Household expenditures (termed personal consumption) have always occupied the majority of dollars spent when GDP (gross domestic product) is calculated. Roughly 70% of the United States GDP's composition is the result of end consumption. The remaining 30% is divvied up with approximately 20% to government expenditure and 10% to business investment. (For an overview of the GDP, see our Gross Domestic Product, Economic Indicators Tutorial.)

This overconsumption argument must be seen in historical context. In 1956, household expenditures resulted in about 63% of the $506 billion economy. While a 7% increase in 2009's $14 trillion dollar economy is a noticeable number, it must also be remembered that the lines between business and household consumption are more blurred in today's home-based, small business, flexible employee economy where office supplies are purchased at the same time as a gallon of milk.

Decade by Decade
Concurrent with the overconsumption argument is the claim that U.S. citizens do not save enough money. Household income really has only two outlets - savings or spending (savings % + spending % = 100%). While it is true that the calculated personal savings rate (PSR) has, in general, fallen noticeably between the 1960s and the early 2000s (1960s PSR were roughly 7-8%; year 2000 PSR were generally 2-3%). During the recession that began in December, 2007, the savings mentality was sparked as evidenced by a PSR of 4.9% after 20 months into that recession.

Repairing the Economy, Mathematically Speaking
This brings us to the question of how the economy is to recover if the personal savings rate remains elevated. In its most basic form (absent import/export calculations) GDP is calculated as the sum of household consumption, government spending and business investment. Shown formulaically as Y=C+G+I. (Note that government expenditures are termed "spending," not the more politically appealing term "investment"). Another method to recovery is business spending, which is indeed investment since business exists to generate profits above input levels. Incidentally, business spending is the most volatile of the three measures - consumer spending, despite conventional wisdom, rarely falls far in percentage terms from its perch, and heaven knows that governments rarely reduce baseline budgets.

It should be clear why government-led stimulus spending plans have, since the 1930s, largely been aimed at the consumer (the 70%). Any small change in the behavior of the collective should provide the greatest jolt for economic activity, as measured by GDP growth.

A Recovery Process Without Consumers?
An elevated personal savings rate typically diminishes hope for recovery, regardless of the number of rounds of stimulus and its final count. The intuition follows that, if households are not spending, then product is not moving, salespeople are not selling, manufacturers are not producing, employment is not increasing and the economy is not recovering.

Government policy since the Great Depression has largely followed the Keynesian model. Under this prescriptive the problem is believed to be lack of consumption by households, thus it is the government's role to increase spending, thereby providing an outlet for production of goods and services, which keeps and increases employment. The underlying idea is that individuals with employment security will eventually show increased confidence and begin spending. This would allow government to step aside and reduce its efforts. (Also, learn how government actions may have contributed to the great depression in What Caused The Great Depression?)

A Saving Economy
If those options seem unpalatable, there is yet another rarely discussed option. It involves the encouragement of savings. Not by executive order, judicial decree, moral persuasion or some other form of pressure, but by simply allowing a natural course to take place.

There is little greater incentive for individuals and households to save money than a high real rate of return on savings. In stable money environments, individuals and entities have always responded well to any bank, credit union or savings & loan that will offer a relatively high savings account percentage (passbook savings, money market accounts, certificates of deposit). Economists refer to this behavior as "voluntary savings." It is also important to note that savings is simply consumption that is deferred. Think of this in terms of households saving for education expenses, retirement or purchase of a different car or other big ticket item.

The process of recovery through voluntary savings is really quite simple. Saving takes place with the funds deposited into a bank, S&L or credit union. The bank then loans out the money to a business for investment or to an individual for spending. If the business venture is productive, the bank will receive principal and interest payments for the term. Then the cycle repeats itself.

This recovery process is hijacked when the interest rate is reduced and the incentive to save or defer consumption is destroyed. Households and business are now induced to consume today. Thus, production is artificially expanded, in some cases, to the extent that large amounts of investment take place to expand capacity. Economist Gottfried Haberler refers to this process and the diversion of funds throughout the stages of production as forced savings. The artificiality of the expansion will work to bid up input costs: raw materials, interest rates, then wages, etc.

Portfolio Intuition: Aligning your Portfolio to Profit
The alignment of the investment portfolio for recovery is essentially the same regardless of what occurs with the PSR. The question is largely one of timing.

The flow of money through the economy and the time in which that takes place should dictate how an investor allocates assets in the portfolio. The process begins with where money is created - at the bank. Modern banks operate through the entire spectrum of the production channel. The higher end of the channel consists of business banking functions - small- and medium-sized business lending and investment banking functions - involving raising money for expansion or other business needs. The lower end of the channel consists of bank activities aimed at servicing the individual or household: checking accounts, savings accounts, etc. The flow of money begins with banking and that is likely a good place to start in terms of finding investments to overweight. This intuition holds even though many banks will be liquidating bad investments after coming out of a recession. In an efficient market that information will be largely priced into the stock price. (See Working Through the Efficient Market Hypothesis to understand the concept of an efficient market.)

From there, an investor should look through the ranks of those that operate at the top of the production channel - those furthest from the consumer - firms in the materials, industrials, and transportation sectors should be favored at the expense of consumer staples and consumer discretionary firms.

The PSR is a valuable indication that can lend insight into how a recovery will unfold. However, the PSR needs to be considered in relation to interest rate levels. If interest rates are held down, as they usually are when an economy emerges from recession, and the PSR remains high, it may be an indication that consumer confidence has not returned and consumption is likely to remain low, but that the future recovery is likely to be more sustained. Savings increase an investor's wealth level, and wealth levels have long been recognized as a factor in demand and spending.

If, however, PSR falls quickly, it could indicate a turbulent market to come. After all, for banks and individuals alike, the effect of savings and wealth levels takes time. A quick "recovery" may not be sustainable. Thus, an investor may want to implement the recovery strategy over a greater period of time - holding more cash in the short term while utilizing principles of dollar cost averaging to profit from the market's movements.

For additional reading, check out Rules For Post-Recession Investing.

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