As household debt edges down, spending edges up

Source: New York Times

The bursting of the real estate bubble and the ensuing credit crisis forced American consumers to do something that they had little experience in trying: reduce their debt.

It has been a painful process both for borrowers, who have faced foreclosures and bankruptcies, and for lenders, whose have had to take losses vastly in excess of what they thought possible.

But the process is working far faster in the United States than in countries like Britain and Spain, which also faced plunging real estate prices. And now it appears to be contributing to an economic recovery that has gained a little momentum, despite facing headwinds from the European debt crisis. This week’s report that retail sales grew faster than expected in March was the latest sign that consumers — or at least a substantial number of them — are growing more optimistic.

One measure of the financial health of householders is the level of financial obligations, like required mortgage and credit card payments, to disposable income. By the fall of 2007, those obligations took up 14 percent of disposable income, more than at any time since the Federal Reserve began calculating the statistic in 1980.

But now the situation has turned around. The latest figures, for the final quarter of 2011, show that required debt service payments now make up just 10.9 percent of disposable income, the lowest proportion since 1994. A broader measure — which adds in such obligations as property tax and insurance premiums for homeowners, and rent for those who do not own their homes — has fallen to the lowest level since 1984.

There is little mystery in how that happened. First, debt levels have fallen. Over all, households owe about $13.2 trillion, nearly $600 billion less than in late 2008. Second, low interest rates mean that servicing that debt costs less. The Commerce Department says that mortgage interest payments, in dollars, are lower than at any time since 2005.

Getting those debt levels down was not a simple matter of making payments, of course. The McKinsey Global Institute estimates that about two-thirds of the reduction came from the cancellation of debt, through write-offs and foreclosures.

But the benefit is appearing. This week’s report of surprisingly strong retail sales in March may in part be because of warm weather. However, it also owes something to the fact that money that once went to mortgage payments may now be available for other things.

To get some idea of what needs to be done now — and what the result will be — the McKinsey institute points to two incidents in the early 1990s that got little attention at the time in the United States. Those were the bursting of real estate bubbles in Sweden and Finland. Details differ, but in each country there were two distinct phases of deleveraging.

“In the first,” the McKinsey institute said in an analysis published early this year, “households, corporations and financial institutions reduce debt significantly over several years, while economic growth is negative or minimal and government debt rises.” That is certainly what has happened in the United States.

The second phase is the good part, the institute said. “Growth rebounds and government debt is reduced gradually over several years.”

In this country, the deleveraging process has some way to go, with many foreclosures still pending, but it is at least possible that economic growth is beginning to accelerate. It is clear that the United States has made a lot more progress in cutting consumer debt than has been made in either Britain or Spain, two other countries that suffered from falling real estate prices.

To get the deleveraging process under way, it is important for lenders to face reality, admit losses and deal with them. For banks, and their regulators, there is a great temptation to obscure losses, hoping that the market will recover. That was a little harder to do in the recent cycle, thanks to new mark-to-market accounting rules. Those rules were weakened after they were denounced by banks, supported by their regulators, but they still had some effect.

Perhaps more significantly, many of the worst loans — and the ones that most needed to be dealt with — were generally not on bank balance sheets. The vast majority of home mortgage loans had been sold to investors in mortgage securitizations, many of them guaranteed by Fannie Mae and Freddie Mac and others privately issued. Securitizations must regularly report on how many loans are not performing. As a result, the losses could not be hidden — and the recovery process delayed — as happened in Japan during the decade after its bubble burst in 1990.

The McKinsey report identifies six markers of success that are useful in assessing a nation’s deleveraging process. A stable banking system must emerge. After the inevitable surge in government debt, there needs to be a credible plan for long-term fiscal sustainability. Structural reforms may be needed to make economies more competitive. Exports need to rise, as does private investment. Finally, the housing market needs to stabilize.

Susan Lund, the director of research for the McKinsey institute, says the two areas where the United States is weakest are in coming up with a credible fiscal plan and in stabilizing the real estate market. Home prices continue to fall in some of the hardest hit areas, where debts continue to be high relative to income. I’d add in private investment. Corporations are generating a lot more cash than they are willing to invest. To some extent, that may simply reflect the trauma of the crisis, when cash was king, and it may take time to solve it.

There are plenty of reasons to doubt that the current economic recovery will become self-sustaining, starting with Europe’s problems and including the threat that American fiscal policy will shut off growth by imposing too much austerity too soon.

Ms. Lund points out that from 2003 to 2007, American homeowners took out $2.2 trillion from home equity loans and mortgage refinancings, a source of economic stimulus that will not return anytime soon. “Compared to the much-debated government fiscal stimulus, this was more than twice the size,” she noted. She thinks the household deleveraging process will continue for two more years.

But who would have forecast that the burden of household debt — at least in much of the country — would by now have been reduced so far that consumers are again a source of growth? That fact is a reminder that the outlook is seldom as bleak as it seems in the immediate aftermath of a calamity.


Floyd Norris comments on finance and the economy at nytimes.com/economix.


This article has been revised to reflect the following correction:

Correction: April 19, 2012



An earlier version of this column referred to household debt of $13.2 trillion as being nearly $600 billion less than in 1998. The correct year is 2008.

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