Is the Strong Recovery Sustainable?

The economy seems to be looking brighter. After years of a weak economic recovery, where more jobs were lost than gained, the labor market finally gained some steam in March of this year. However, because the economy is still millions of jobs short from where it reasonably should be, employers do not feel compelled to pay higher wages. Unless households can begin to fuel their spending out of faster income growth, the strong economic and employment growth of the past few months is not sustainable.

Throughout the recession and the recovery, consumption was the primary force behind economic growth. Consumption, as a share of gross domestic product (GDP), rose for the first time since WWII above 70 percent in the recession and remained at this level throughout the first quarter of 2004.

But income growth in this recovery was weaker than in any prior recovery. For much of the recession and the recovery, employment actually declined, making this the first 'job-loss' recovery since the Great Depression. And wage growth barely matches price increases. Inflation adjusted hourly earnings rose by a total of 0.6 percent throughout the recovery from November 2001 to April 2004 – a whopping monthly increase of 0.02 percent.

To finance their consumption, households borrowed increasing amounts of debt. Total consumer debt amounted to an unprecedented 115 percent of personal disposable income in the first quarter of 2004, up from 101 percent at the start of the recession in March 2001.

Much of the additional debt came in the form of higher mortgages. Thanks to low mortgage rates and high and rising home prices, households accrued more and more home equity that they could borrow against. And borrowing is what households did. In the middle of 2003, households had essentially 5 percent more disposable income to spend due to the fact that they cashed out their home equity. But with interest rates rising in the second half of 2003, this source of extra cash shrank rapidly. In the fourth quarter of 2004, the additional spending power arising from home equity cash outs equaled only 1.4 percent of disposable income.

Consumers received another boost as long-term interest rates fell again in early 2004. From August 2003 to March 2004, mortgage rates fell from 6.4 percent to 5.4 percent. Subsequently, home equity cash outs added another 3.8 percent to disposable income in the first quarter of 2004, data released by the Board of Governors of the Federal Reserve System yesterday showed.

In the coming months, though, this addition to households spending power is likely to diminish again. Already mortgage interest rates have risen sharply, dampening the refinancing boom quite substantially. From March 2004 to the end of May 2004, mortgage rates rose from 5.4 percent to 6.3 percent, thereby erasing in two months the interest rate declines of the previous eight months.

Moreover, the rise in home prices that gave households much of the additional equity in their homes seems to be slowing down. In the first quarter of 2004, house prices rose by an annualized rate of 3.8 percent, the smallest house price increase since 1998. This is also only half the average increase in home prices of the prior three years. In other words, the home equity that households could borrow against is rising substantially slower now than it did in the past three years, and hence will likely not continue to fuel the boom in consumption.

For the recovery to be sustainable, somebody has to be willing to buy all the stuff that businesses, which continue to raise their productivity, are generating. However, the government is trying to curtail its appetite for spending in the face of large budget deficits at the federal level and continued financial struggles at the state and local level. Foreigners are also shying away from purchasing U.S. products because their incomes are growing even slower than that of households in the United States and because the value of the dollar makes U.S. products higher than they should be. And now, a likely end to the refinancing boom may give households some pause, unless employment growth continues at a solid pace and wage growth picks up soon. Without consumer spending picking up as a result of faster income growth, there is no reason for businesses to invest more in productive capacity. In other words, strong economic growth is only sustainable if wages see more of a boost than they have so far, largely because the main factor of the recent recovery – the refinancing boom – is likely to disappear.

Christian E. Weller is a senior economist at the Center for American Progress.