The Challenge of Private Debt For the Post-Election Economy
Congratulations to President Obama on his victory this week. I hope he really wanted it because he faces some stiff economic challenges in his second term; chief among them the slow private debt deleveraging that will hamper economic growth for at least the next few years.
While painful, this is a necessary correction to the unstable economic boom of the past few decades that was partly financed through binge borrowing by individuals and businesses. With nominal home values rapidly rising in the 1990s and 2000s borrowers leveraged their homes, stopped saving, and used plastic for consumption instead of wages (which were not growing very quickly during the same time period). This behavior wasn't sustainable, and the cheap money days ended along with the housing boom; leaving households deep in debt. The president will be tempted to propose some kind of private debt forgiveness to get through this deleveraging cycle faster, but that would be the worst response possible and would just set the stage for an even bigger and more painful correction in the future.
Of the challenges facing the president in his second term, many are considered long-run dangers--including the rising costs of health care, unsustainable Medicare and Social Security costs, and declining education quality. However, the private debt deleveraging of households and businesses is something that will unfold in the next two years and will affect every aspect of the economy from the employment level to household income.
Consider the raw numbers:
Consumer credit, largely credit card debt, stands at a whopping $2.7 trillion - higher than at any point in history. It reached $2.58 trillion in the summer of 2008 as consumers briefly backed off using debt to finance consumption as the housing bubble burst. However, starting in 2010 the deleveraging cycle stopped and consumers once again reverted to their old habit of using plastic for discretionary purchases even as many of them remained unemployed and median household incomes stagnated.
In contrast, household mortgage debt has maintained a consistent deleveraging pattern, falling from $10.6 trillion in 2007 to $9.6 trillion now. While good, in context this is actually very slow and private debt needs to drop a lot further. Consider that housing values - as measured by the widely respected S&P/Case-Shiller home price index - have fallen to early 2003 levels. However, in the first half of 2012 (the most recent data available) total mortgage debt remains 67 percent higher than at the same time in 2003. That is a wide gap to cross and a lot of deleveraging to process.
So what does all this mean for the near-term economy and President Obama's second term?
If you are a Keynesian, then consumers shedding their existing debt means a reduction in aggregate spending, stalling the key engine of growth. Families more interested in paying down their mortgage debt than going out to dinner, taking a vacation, or buying a new hovercraft from Brookstone mean less business activity, means fewer revenue streams for entrepreneurs and fewer employment opportunities. On the flip side, the fact that credit card debt is back on the rise is not a positive sign either, because it is just depending on the previous behavior that created all the debt in the first place. As a result, anything that looks like a recovery today is being built on a mini debt-fueled bubble.
The story isn't much better if you prefer a more supply-side economic approach to jumpstarting growth, and want to reduce taxes and regulations on businesses so they can thrive. If businesses, particularly small businesses whose expenses are part of their household budgets, are more interested in deleveraging than expanding, then tax cuts and regulatory burdens will have only a small effect on economic growth in the short run. This does not mean these policies should be ignored, but rather that their true value will be to set the stage for a stronger long-term recovery as lower taxes and regulatory costs will allow these businesses to clear their balance sheets faster. The deleveraging cycle still needs to process.
From either perspective, private debt is going to put downward pressure on economic growth in the near-term. It is unlikely that private debt would trigger a double-dip recession, but the economy will not be growing at much beyond 2 percent over the next 18 to 24 months. And this weak economy in turn means high unemployment and weak wage growth, if any.
All of this is consistent with history. A recent paper from the Bank of International Settlements found that when household debt hits 85 percent of GDP, economic growth slows down. During the Reagan, Bush I, and Clinton years that number was around 67 percent. However from 2000 to 2002, the household debt-to-GDP ratio jumped to 78 percent and by 2008 total household debt was a whopping 96 percent of GDP. It has fallen to around 83 percent this year, below the danger-zone threshold, but still far above the stable 1990slevels.
This data suggests that private debt will need another 18 to 24 months of deleveraging before households begin to feel confident in their finances. That's exactly what a McKinsey report from earlier this year estimated as well.
The natural response would be to try and do something to avoid the economic pain that debt leveraging inevitably produces. This summer, former banker Richard Vague and political writer Steve Clemons wrote in The Atlantic that this debt mountain could be leveled off with large scale restructuring of a trillion of private loans. Even assuming away the complexity problem associated with such a proposal, forgiving a trillion dollar of private debt forcibly would have vicious ramifications for decades to come. The capacity for responsible borrowers to get a loan would shrink dramatically and the cost of borrowing would skyrocket, unnecessarily tying up resources in the debt servicing process.
Debt is not inherently a bad thing. It is the fuel that finances innovations and entrepreneurship that drive the capitalistic economy. The problem arises when borrowers take on more than they can afford, and when lenders give out money without considering the risk-worthiness of the creditors simply because they have too much easy money at their disposal.
Much of the debt in the system today was taken on irresponsibly because households wanted to sustain consumption habits their incomes could not keep up with, and because houses were used like ATMs--and because irresponsible financial institutions let this happen. Since the labor market is weak now and housing has a long way towards recovery, there is little option but to deleverage or feed a new economic bubble. As such, the only sensible course will be to wait out the storm. If the president wants to do something in the meantime, he should try and strengthen the fundamentals of the economy by reducing the regulatory burden on business, encouraging the Fed to stop devaluing the dollar any further through QEnfinity, rolling back housing subsidies so the market can recover, and resisting from starting protectionist wars in East Asia. This would go a long way towards getting the economy ready for takeoff once the underlying debt issue resolves itself.