http://www.nytimes.com/2008/10/31/opinion/31krugman.html When Consumers Capitulate By PAUL KRUGMAN Published: October 31, 2008 The long-feared capitulation of American consumers has arrived. According to Thursdayâs G.D.P. report, real consumer spending fell at an annual rate of 3.1 percent in the third quarter; real spending on durable goods (stuff like cars and TVs) fell at an annual rate of 14 percent. To appreciate the significance of these numbers, you need to know that American consumers almost never cut spending. Consumer demand kept rising right through the 2001 recession; the last time it fell even for a single quarter was in 1991, and there hasnât been a decline this steep since 1980, when the economy was suffering from a severe recession combined with double-digit inflation. Also, these numbers are from the third quarter â the months of July, August, and September. So these data are basically telling us what happened before confidence collapsed after the fall of Lehman Brothers in mid-September, not to mention before the Dow plunged below 10,000. Nor do the data show the full effects of the sharp cutback in the availability of consumer credit, which is still under way. So this looks like the beginning of a very big change in consumer behavior. And it couldnât have come at a worse time. Itâs true that American consumers have long been living beyond their means. In the mid-1980s Americans saved about 10 percent of their income. Lately, however, the savings rate has generally been below 2 percent â sometimes it has even been negative â and consumer debt has risen to 98 percent of G.D.P., twice its level a quarter-century ago. Some economists told us not to worry because Americans were offsetting their growing debt with the ever-rising values of their homes and stock portfolios. Somehow, though, weâre not hearing that argument much lately. Sooner or later, then, consumers were going to have to pull in their belts. But the timing of the new sobriety is deeply unfortunate. One is tempted to echo St. Augustineâs plea: âGrant me chastity and continence, but not yet.â For consumers are cutting back just as the U.S. economy has fallen into a liquidity trap â a situation in which the Federal Reserve has lost its grip on the economy. Some background: one of the high points of the semester, if youâre a teacher of introductory macroeconomics, comes when you explain how individual virtue can be public vice, how attempts by consumers to do the right thing by saving more can leave everyone worse off. The point is that if consumers cut their spending, and nothing else takes the place of that spending, the economy will slide into a recession, reducing everyoneâs income. In fact, consumersâ income may actually fall more than their spending, so that their attempt to save more backfires â a possibility known as the paradox of thrift. At this point, however, the instructor hastens to explain that virtue isnât really vice: in practice, if consumers were to cut back, the Fed would respond by slashing interest rates, which would help the economy avoid recession and lead to a rise in investment. So virtue is virtue after all, unless for some reason the Fed canât offset the fall in consumer spending. Iâll bet you can guess whatâs coming next. For the fact is that we are in a liquidity trap right now: Fed policy has lost most of its traction. Itâs true that Ben Bernanke hasnât yet reduced interest rates all the way to zero, as the Japanese did in the 1990s. But itâs hard to believe that cutting the federal funds rate from 1 percent to nothing would have much positive effect on the economy. In particular, the financial crisis has made Fed policy largely irrelevant for much of the private sector: The Fed has been steadily cutting away, yet mortgage rates and the interest rates many businesses pay are higher than they were early this year. The capitulation of the American consumer, then, is coming at a particularly bad time. But itâs no use whining. What we need is a policy response. The ongoing efforts to bail out the financial system, even if they work, wonât do more than slightly mitigate the problem. Maybe some consumers will be able to keep their credit cards, but as weâve seen, Americans were overextended even before banks started cutting them off. No, what the economy needs now is something to take the place of retrenching consumers. That means a major fiscal stimulus. And this time the stimulus should take the form of actual government spending rather than rebate checks that consumers probably wouldnât spend. Letâs hope, then, that Congress gets to work on a package to rescue the economy as soon as the election is behind us. And letâs also hope that the lame-duck Bush administration doesnât get in the way.