A Drag on the Economic Rebound: Consumer Spending

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Don't get too excited about signs of life in the economy. Some days it seems there's good news everywhere: home sales ticking up, slower job losses, the Dow turning positive for the year. But all that misses a looming reality. American consumers, whose overspending largely got us into this mess, are still under massive pressure, owing to the record debt they racked up during the boom years. People are unwinding those burdensome obligations — from mortgages to car loans to credit-card debt — as fast as they can, but the process is sure to take years, and until it is complete, the economy can't fully bounce back. "Even though we're probably past the worst in the business cycle and probably even in the bear market, we're talking about something much bigger here," says David Rosenberg, chief economist at money manager Gluskin Sheff. "The largest balance sheet in the world is the U.S. household balance sheet, and it's contracting at a record rate."

One way to understand the Great Consumer Retrenchment is to look at the amount of debt the typical household carries as a percentage of its disposable income. The ratio of debt to income increased from about 35% in the early 1950s to about 65% by the mid-1960s, where it more or less stayed until the late 1980s. That's when debt started its epic rise, hitting 100% of income in 2001 and going all the way up to 133% in 2007. (Read "Five Reasons for Economic Optimism.")

That figure is now starting to fall. At the end of 2008, the debt-to-income ratio was down to 130%, and new numbers from the Federal Reserve on Thursday are sure to show another drop.

Two things are driving that figure down. First, people are paying off debt — which goes hand in hand with their not spending money on as many new things. In April, outstanding consumer credit — which includes credit cards, auto loans and tuition-financing but not mortgages — fell by $15.7 billion to $2.52 trillion, an annualized drop of 7.4% and the second largest dollar drop on record, after March's $16.6 billion decline. Numbers from April show that people are now saving 5.7% of their disposable income, the highest rate in 14 years.

Second, people are shirking their obligations. According to the Mortgage Bankers Association, one in eight U.S. mortgages is now in either delinquency or default. Banks are figuring that nearly 10% of the money they're owed from credit cards is money they'll never see. "People were consuming more than their income, and that gave a big boost to the U.S. economy," says Kevin Lansing, a senior economist at the Federal Reserve Bank of San Francisco. "It doesn't seem like that's going to happen going forward."

Chances are, there is much more unraveling — deleveraging, to be technical about it — to come. Gluskin Sheff's Rosenberg looked at the ratio of household debt to total net worth and figured that for things to fall back in line with where they've been historically, Americans would have to get rid of some $3 trillion to $5 trillion in debt over the next few years. (Read "Lidia Bastianich Saves Our Dough.")

Lansing and San Francisco Fed colleague Reuven Glick ran a simulation of what would happen if U.S. consumers followed a path similar to that of Japanese businesses in the 1990s. That was another episode of a great debt dump following a stock-and-real-estate bubble — it's one of the examples economists often turn to in trying to understand what's going on now. Lansing and Glick figured that for U.S. households to resume a debt-to-income ratio of 100% over the next decade, the savings rate would have to nearly double, from its already elevated 5.7% all the way up to 10%. That would subtract three-quarters of a percentage point from consumption growth each year.

Yet that raises an interesting question: Why would we think that a debt-to-income ratio of 100% is sustainable? Well, for one thing, the economy has ostensibly evolved since the 1950s, and even since the 1980s. Advancements like securitized lending seem to have created a system in which interest rates are lower and consumers are able to shoulder more debt than they once were. The percentage of income that goes toward paying interest on debt went from 11% at the beginning of 1980 to 14% at the beginning of 2008, a much smaller jump than the increase in gross amount of borrowing taken on. In other words, there might be reason to believe we can now comfortably carry more debt than we did 20 or 50 years ago.

Still, it is likely to be a while before we hit that new normal. Rosenberg points out that during the Great Depression, the worst of GDP contraction and stock-market losses had hit by the early 1930s. And yet the malaise carried on for the rest of the decade. Unemployment hung above 15%, and people didn't spend money. "Even people who had the means didn't go on buying sprees. That's not how they lived," says Rosenberg. We may now be in for some of the same.

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