Consumers must keep the faith — and keep spending — to avoid recession

Economic recessions are ultimately a loss of faith. Consumers lose faith that they will hold on to their jobs and curtail their spending. Businesses lose faith that they will be able to sell whatever they produce and lay off workers. Lenders lose faith that they will be repaid in a timely way and aggressively tighten lending terms.

A vicious self-reinforcing cycle takes hold: Consumers pull back on spending, businesses respond by laying off workers, and lenders curb credit, further spooking consumers who cut back even more. A broad-based persistent decline in economic activity — a recession — is ignited.

Consumers have not lost faith in the economy, but they are wavering. In the 70-plus years that the University of Michigan has surveyed the mood of American households, there were less than a handful of times that sentiment was weaker than it is now. Businesses are similarly on edge, according to a survey by the National Federation of Independent Business, which has been compiling this data for 50 years.

Lenders have also turned skittish. The Federal Reserve’s quarterly survey of senior loan officers at commercial banks shows most banks aggressively tightening their lending standards.

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Despite the fragile collective psyche, there are good reasons to think it will not break. Consumers can take solace in the so-called excess savings they built up during the height of the pandemic. This is the extra saving that consumers did above what they would have done if there had not been a pandemic — in other words, as if they had maintained the same saving rate during the pandemic as prior to it.

Low- and low-middle-income households initially saved a significant amount of the government support they received to financially navigate the pandemic, including three rounds of stimulus checks, enhanced unemployment and rental assistance, and moratoriums on student loan and mortgage payments. High-income households saved prodigiously as they sheltered in place, unable to spend much of their incomes.

There was concern that with so much cash sitting in people’s checking accounts there would be a spending boom once the economy reopened. Consumer spending did pick up with the COVID-19 vaccine rollout and government support provided in the American Rescue Plan in spring 2021, but consumers have not spent with abandon. They have simply done their part, spending at a pace consistent with pre-pandemic spending trends.

Businesses also have reason to buck up. While they’ve had to deal with a lot, from a severe labor shortage to their falling stock price, through it all, they’ve remained highly profitable. Their profit margins — what they earn above their labor and other costs — remain about as high as they has ever been. They have the wherewithal to continue making the investments they need to address challenges such as global supply chain disruptions, and to adopt new technologies, such as artificial intelligence, which are critical to their future growth.

Their profitability will also help ensure that they don’t lay off lots of workers. Businesses are throttling back on hiring, which is down to where it was pre-pandemic, but they are loath to fire people. They know, with the aging out of the workforce by the large baby boom generation and weaker foreign immigration, that their number-one problem for the foreseeable future will be finding and retaining workers.

It is much less costly and disruptive to businesses to reduce payrolls if they need to through less hiring than through more layoffs. It is also much less scary to consumers. Losing a job is a much bigger blow to the psyche than not being able to quickly find a new job.

Lenders have also arguably never been on firmer ground. This is due largely to the regulatory overhaul of the financial system after the financial crisis more than a decade ago. These reforms require banks to hold much more capital — the cash cushion protecting them from consumers and businesses defaulting on their loans — and to have more cash on hand if things do go bad.

It has long been difficult for the financial system to strike a balance between too much credit and not enough. Too much credit leads to too much debt, a financial crisis and recession. Not enough credit induces a credit crunch and stunts economic growth. Regulators looking down on the financial system from on high would like to see credit growth consistent with growth in the economy, which reflects the ability of consumers and businesses to make good on their debts. And that is what they have seen, more or less, since the post financial crisis reforms.

We are nearing the moment of truth for this business cycle. Will the economy suffer a recession, or will it be able to skirt one? The answer ultimately rests on whether consumers, businesses and lenders lose faith in the economy and stop spending, investing, and lending. They should keep the faith.

Mark Zandi is chief economist for Moody’s Analytics.