How savers could doom the economy

By Jon Markman

Pramod Kadambi wakes up every morning fearing the world has come to an end. He and his wife don't spend money on anything but essentials. Friends who have lost their jobs visit and cry. He sees war or revolution coming. Gold coins and guns are new additions to the household.

An unshaven, out-of-work survivalist in the backwoods of Georgia? Not at all. He's a young medical professional in California earning more than a million dollars a year -- and the new face of the wealthy in America. That makes him the Obama administration's worst nightmare: someone who could help revive the nation's economy but instead has shut down his wallet in stark dread.

Over the next few months, a searing debate over paying for the nation's trillion-dollar deficit with new tax increases on the rich will divide the country by class and political ideology. Yet it's becoming increasingly clear that the dispute will be moot as the economy is poised to sink more deeply into a recession and bear market that will provide shockingly less income for authorities to tax.

How much less? Maybe as little as half, and fretful savers like Kadambi are part of the reason. Most analyses of the $787 billion fiscal stimulus package and President Barack Obama's spending priorities so far have assumed all the economic theories embedded in the plans by Harvard and Princeton economists in the White House are accurate and unassailable, and will direct federal money to work like magic to restore order if only recalcitrant Republicans and naysayers would get out the way.

What's hasn't really been challenged is whether the assumptions underlying the plans' model fit any sort of reality that exists outside the hallways of Ivy League economics departments and whether emotional individuals acting in their own self-interest to save money -- rather than as robotic consumption machines that spend like crazy -- can mess them up.

Saving for (and creating) a rainy day

Fresh evaluation from Wall Street analysts steeped in economic traditions outside Boston and the Beltway is focusing on the idea that the government's recovery efforts depend too much on people acting rationally in a way that fits historical patterns of calmer times. If people instead ramp up their savings rates to a degree not anticipated by the economists' models, then consumer spending will decline at a rate that that will crush corporate earnings and, in turn, push stocks a lot lower. The resulting loss of confidence will then reflexively cause people to save more, leading to a vicious downward spiral.

• Talk back: Will savers nix the recovery? Does this analysis ring true?

To understand this scary effect, an obscure but well-regarded model of economic behavior called the Levy-Kalecki formula has begun to gain favor in some circles in part because, since its creation 70 years ago, it has done an unusually good job of forecasting how high levels of saving and a decline in borrowing can lead to the devastation of profits.

Plugging current U.S. output figures into a classic version of the Levy-Kalecki formula shows that if households save as little as 7% of their incomes over the next year, the S&P 500 Index ($INX) could plunge as low as 550, which would amount to a 21% decline in value from the current level. The equivalent for the Dow Jones industrials ($INDU) would be about 5,300.

If the wealthy are taxed at higher rates, as currently contemplated by the Obama administration, and savings rates go to 10% per annum, the formula suggests corporate profits will be cut in half from their peak two years ago. Because earnings at the companies that make up the S&P 500 totaled $84.70 a share in 2007, that would mean forecasts of the stock market need to start with the assumption that earnings will sink to about $42 per share.

If investors are confident that a decline to that level is just a temporary aberration, they will apply a price-earnings multiple similar to what we see today, around 18, and then you get a forecast of 755 for the S&P 500, which is a little higher than where we are now. But if investors fear earnings will continue to slip, then they'll cut the multiple to as little as 9 or 10, as they did in the 1970s, and if you do the math you get a projection of 420 for the S&P 500, or around Dow 4,000.

Yow. Talk like this used to be strictly in the realm of grumpy old men and cuckoo birds, but it's occurring now in smart circles because mainstream economic theories are not adequately explaining consumer and government behavior in this cycle. Wall Street practitioners are thus turning to alternative theories, and the Levy-Kalecki formula -- independently developed by New York physicist-entrepreneur Jerome Levy in 1914 and Polish economist Michal Kalecki in 1935 and then unified by American economist Hyman Minsky in the 1960s -- is helping to better elucidate the relationship among debt, savings and profits.

Continued: Le freak, c'est chic

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