Daily Themes - 27 October 2010

Prolonged consumer de-leveraging to weigh on US economy

The latest US recession and recovery have followed a familiar pattern - large imbalances in the private sector leading to a bust and subsequent rebalancing. In the 2001 recession, it was the rapid accumulation of corporate debt. This time it was an almost 25-year spending spree by US households. Just as the massive build-up in household debt that fuelled this spending spree was a long time in the making, we believe the rebalancing process will also be prolonged. As households repair their balance sheets, this will crimp spending and put downward pressure on growth and inflation.

The savings rate of US households had been in decline for almost 25 years leading up to the credit crisis, falling from around 12% in the early 1980s to a low of 1.8% in early 2007. This allowed consumption to grow faster than disposable income, boosting the trend rate of GDP growth and reducing the duration of recessions significantly during that period. Ballooning household debt, which grew from around 70% of disposable income at the beginning of the ‘80s to a peak of 135% in 2007, fed a bubble in house prices.

Spendthrift by nature, thrifty by necessity

But there is an upper limit to what households can pay to service their debts, making it inevitable that debt accumulation would come to an end. Household debt reduction, or deleveraging, started in the final quarter of 2007, roughly coinciding with the start of the recession. Since then the savings ratio has jumped to 6% and households have so far managed to reduce their debt burden to 123% of disposable income. But it remains above the long-term trend. The US Federal Reserve (Fed) has kept rates at extremely low levels during this period, significantly reducing the cost of servicing household debts. However, low rates only allow for gradual and milder adjustment, and cannot reverse deleveraging. Unless households manage to pay down a significant part of their obligations, debt service costs will rise when rates eventually increase. This is why the Fed is so desperate to keep long-term interest rates low and is about to engage in another round of quantitative easing. Otherwise, the recovery could well be derailed.

All else being equal, increases in the savings ratio reduce consumption and GDP growth. Unless disposable income grows at a fast pace, deleveraging reduces growth significantly. A 2009 survey from the San Francisco branch of the US Federal Reserve found that if the savings ratio was to increase by 6 percentage points over 10 years, this would subtract 0.75% from GDP each year.

Worse than your average debt hangover

Academic research suggests the typical deleveraging process lasts between 5-7 years. It has also shown that recessions are preceded by an average 40% increase in private-sector debt to GDP, and followed by a contraction of the same magnitude. A survey from the Bank of International Settlements found that in 17 of 20 banking crises preceded by such expansions in credit, deleveraging followed, with a 10% contraction in debt to GDP being the mildest and 104% being the worst. This compares to a reduction of only 5% in the ratio of US household debt to GDP from its peak in the current crisis, which suggests that household deleveraging has further to go.

In addition, in the years leading up to the credit crisis household debt deviated significantly from longer-term trends, and the banking sector still holds a significant amount of bad debts. With other countries running similar deleveraging processes in parallel, we expect US households to continue paying down their debt for a few more years.

Lessons from Japan’s ‘lost decade’

Japan’s experience of deleveraging in the ‘90s, following the bursting of a real-estate bubble, could provide some useful lessons. While in the US the deleveraging process is expected to be milder, given much healthier balance sheets for non-financial companies, in other respects the US experience has been similar.

As in Japan, banks leveraged their balance sheets significantly before the crisis and are suffering in its wake. Despite the fact that they were quick to write down most of their bad debts, they are still hesitant to lend to households. For example, loan to value ratios for new mortgages are still significantly lower than before the crisis. Households are also more hesitant to borrow, given stubbornly high unemployment and the fact that house prices have not recovered yet

Another lesson from Japan’s ‘lost decade’ is that deflation can significantly extend the deleveraging process, as household incomes decline and the real value of debt increases. Consumers therefore have to cut their spending significantly and save to pay down their debt. If the US experiences wage deflation, the savings ratio would have to increase further, detracting from GDP growth. It is an increase in the savings ratio, rather than high levels of savings, which constrains growth.

If the US savings ratio peaks at the current level, consumers will be able to increase their spending at the pace that their disposable income grows. We expect real income to grow at around 1-1.5% next year, which could imply consumption growth of the same pace. Nevertheless, this compares unfavourably with previous cycles, in which consumers increased their spending faster than their income and boosted GDP growth significantly.

No more bang from the US consumers’ buck

Given the magnitude of household debt that still needs to be unwound, we envisage a longer deleveraging process than average. It won’t be enough to tip the economy back into recession, but it will keep growth below trend as it runs its course. Interest rates will also be kept very low, as central banks try to ease the pain of deleveraging by keeping debt-servicing costs low.

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