Sunday, November 2, 2008

To Buy or Not to Buy

To Buy or Not to Buy

From Baseline Scenario

By Peter Boone, Simon Johnson, and James Kwak, copyright of the authors

Judging by the traffic on the Planet Money blog, many people are wondering if now is the time to be spending money. On the one hand, we hear that the economy is crashing because of a decline in consumer spending. On the other hand, we hear that the economy is crashing, which frightens us to consuming less and saving more for the rainy days ahead. Real economists worry about these things, too - see Paul Krugman and Tyler Cowen, for example. But at the end of the day, all economists can do is speculate and watch what happens, because aggregate consumption is just the sum of hundreds of millions of individuals making their own purchasing decisions.

I’m not a personal financial advisor, but I think this can be broken down logically. Let’s assume that, before the current downturn, you chose with your level of spending (and, by implication, your level of saving) rationally. Then there are three main reasons why you might want to reduce spending today:

(1) you don’t have the purchasing power you need to maintain your spending

(2) you are going to lose your job (I know there’s a problem with that statement, and I’ll come back to it)

(3) the assets you are counting on for retirement have fallen enough that you need to increase savings in order to replenish them.

(1) applies if, for example, you were going to remodel your kitchen but you can’t tap your home equity line anymore because you have less equity than you used to, or your bank has cut your credit card limit below the level you need to maintain your spending. In these cases, you have no choice. If, however, your bank just reduced your credit card limit from $20,000 to $10,000, but you never use more than $5,000 of the limit anyway, then this doesn’t affect you.

(3) applies if you are relatively close to retirement and you didn’t have a big cushion to begin with. If you were just barely on track to meet your retirement savings objectives, and now your 401(k) has lost 40% of its value along with the stock market, then you may have to boost your savings rate. However, if you are in your 20s (or your 30s, if you spent an inordinate amount of time in school), you probably don’t have enough assets to have suffered much losses. What you care about (roughly speaking) is the value of the global stock market when you retire in 2045, which depends on the state of the global economy in 2045, which, one can argue, is pretty much unaffected by whatever happens now. In fact, the fall in asset values may be good for you, because most of your wealth accumulation is ahead of you, meaning you will be able to buy the same assets more cheaply than you could have a year ago. (If you are one of the many people who never earned enough to accumulate much for retirement - and I know this is a huge problem in our society - and are therefore relying on Social Security, then (3) doesn’t affect you either.)

(2) applies if you are going to lose your job. But even in a deep recession, not that many people lose their jobs. The forecasts I see are roughly that unemployment will rise from about 6% now to about 8.5% in a bad recession - could be better, could be worse. That means that 2.5% more people will be unemployed than are unemployed now, or 1 in 40 people. (This is a simplification, because more than 1 in 40 people will be laid off, but some people currently unemployed will get jobs, and some people will get laid off more than once, and so on.) The problem is that most people don’t know if they will be laid off or not. If you think there is a decent chance that you will get laid off, and that you will have trouble finding a job afterward, then it makes sense to increase your savings to protect against that possibility. But if you are sure that you won’t be laid off, or sure that you could find another job relatively easily, then (2) doesn’t affect you.

(1), (2), and (3) collectively will apply to a fair number of people. But if you are young, are secure in your job and your employment prospects, and still have enough credit to buy what you want to buy, then I don’t see why a recession should cause you to change your habits significantly.

In any case, you shouldn’t buy or not buy because of what you think the US economy needs. It’s not your responsibility. If collective thrift by the American people threatens to plunge us further into recession, then it’s the government’s job to compensate by increasing spending, as Krugman argues (and as we’ve been repeating on this blog). So do what you need to do for yourself and your family.

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