In May, Personal Income rose 0.3%, matching from the 0.3% rise in April and down from the 0.4% rise in March, but only after the April numbers were revised down from 0.4%. The increase was below the consensus expectation of a 0.4% increase.

Meanwhile, Personal Consumption Expenditures (PCE) were unchanged, lower than the consensus expectation of a 0.1% rise. That is a deceleration from the 0.3% rise in April and the 0.6% increase in March.

Of course, if spending is unchanged and income is rising, it means that the savings rate is going up. The savings rate rose to 5.0% after being at 4.9% in both April and March. The savings rate is well above the dangerously low levels that prevailed from 2004 to 2008. The graph below shows the long-term history of the savings rate using a three-month moving average (from this source).

Over the long run, a higher savings rate is good for the country, and is desperately needed as the savings rate has been in more or less a constant secular decline for the last 30 years. Without domestic savings, we have to borrow from abroad to invest in the economy. Capital imports are the flip side of the trade deficit. If we sell less abroad than we buy, then we go into debt abroad. That is the same thing as importing capital.

The chronically low savings rate has left the country trillions of dollars in debt to the rest of the world. Note that is the 1960’s and 1970’s the savings rate was normally around 9 or 10%, and started a long secular decline after the 1982-83 recession. Prior to the 1980’s the U.S. was the world’s largest creditor nation by a large margin. Now we are by far the world’s largest debtor.

The fall in the savings rate, and the increase in our indebtedness to the rest of the world is not a coincidence, it is a causal relationship. The extraordinarily low savings rates in the five or six years leading up to the Great Recession were a disaster for the country, even though it made things seem good at the time.

A falling savings rate can give a very powerful boost to the economy, but only as long as it continues to fall. A low savings rate, undermines the long term economic strength of a country. In effect, it is a country having a feast on its seed corn. We are paying the price for that party now.

In the short run, on the other hand, a rising savings rate slows economic growth, and vice versa. If someone gets a raise but does not spend more, then that raise does not stimulate other economic activity.  If the raise is not spent, then there is no increase in aggregate demand. It either increases future potential demand, or pays for demand that occurred in the past (i.e. debt is paid down).

On the other hand, if people are socking away less than they were for a rainy day, it increases current demand. If people go out to eat rather than stay home, it means that there is more work for waiters and cooks. If you are saving more seed corn to plant next year, there is going to be less to eat today.

Will Savings Rate Stabilize?

The question is, will the savings rate stabilize here? The desire of consumers to sit on their wallets and not spend increases in income is very understandable. The collapse of housing prices destroyed trillions of dollars of wealth. That wealth people had been planning on using to finance their retirements or put the kids through college.

Thus, personal housing wealth does not form the basis for large plutocratic fortunes. It is the stuff of which modest middle-class nest eggs are made. Now that money has to be replenished the hard way — by spending less than you earn. Note how the savings rate tends to rise during recessions. That might seem counterintuitive, since it is very hard to save when you are unemployed, but it really isn’t.

“The Paradox of Thrift”

The very fact that more people decide to save is one of the reasons recessions are, well, recessionary. On an individual basis, being thrifty is a good thing and so is paying down your debt. However, if everyone decides to do it at the same time, it is a very bad thing. This is what Lord Keynes called “The Paradox of Thrift.”

It is the change in the savings rate, not the level that causes the pain. We need more domestically formed capital, rather than relying on importing capital from abroad. Importing capital is the flip side of running a trade deficit.

The rise in the savings rate during the Great Recession was very rapid, and was one of the key reasons the recession was so severe. We are still a long way from the sort of savings rate we had back in the 1960’s and 1970’s, but we are a lot closer than we were a few years ago. People are making progress on repairing their balance sheets, but the damaged caused by the financial meltdown of 2008 and the resulting Great Recession, was catastrophic.

The process is being undermined by the resumed decline in housing prices. That decline in wealth does not show up in the savings statistics, but savings have to compensate for it.

The progress that consumers have been making in shoring up their ability to meet their financial obligations can be seen in the graph below. The red line shows just debt service as a percent of disposable personal income, while the blue line is a broader measure that includes things like rent payments. This is an underappreciated sign that things are getting better and is setting the foundation for a more durable recovery.

The components of personal income are as important as is the total number. In total, personal income rose by $36.2 billion in May, down from an increase of $37.7 billion in April and well off the $56.7 billion increase in March. (These are seasonally adjusted annual rates, as are all the subsequent numbers on the components of personal income.)

In May, private sector wages rose by $14.1 billion, down from a $26.4 billion increase in April and a $17.4 billion rise in March. Wages in the goods-producing sector rose by $4.1 billion in May, down from a $4.3 billion increase in April. In March, wages in goods producing industries rose by $6.5 billion.

Wages in the private service sector were up $9.8 billion versus an increase of $22.2 billion in April and a $10.7 billion rise in March. Overall government wages have been rising very slowly, unchanged in May after a rise of just $400 million in April and $600 million in March.

Private wages and salaries are the most important, and highest quality, form of personal income. Government wages have to be paid out of either taxes or government deficits. Government workers do, however, spend their money in the private sector, just like private sector workers do. To keep the numbers in perspective, total private sector wages are 4.54x larger than total government wages. Since October, private sector wages have increased a total of $104.9 billion, while government wages have increased by just $3.9 billion, a ratio of 26.9x.

Proprietors’ Income

Another important source of personal income is proprietors’ income. In other words, what the self-employed and small businesses were earning. That fell by $1.7 billion in May, down from a $3.2 billion rise in April and a $4.5 billion increase in March.

Much of the weakness was down on the farm. Farm proprietors’ incomes fell by $1.3 billion, matching its decline in April after a rise of just $100 million in March. Don’t feel too bad for the farmers, though. Strong commodities prices led to a stunning increase in farm incomes that is only partially being unwound.

Weather is not helping out this spring. I am writing from an area that is a major producer of corn and soybeans (western Ohio and eastern Indiana), and driving around it looks like many of the fields have not been planted and those that have seem far behind where they should be. Ankle-high by the fourth of July is not going to lead to a very big crop. It has simply been too wet to get the crops planted. A poor harvest this year is likely to lead to more inflation at the grocery store later this year.

Non-Farm Proprietors’ Income

Non-farm proprietors income fell by $400 million, down from a $4.5 billion rise in April, and a $5.4 billion rise in March. In other words, what we normally think of as small business income is showing signs of slowing down as well. Farm proprietors’ income is tiny relative to non-farm, at just $54.8 billion versus $1.0496 trillion.

Non-farm proprietors income actually peaked back in December of 2006 at $1.1129 trillion, so small business income is still 5.7% below peak levels. On they other hand, it bottomed out in May 2009 at $971.6 billion, so we are now 8.0% above the valley floor.

Other Forms of Income

Rental income rose by $3.3 billion in May, up from an $2.9 billion increase in April, but well off the $8.2 billion rise in March. Rental income has increased every month since November 2009. Given the still-weak condition of the real estate market, this is somewhat surprising, but a sign that it is slowly on the mend. This is a hopeful sign for the recovery of the real estate sector which has been a major drag on the overall economy.

Capital income, or income from dividends and interest rose by $10.0 billion in May, a substantial acceleration from the $6.0 billion rise in April and just a $600 billion rise in March. This income is particularly important to retirees. Interest income was up $5.6 billion, matching its April rise and up from a $3.3 billion increase in March. Dividend income rose $4.4 billion way up from a $400 million rise in April and a decline of $2.7 billion in March.

The final big component of personal income is government transfer payments. Like government salaries, this source of income has to come from either taxes or increased deficits and so it is a less desirable source of personal income from the point of view of the economy as a whole.

However, it is still income that gets spent in the economy. Wal-Mart (WMT) really doesn’t care if the money spent in its stores is from the elderly using their Social Security checks or the dividends they get from their investments, or really if it is retirees shopping there or people still in their working years spending their wages there, or their unemployment benefits. Transfer payments rose this month by $9.3 billion, way up from an actual decline of $2.4 billion in April but still far below the $23.1 billion rise in March.

Over the long-term though, the economy cannot simply grow through ever-increasing amounts of money being handed out by the government. Those payments are very useful in the short run to help hold up overall consumer spending when the economy has turned soft.

Personal Income Minus Transfer Payments

In the long run, the economy needs income from wages and salaries, and from small businesses earning profits. It is those earnings and profits that pay the taxes that support the transfer payments.

It is then worth looking at personal income excluding transfer payments, as shown in the third graph. Since it is a long-term graph, inflation plays a much bigger role over time, and the graph is based on real personal income rather than nominal (which the rest of the numbers in this post are based on).

Note that during most recessions (and the immediate aftermath) incomes excluding transfer payments flatten out, but do not fall significantly. The blue line (left scale) shows we have not yet surpassed the level of total personal income ex-transfer payments we were at before the Great Recession.

The red line shows that the year-over-year decline in such income was by far the steepest in modern history during the Great Recession. (unfortunately the chart is not updated with the May data).

Disappointing Report

Overall, I would have to rate this report as a bit of a disappointment. Income was up, but less than expected, and last month was revised down.

The quality of the income growth we got was pretty solid, but the declining support from transfer payments is fairly significant if one takes a step back. For all of 2010, total personal income rose by $371.8 billion, of which $163.8 billion (44.0%) came from increases in transfer payments. Since December, though, total personal income is up $317.2 billion, of which only $18.9 billion (5.96%) was due to higher transfer payments.

The quality of the income growth has improved significantly. In May alone, transfer payments were responsible for 25.7% of the increase. That is fairly substantial backsliding.

Aside from the payroll tax effect in January, the increase in personal income so far this year is coming from sustainable sources like higher wages and salaries, most notably from the private sector, and from higher proprietors incomes. In other words, small businesses are starting to do better, even non-farm small businesses. May was a disappointing reversal of that trend.

Growth in dividend income is likely to continue as firms share their strong earnings growth with their shareholders. It should get a big boost in the next few months due to the increased dividends that the recently bailed out banks are going to be paying. The rise in the savings rate is good over the long term, but is not helpful right now in getting the economy back up closer to potential.

Spending Also a Disappointment

On the spending side the report was also disappointing, with no change when an already downbeat 0.1% rise was expected. That is not enough to keep up with inflation. In real terms, personal consumption expenditures fell by 0.1%, matching a 0.1% decline in April and down from a 0.2% rise in March. In other words, over the last three months real spending has not changed. That is a pretty good indication that the overall growth of the economy has slowed to a crawl.

The consumer, which represents about 70% of the economy, is not going to be contributing to growth (at least not very much) in the second quarter. If anything, there is a good chance that second quarter GDP growth will be lower than the 1.9% rate we got in the first quarter.

In total, spending rose by just $4.6 billion in May, down from a $28.8 billion increase in April. March was even more robust than that, with a $64.3 billion rise. That is a massive deceleration in spending over the last two months.

Most of that downward movement in spending was for goods. In May, spending on goods plunged by $25.8 billion, reversing a $25.0 billion increase in April. Spending on services rebounded, rising by $30.4 billion, up from a $3.8 billion rise in April, but down from a $42.4 billion rise in March.  

The report was weak. This is more evidence that the recovery is losing steam. This is not the time to be tightening up on either monetary or fiscal policy. Unfortunately, it looks like the powers that be are intent on doing both.
 
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