American households have dramatically turned away from years of rising spending and borrowing to embrace a new ethic of thrift and saving. This change of heart appears likely to continue for many years, which suggests the United States will have a weaker economic recovery than has been seen after other post-war recessions. While painful in the short term, this return of thrift will be beneficial in the long run.
By Robert Stowe England
June 14, 2009
[Note: The following remarks were made at the 30th annual conference of American Independent Writers at George Washington University in Washington, D.C. on June 13.]
Whatever history’s ultimate conclusion about the current economic downturn, it has already earned its place in the record books on several accounts.
We have the highest unemployment rate in 25 years at 9.4 percent. We have lost 5.4 million jobs. Housing prices have declined the most since the Great Depression. More national debt has already been created during this downturn than in any previous one – with the potential of new deficit spending beyond all that has spent throughout American history.
The Federal Reserve has more than doubled its balance sheet to its highest level ever, $2.08 trillion, with the potential to go much higher. (A year ago the Fed's balance sheet was $906 billion.) Legendary Wall Street firms have vanished. A huge slice of the shadow banking system – the part not backed by government guarantees – has collapsed.
The banking system is loaded with trillions of dollars of toxic assets. The government owns a major share of Citigroup, nearly all of AIG, the world’s largest insurance company, plus a controlling interest in GM and Chrysler. We are increasingly dependent on China to buy our debt, and around the globe, the dollar is frequently under attack.
How do you get your arms around all that and make it relevant to your own life?
If you feel intimidated, you’re in good company. Remember that virtually the entire economics profession here and abroad and nearly every financial journalist around the globe failed to see the financial meltdown coming.
Two economists who did – Nouriel Roubini (New York University Stern School of Business) and Robert Shiller (Yale University) – were ignored. As was investment strategist Peter Schiff (Euro Pacific Capital, Darien, Connecticut).
Analysts, strategists and economists spent nearly two years of trying to determine what went wrong and what should be done about it since the mortgage meltdown in August 2007 launched the crisis that has led to a deep recession.
Given their track record, you can probably assume that the same people who didn’t see it coming do not yet fully understand the significance of all that has happened. They still have their “informed” opinions; and, while we can give them a hearing, I doubt that their views are more likely to be on target or more helpful than our own views based on a common sense understanding of basic human nature and the hard realities of household finances.
Let's face it. Households, despite some missteps by those who borrowed too much, have shown themselves to be much better at managing their financial affairs than the federal government, the Fed, and virtually all financial institutions. Households, for example, cannot long delay the cold realities of budgetary imbalances or serious financial miscalculations.
So, casting aside all caution, here’s my two cents worth on the economy and, of course, feel free to take it with a large grain of salt.
First, where are we today? The pace of economic decline has slowed dramatically. Importantly, the pace of decline in home prices has slowed and home sales have turned up, as first-time homebuyers and investors snap up foreclosed properties on the lower end.
However, a sharp rise in interest rates over the past few weeks means that continued progress in turning around the housing sector is likely to slow. A recovery in housing prices is critical to the effort to put a cap on the mounting losses in mortgages, mortgage-backed securities and their exotic and toxic derivatives held by banks and other financial institutions. To the extent that those losses are contained, banks and credit markets can expand better to meet demand and the recovery can proceed.
Yet, even if the housing sector rebounds, do not expect a normal recovery. The reason? Our of necessity, the central player in our economy – the American consumer – has rediscovered the virtue of thrift. And because of this fundamental change of heart and spending habits, the economic recovery that could begin any time between now and early next year is likely to be weak by historic post-war standards.
Let me explain why. Americans have been living beyond their means for so long they can no longer continue to do so. The march of American households deeper and deeper into debt has gone on almost continuously for nearly 50 years. In 1960, for example, that ratio of household debt to personal disposable income stood at a financially healthy, if not frugal, 55 percent. The parents of baby boomers who headed households at that time grew up in the Great Depression, during which the imperative to be thrifty was deeply imbedded in their psyches.
By the early 1980s, the ratio of household debt to personal disposable income had risen to 65 percent – still respectable and manageable. However, over the 1990s debt levels soared as more global funds flowed into the United States to support lending to the American consumer; and, financial innovations made it easier for consumers to borrow as much as they wanted to borrow, often without regard to their ability to repay.
By 2002 the ratio of household debt to disposable personal income had reached 100 percent. As the housing bubble grew ever larger, the ratio of debt to income balooned to 133 percent in 2007.
Since 2007, households have started to pay down their debt and gradually increase their savings rate, which has moved from virtually zero to 3.9 percent in the first quarter of 2009. It is likely headed higher.
As a result of these changes, in the first quarter of 2009, the ratio of household debt to disposable personal income had already moved down to 128 percent. (This ratio is reached by dividing $13.795 billion in debt from the Fed's Flow of Funds report by $10.785 trillion in disposable income from the Bureau of Economic Analysis's National and Income Product accounts tables).
How long with this deleveraging go on?
Based on historic patterns, a recent “economic letter” by Reuven Glick and Kevin Lansing of the San Francisco Fed hypothesized that household deleveraging could take anywhere from three years to a decade or longer. The authors said it might, for example, take until 2018 for households to lower their leverage to a debt-to-income ratio of 100 percent.
What this suggests is that the current thrifty attitude is not just a temporary statistical glitch but a fundamental change. It is time for us to seriously consider whether or not the era of rising household debt is over and the era of declining household debt has begun.
Earlier this week bond king Bill Gross of PIMCO described the reversal of direction in household finances this way: “The old slogan of ‘shop ’til you drop’ is being replaced by ‘save to the grave.’"
If this is our future, the demand for credit by consumers is unlikely to expand very much, even with a growing population. And the American consumer, whose activity has for decades been the engine of economic growth, may not be the powerhouse that has driven 70 percent of the economy.
At the same time the process of getting rid of those bad assets is also likely to take a long time to unwind, in spite of all the programs developed to move them off the balance sheets of lenders. As a result, even credit worthy consumers and businesses are unable to obtain credit. And the shadow banking system that was once an economic powerhouse to meet consumer borrowing demand is likely to come back as only a shadow of its former self.
We are living today in a Minsky moment. That’s the phrase coined by PIMCO executive Paul McCulley in 1998 during the Asian debt crisis to describe the point when the debt crisis broke.
McCulley’s “Minsky moment” is so named because it is derived from the thinking of economist Hyman Minsky, who created a debt model he dubbed the Financial Instability Hypothesis. Minsky’s theory goes like this: in good times people and businesses are overcome by euphoria and build up debt beyond their ability to repay out of their income and profits. Once the debt level reaches its peak and households and businesses start to fail, it leads to a financial crisis and a severe economic downturn. The moment of truth is the Minsky moment. And we have now seen perhaps the biggest Minsky moment in our lifetimes.
Of course, not all economists subscribe to a dour view of the future. Some believe the intrepid American consumer will come roaring back and the economy will take off again. The optimists argue that it is quite possible that the recovery, when it begins, will be the typical V-shaped recovery where we bounce back quickly. They point out that the sharp decline in the economy came from the credit market meltdown and the threat of a worldwide panic, but now that Armageddon has been taken off the table, the optimists contend, the bounce will be strong.
Yet, the majority view, for what it’s worth, still contends we will have an L-shaped recovery, during unemployment will remain high for years and gains in wages will be modest.
If the weak recovery scenario turns out to be our future reality, it need not be viewed as a negative. While painful in the short term, in the long run, the newly rediscovered virtue of thrift and debt reduction will pay off for households, the economy and society at large.
As we manage our lives as independent writers, we can continue to make headway toward our career and financial goals. We will need to be more flexible and ready to consider new ways of thinking. Opportunities will appear in unlikely places and we need to be prepared to recognize them, seek them out and take advantage of them.
See related blog post on household debt reduction at this link: http://mindovermarket.blogspot.com/2009/05/warning-painful-houshold-deleveraging.html
Copyright 2009© by Robert Stowe England