Income Effect May Initially Knock Consumer Spending Down But Credit Constraints Will Keep Spending Down

The WSJ Real Time Economics blog highlights one economist's view that the income effect - not the debt burden - is the main reason for depressed consumer spending.  It is nice to know that people haven't significantly increased their debt service payments to income, so the burden may not be that much greater on existing debt.  But think about the constrained credit markets as getting new debt or credit is a different burden with the same effect.  This fact cannot be denied- it is harder to get credit especially if you are the one in four with a credit score of 600 or less.  So it is the supply side that is constraining the credit.  This is evidenced through credit cards limits being significantly lower and a much greater proportion of credit card applicants who have been denied credit.  As more Americans are laid off, defaults increase as some are forced to renege on a mortgage they can no longer handle (because their income is gone or cut in half with state unemployment insurance benefits) and their credit score is significantly impacted so they are not considered credit worthy (600 or less FICO credit score).  People with significantly less income and having recently defaulted are not able to get credit to buy stuff and this impacts spending and aggregate demand.  So more people are getting laid off as unemployment insurance claims hit a 4 month high at 479,000 this week.  The unemployed (who now receive half or less income ) can't spend like they did when they had an income stream.  In fact they can't spend almost half (subtract for savings) of what they used to spend.  Almost one half of their normal consumption level is the new norm for them.

Where can they go if they want to maintain or at least semi-resemble the lives they had before they lost their jobs?  They have to borrow the rest.  Unfortunately for them (and us) they are unable to borrow because they are less credit worthy (having no suitable income stream) so no one will extend credit to these risky borrowers.  So it is the not only the income effect but the credit effect.  Think about it this way- the standard of living and life style of most people (most people don't save very much) is maintained with a cash flow that comes from either borrowing or a job.  Well when both of those things are suddenly constrained where is the needed cash flow supposed to come from?  Bottom Line: Don't expect consumer spending to pick up anytime soon and don't expect unemployment to fall anytime soon either.  These two things are related as 70% of our economy is based on the consumption of services.  The Employment Situation came out today to reveal what we already know- unemployment is not budging and has held firm at 9.5% the past two months.