SERIOUS MONEY:THE US economy is in recovery and risk appetite has returned to financial markets, but serious headwinds remain. The spectacular borrowing binge by US households was a primary driver of the recession of 2007 to 2009 and remains an impediment to a self-sustaining recovery.
Signs of consumer stress first surfaced as early as the second quarter of 2006 once house prices began their descent – a full five quarters before the unemployment rate edged higher – and gained momentum once credit-card availability was cut towards the end of 2008.
Massive deleveraging is now under way. Outstanding household debt has contracted for an unprecedented seven consecutive quarters, but it still remains abnormally high relative to disposable income. Much of the reduction to date simply reflects the write-off of bad loans and not genuine deleveraging.
The rehabilitation of household balance sheets must continue. But if household incomes stagnate, as seems likely in the face of an oversupplied labour market, each percentage-point reduction in the debt-to-income ratio will translate into at least $100 billion (€83 billion) less spending – a potential drag on economic growth.
The surge in household debt in recent years has been well documented, with the amount of outstanding debt increasing by more than 30 percentage points relative to gross domestic product (GDP) from 1997 to 2007, and by more than 40 percentage points relative to disposable income over the same period.
The phenomenal growth in debt was precipitated by the advent of subprime mortgage securitisation, which provided new home purchase financing for a segment of the population that was traditionally unable to obtain mortgages. It was also fuelled by the increase in house prices and low interest rates, which enticed existing homeowners to extract cash from their home equity.
Existing homeowners borrowed 25 to 30 cents on every dollar of home value appreciation, and mortgage equity withdrawals averaged more than 5 per cent of disposable income from 2004 to 2006.
Staggering debt growth was accompanied by a precipitous decline in personal savings rates, which bottomed out at about 1 to 2 per cent from 2005 to 2007. The combination unleashed a consumption boom that saw personal consumption expenditure increase from $7 trillion to $10 trillion from 2000 to 2007, capturing almost 80 per cent of real GDP growth during this period. All else being equal, if consumers had saved at the same rate as in 1980, they would have spent roughly $1 trillion less in 2007 alone.
The rapid accumulation of debt led to household financial obligations reaching record levels as a percentage of disposable income. Consumers became vulnerable to either a negative income or interest rate shock. Household default rates began to edge higher as early as the second quarter of 2006. The ratio has since dropped by more than one percentage point to below 18 per cent, but it is concerning that, in the face of near-zero policy rates, the ratio is still higher than the comparable numbers recorded in the months leading up to the recessions of 1980/1981, 1981/1982 and 1990/1991.
Household leverage is still too high, but the magnitude of the adjustment required is simply too great to be achieved without substantial economic damage, unless consumers earn solid income gains.
Outstanding debt is still some 20 percentage points above its long-term trend, an amount equivalent to more than $2 trillion. The outlook for solid income gains, however, is not encouraging.
The US labour market is roughly 12 million jobs shy of being at full employment, and almost 17 per cent of the labour force is underemployed. Roughly 18 cents in every dollar of personal income comes from the federal government in the form of transfer payments. Personal income excluding transfer payments fell short of consumption recently for the first time on record. Almost 39 million Americans received food stamps in December and the figure is expected to rise to 43 million next year.
The probability of exiting unemployment in any given month is at a post-second World War low, as hiring plans remain soft. This is hardly an environment that is conducive to robust income gains.
Household deleveraging is set to exert a significant drag on economic growth and a return to the halcyon days of the “Great Moderation” is a distant dream. The accumulation of excessive household debts provided an artificial boost to consumption that has now disappeared. The result is excess supply and deflationary impulses.
Fiscal policy has attempted to fill the gap for now, but current public debt trajectories are not sustainable and are dependent on the kindness of strangers. The deleveraging risks mean that the secular bear market is not over.
charliefell@sequoia.ie
