The Pulse of Capitalism

Issue 99-1, April 1999

Personal Income

"The consumer is two-thirds of the economy." or, "Exports declined in the latest period, but the consumer stepped up to the plate to keep the economy on an upward trend." These are familiar lines from media commentators. These assertions are based on the fact that personal consumption expenditures are equal to roughly two-thirds of GDP. To understand the current economy, therefore, we must review what has been happening to personal income and its constituents in recent decades. The first step is to identify the sources of personal income. These data and what follows are found in Survey of Current Business.

Changes in Personal Income 1960-1997

The principal changes in personal income in the past four decades have been a decrease in the share received by wage and salary recipients from 69.4 to 63.1 percent, a decrease in proprietors' income from 12.7 to 8.1 percent (largely farm), an increase in personal interest income from 6.1 to 11.0 percent, an increase in transfer payments from 7.0 to 16.4 percent, and a related increase in personal contributions for social insurance (a deduction from earned income) from 2.3 to 4.7 percent. A one percent change, it should be noted, in 1997 dollars equaled $67.8 billion. In total, these changes represented about a 13 percent shift from categories of earned income to categories of unearned income. These changes reflect the growth of retirees relative to the work force and the increase of interest-paying debt in the economy.

Changes in Disposition of Personal Income 1960-1997

As shown in the table, personal tax and nontax payments rose from 11.9 percent of personal income in 1960 to 14.6 percent in 1997. Personal outlays grew from 94.3 to 97.9 percent, and personal saving fell from 5.7 to 2.1 percent. But, to assess these changes, we need additional detail. First, the deduction for tax and nontax payments breaks down as follows:

Personal tax and nontax payments, as we have noted, rose from 11.9 percent of personal income to 14.6 percent. But all of this increase was due to higher state and local taxes, not federal. Deducting tax payments from personal income gives us disposable personal income. From this we subtract personal outlays, the second major use of personal income. Personal outlays break down as follows:

This table shows that all but about 3 percent of personal outlays are expended in personal consumption expenditures. Within this classification, expenditures for durable goods have been quite constant. Durables of course, include cars, appliances, electronics, etc.; the stability of this ratio indicates that demand and costs have been pretty constant. However, there has been a marked shift in non-durable goods from 45.0 down to 28.2 percent, and in services from 40.0 up to 56.8 percent. To explain this shift, we need a further breakdown of these two categories.

This table shows that the decline in non-durable expenditures has been fairly uniform across all constituents. The largest decline is in the food category, probably reflecting not only low farm prices but also competition at the retail level. By contrast, the rise in the services classification is virtually all in medical care and "other". The surge in medical costs has been publicized for the past decade, but little has been done to stop it. Conditions of monopoly and the severance of a direct monetary link between consumer and provider as well as ever more exotic treatment methods are at the base of this escalation. The "other" category includes such activities as education and recreation which also seem immune to market control through competition. The escalation of sports figures salaries is an outstanding example of this phenomenon. Apparently, only a real economic depression will stop this process.

Changes in Personal Saving

The residual left after deducting tax and nontax payments plus personal outlays from personal income is personal saving. In many ways, it is the most important change in this whole equation. First, a reduction in saving translates into an increase in consumption, even if it results from higher taxation since all tax revenues are spent. Second, it has a direct bearing on the amount of debt that households can incur.

One cannot fail to be struck by the disparities in this table, From 1960 to 1980, personal saving rose from 5.7 to 7.9 percent of disposable personal income, but from 1980 to 1997 , it fell from 7.9 to 2.1 percent of income. This trend continued in 1998 when saving fell each quarter to reach zero percent in the fourth. In the future, the economy will receive no further stimulus from this source.

At the same time, household debt rose from 59.9 to 95.0 percent of disposable personal income. As a multiple of personal saving, it rose from 10.5 to 45.5 times saving. Thus, during the past two decades, the economy has had a double-barreled boost from reduced saving on the one hand and higher debt levels on the other.

Like stock market valuations, no one knows how high household debt can rise relative to income, but at some point there is a ceiling. The higher the debt level rises, the more susceptible the economy becomes to a cascading downturn if expansion falters.

It may seem strange that personal saving has fallen to zero at a time when we know that individuals are investing unprecedented amounts in mutual fund shares, but there is an explanation for this as shown in the following table:

As these figures show, since 1994 the personal sector has consistently sold more directly owned corporate equities then it has acquired in the form of mutual fund shares. One significant source of these sales of corporate equities must be the exercise of stock options by corporate officers. These options have mushroomed in recent years and have no tangible value until they are exercised and the stock sold.

These figures may also answer another question: With $20 billion or so flowing into mutual funds every month, are not securities markets almost sure to keep rising? The answer seems to be no. If stock prices stop rising, sales of directly owned shares and purchases of mutual fund shares are both likely to decline. Mutual funds, in a prolonged decline, could turn out to be their own worst enemies as they would be slow to change their investment objectives despite ongoing losses.

Summary

Over the past four decades, significant shifts have occurred in personal income and its disposition. There has been a change of about 13 percentage points of personal income from earned (wages, proprietors, social insurance payments) to unearned sources (interest and transfer payments). The tax and nontax deductions from personal income have risen as a result of higher taxes at the state and local levels. Expenditures for non-durable goods have fallen, but expenditures for services have increased sharply. This increase has been due primarily to medical care, and to activities such as recreation and education included in the classification "other". As a consequence of these developments, personal saving fell through the whole period to reach a low of zero percent in the fourth quarter of 1998. We do not know what the consequences of this decline will be, but they are likely to be adverse for the economy.

Aside from the United States, 1998 proved to be a year of weakening economic growth for the leading economies. GDP growth fell in Canada, Japan, and Britain with moderate increases in Germany and the U.S. Industrial production advanced except in Japan, while retail sales were weak or fell except in the U.S. The British economy appears to be slipping noticeably, while the strength in America may partially reflect weakness elsewhere as foreign funds flow into U.S. markets.

Consumer price inflation slowed slightly from 1998, and unemployment rates declined except in Japan. Interest rates increased except in the U.S., another reflection of strong capital inflow.

Interestingly, the Canadian as well as the Japanese stock market actually declined in 1998. The German market declined in the first quarter of 1999 as well, whereas the U.S. market has surged to another all-time high.

The pattern of current account balances did not change greatly. The Japanese surplus again exceeded the $100 billion level, while the U.S. deficit for the first time exceeded $200 billion. The Euro-11 group had an overall surplus approaching $100 billion. Currency changes were moderate with the U.S. dollar rising against most major currencies.

Real GDP grew 4.3 percent in 1998 compared with 3.7 percent in 1997. The advance was led by strong personal consumption expenditures. Industrial production increased 3.6 percent in 1998 compared with 6.1 percent in 1997; durable goods production was the strongest sector. Capacity utilization declined one percentage point. Manufacturers' new orders rose less than half as much as in 1997.

New construction expenditures rose slightly more than in 1997. New housing units was by far the strongest sector; the construction index rose to 151, a 50 percent increase since 1992.

One of the prime causes of the current boom has been rising real private investment since 1993. Producers durable equipment - computers and related equipment as well as transportation and related equipment - rose the most in 1998. Residential investment rose, but nonresidential buildings investment was almost unchanged.

Business and retail sales and inventories trends were unchanged in 1998. Inventory-sales ratios remain low.

These strong business indicators are underpinned by rising real per capita personal consumption expenditures. These expenditures rose $720 in 1998 compared with $448 in 1997 and $395 in 1996. This rise, in turn, was facilitated by another strong rise in employment. Virtually all sectors experienced some increase in employment, but about half of the total increase was in the "services" category.

The 5.3 percent increase in national income in 1998 was consistent with recent yearly increases. Compensation of employees increased 6.2 percent. Per capita income rose 2.3 percent, the largest increase of the decade. Average weekly earnings rose $6.80, which is also the highest in many years.

Gross saving increased $71.5 billion in 1998 in contrast to an increase of $131.6 bn in 1997. The drastic decline in personal saving has been noted. Business saving also declined, but government saving rose. The commodity price index at 86.9 was 15.1 percent lower than in the preceding year. Food and metals declined drastically with a lesser decline in nonfood agricultural goods. The producer price index also declined in 1998 for the first time in a decade. This weakness, of course, is one of the factors causing lower inflation.

Meanwhile, economic weakness is now beginning to impact corporate profits, which rose $15.0 bn or 1.8 percent, the smallest increase since 1992. If this weakness persists, it will undermine the bull market in stocks.

Long term interest rates declined to the lowest levels since the late 1960s. In December, the 30 year Treasury rate was only .64 percent higher than the 3 month rate. Money supply growth accelerated to 11.3 percent, continuing the rapid growth that began in 1995. Total bank credit, likewise, grew at a double-digit rate in 1998, while consumer credit growth accelerated after falling in 1997. Federal Reserve open market purchases through 11 months were below the year-earlier level. Total credit market debt growth accelerated to 9.9 percent. Federal debt contracted nearly 1-1/2 percent, but debt in the nonfederal sectors rose 8-3/4 percent, 2 percentage points faster than in 1997.

The negative trade and current account balances soared to all time highs in 1998. The change in net international investment position was slightly less negative than in 1997, but the three-year cumulative negative net change was $687.0 billion, a huge deterioration. Foreign investment shifted from Treasury securities to other U.S. securities, contributing to both lower corporate bond yields and rising stock prices. These negative trends appear to be ignored in the general euphoria over the "strong U.S. economy with low inflation and low unemployment."