By Robert Stowe England
May 30, 2009
Americans have been living beyond their means for so long that they can no longer do so. They have, in fact, begun a long and likely painful process of deleveraging or debt reduction that could last for many years.
Economists measure household frugality or profligacy by calculating the ratio of debt to personal disposable income. In 2007 that ratio for the average American household reached an all-time high of 133 percent. By contrast, in 1960 the ratio stood at 55 percent.
As households deleverage and build up their savings to overcome sharp losses in home equity and investments, consumption by the household sector is likely to be weak in the coming recovery, according to economists Reuven Glick and Kevin J. Lansing of the Federal Reserve Bank of San Francisco.
Their observations were made May 15 in the FRBSF Economic Letter in an article titled "U.S. Household Deleveraging and Future Consumption Growth."
Glick and Lansing cited economist Hyman Minsky who proposed more than two decades ago a financial instability hypothesis asserting that prolonged good economic times induce behavior that leads to really bad economic times. As Glick and Lansing explain in economics lingo, Minsky "argued that prosperous times can often induce borrowers to accumulate debt beyond their ability to repay out of current income, thus leading to financial crises and severe economic contractions."
In Japan, evidence from the leverage of private non-finanical firms after the bursting of the real estate bubble and stock market bubble showed a 30 percent decline of the same magnitude over a ten-year period. The authors suggest, in fact, that it could take American consumers until 2018 to reduce their leverage by 25 percent, from 133 percent to 100 percent, the level where it stood in 2002.
Given the sharp pace of home price declines and the high level of foreclosures, the process this time around seems more like the pace and rate of decline in household leverage during Great Depression rather than the slower pace of decline in Japan after 1991.
Given the magnitude of losses in home equity and in the stock market, it would seem to this writer that the period of deleveraging and reduced consumption by households will last much longer than three years for the great majority of American households. For those going through foreclosures, short sales of homes and bankruptcies, the rebalancing act will take place much faster, but this will transfer the costs to financial institutions, again with consequences in the larger economy.
It would seem that whether the pace is fast or slow, nearly all households have already found that thrift and frugality are suddenly very, very attractive, if not irresistible. In the long run, these newly rediscovered virtues will pay off for households, the economy and society at large.
Meanwhile, the engine of economic growth -- the American consumer -- is not going to be running on all cylinders for quite awhile.
The San Francisco Fed article can be found at this link: http://www.frbsf.org/publications/economics/letter/2009/el2009-16.pdf
Copyright 2009© by Robert Stowe England