American consumers' response to economic slowdown: a ratchet effect
"Spending for a rainy day," U.S. News & World Report, April 23, 2001

Consumer demand is believed to be a function of taste, price and income. Taste and income are positively related, and price is negatively related, to demand. With the significant decline in stock market and its paper wealth in 2000-2001, as well as a mild recession, the disposable income of American households significantly declined, and consumers had to adjust their consumption patterns accordingly. However, once you are used to a good living, it is very hard to modify it radically even with significantly reduced income. This produces a certain degree of a ratchet effect in consumption.

Wine lovers ordered their favorite expensive imported wines by the glass rather than a whole bottle at a restaurant, instead of moving down to a much cheaper domestic wine. Coffee lovers still spent $3 a cup for the Starbuck's dark roast, instead of a cheaper regular coffee. Tourism continued to be strong even in the weak economy. More importantly, people continued buying roomier and more expensive residential houses. In 1999, one third of all new houses had four bed rooms, and on the average they were 20% bigger than the houses built in 1980s. Sales of new automobiles remained strong.

However, consumers were willing to keep many durable goods longer, especially personal computers and furniture. To economize expenses, people did replace their PCs as frequently as before, yet with very little discomfort. For most people, an older PC simply functioned a little slower than a new one.

It remains to be seen that at what level of income reduction American consumers will significantly change their consumption habits. The signs of subtle such change starts to show up in the economy. For example, a well-to-do consumer, who used to buy all her books to read, applied for a library card for the first time in her life when her wealth from technology stocks declined too deeply. From these observations, we may surmise that at least in industrialized countries, consumption tends to increase with income, but initially refuses to decline with a lower income, until a critical threshold of income reduction has been reached. This pattern explains why the standard of living in industrialized countries continues to increase with only minor hesitations during recessions.

A similar observation has also been made of labor wages. Wages increase rapidly during an economic expansion, but refuse to go down during recessions. Instead, wages remain at the previous level. Recession is always followed by an economic expansion, which encourages further wage increase. Thus, wages keep increasing over time.