Don’t get too excited about signs of life in the economy. Some
days it seems there’s good news everywhere: home sales ticking up, slower
job losses, the Dow turning positive for the year. But all that misses a
looming reality. American consumers, whose overspending largely got us into
this mess, are still under massive pressure thanks to the record debt they
racked up during the boom years. People are unwinding those burdensome
obligations from mortgages to car loans to credit-card debt as fast as they
can, but the process is sure to take years, and until it is complete the
economy can’t fully bounce back. “Even though we’re probably past the worst
in the business cycle and probably even in the bear market, we’re talking
about something much bigger here,” says David Rosenberg, chief economist at
money-manager Gluskin Sheff. “The largest balance sheet in the world is the
U.S. household balance sheet, and it’s contracting at a record rate.”
One way to understand the Great Consumer Retrenchment is to look
at the amount of debt the typical household carries as a percentage of its
disposable income. The ratio of debt to income increased from about 35% in
the early-1950s to about 65% by the mid-1960s, where it more or less stayed
until the late 1980s. That’s when debt started its epic rise, hitting 100%
of income in 2001, and going all the way up to 133% in
That figure is now starting to fall. As of the end of 2008, the
debt-to-income ratio was down to 130%, and new numbers from the Federal
Reserve on Thursday are sure to show another drop.
Two things are driving that figure
down. First, people are paying off debt which goes hand in hand with not
spending money on as many new things. In April, outstanding consumer
credit which includes credit cards, auto loans and tuition financing, but
not mortgages fell by $15.7 billion to $2.52 trillion, an annualized drop of
7.4%, and the second-largest dollar drop on record, after March’s $16.6
billion decline. Numbers from April show that people are now saving 5.7% of
their disposable income, the highest rate in 14 years.
Second, people are shirking their obligations. According to the Mortgage
Bankers Association, one in eight U.S. mortgages is now either in
delinquency or default. Banks are figuring that nearly 10% of the money
they’re owed from credit cards is money they’ll never see. “People were consuming
more than their income, and that gave a big boost to the U.S. economy,” says
Kevin Lansing, a senior economist at the Federal Reserve Bank of San
Francisco . “It doesn’t seem like that’s going to happen going forward.”
Chances are, there is much more unraveling deleveraging, to be
technical about it to come. Gluskin Sheff’s Rosenberg looked at the ratio of
household debt to total net worth and figured that for things to fall back
in line with where they’ve been historically, Americans would have to get
rid of some $3 to $5 trillion in debt over the next few years.
Lansing and San Francisco Fed colleague Reuven Glick ran a simulation of
what would happen if the U.S. consumer followed a path similar to Japanese
businesses in the 1990s. That was another episode of a great debt dump
following a stock-and-real-estate bubble it’s one of the examples economists
often turn to in order to try to understand what’s going on now. Lansing and
Glick figured that for U.S. households to resume a debt-to-income ratio of
100% over the next decade, the savings rate would have to nearly double from
its already-elevated 5.7%, all the way up to 10%. That would subtract
three-quarters of a percentage point from consumption growth each year.
Yet that raises an interesting question: Why would we think
that a debt-to-income ratio of 100% is sustainable Well, for one thing, the economy has ostensibly evolved since the
1950s, and even since the 1980s. Advancements like securitized lending seem
to have created a system where interest rates are lower and consumers are
able to shoulder more debt than they once did. The percentage of income that
goes toward paying interest on debt went from 11% at the beginning of 1980
to 14% in at the beginning of 2008, a much smaller jump than the increase in gross amount of borrowing taken on. In other words, there might be
reason to believe we can now comfortably carry more debt than we did 20 or
50 years ago.
Still, it is likely to be a while before we hit that new normal.
Rosenberg points out that during the Great Depression the worst of GDP
contraction and stock market losses had hit by the early 1930s. And yet the
malaise carried on for the rest of the decade. Unemployment hung above 15%
and people didn’t spend money. “Even people who had the means didn’t go on
buying sprees; that’s not how they lived,” says Rosenberg. We may now be in
for some of the same.
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