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US consumer demand likely to be depressed for several years [ClearOnMoney]
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US consumer demand likely to be depressed for several years

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Commentary

US consumer demand likely to be depressed for several years

25 Jan 2010 by Jim Fickett.

A recent research report looks at the global build-up of debt before the crisis, and the likely path to reduction of debt in the aftermath. The report, and most of the commentary on it, focuses on the global picture. Narrowing the focus to the US household sector, the evidence suggests a long period, perhaps 5-10 years, of gradual debt reduction and hence lower spending.

McKinsey Global Institue, a research arm of the consultancy, recently produced a report entitled Debt and deleveraging: The global credit bubble and its economic consequences (94 pages; free registration required). The study focuses on where debt built up before the crisis, and how the reduction of that debt is likely to play out. Most of the major sources of financial news had comments or summaries; the best one page summary is probably that of the Economist (subscription required).

Here I would like to focus on a small fraction of what McKinsey have to say, in an area having a big impact on future economic growth in the US, namely the deleveraging (debt reduction) of the US household sector.

In order to understand the likely aftermath of the credit crisis, McKinsey ask where deleveraging is most likely to occur. They look at 14 countries, the main sectors within those countries (household, business, and government), and some breakdown into subsectors (for example commercial real estate within business). There is no simple answer to the question of how much debt is too much; McKinsey put forward a reasonable framework:

we have developed a five-part framework to assess the sustainability of leverage for individual sectors of an economy. The components are:

1. Level of leverage. High levels of leverage in a sector, compared with sectors in peer countries, is one indicator of unsustainability. However, for structural reasons, some economies may be able to sustain much higher levels of leverage than others, so this is not a strong indicator of sustainability if taken in isolation.

2. Growth of leverage. Significant increases in a sector's leverage, compared with historical trends or growth in peer countries, can indicate a higher risk of poor quality assets coming onto the sector's balance sheet.

3. Debt service capacity. The ratio of interest and principal repayments to a borrower's income indicates the ability to make required debt payments. A high ratio signals potential problems. …

4. Vulnerability to income shocks. Borrowers with highly variable income streams have a higher risk of default therefore should not carry as much debt. However, a borrower's ability to draw down savings, reserves, or liquid assets offset the risk of income declines and justify higher levels of sustainable debt.

5. Vulnerability to funding and interest rate shocks. Borrowers with fixed-rate, long term loans can sustain higher levels of debt because debt service payments do not vary. Borrowers with variable-rate loans, or short maturities, face greater interest rate risk, which limits the sustainable level of debt.

This framework is then tailored to specific sectors and the available statistical indicators. For households:

  1. Level of leverage is measured as the debt/income ratio (not debt/assets since asset prices were inflated)
  2. Growth of leverage is measured as the compound annual growth rate of debt/income.
  3. Debt service capacity is measured as debt interest payments over disposable income (it would have been desirable to include principal payment as well, but the data were not available)
  4. Vulnerability to income shocks is measured via the ratio of debt to financial assets
  5. Vulnerability to funding and interest rate shocks is measured via the ratio of variable rate mortgages to all mortgages.

Unsurprisingly (but more cogently than most sources), the report concludes that the US household sector is among the top candidates for unsustainable debt, and hence likely significant deleveraging.

Debt reduction can happen via austerity, default, inflation or extraordinary growth. This report analyzes the deleveraging aftermath of 32 financial crises studied by Reinhart and Rogoff (The Aftermath of Financial Crises), and concludes that austerity is the most common mode, and hence the most likely in the current situation. At the country level, this austerity typically takes the form of 6-7 years of credit growth lagging behind GDP growth, beginning about 2 years after the crisis, and reducing the debt-to-GDP ratio by about 25%. They suggest this scenario as the most likely for the US, but with a somewhat longer timeline, due to the large continuing buildup in government debt.

At the level of the US household sector, McKinsey make an additional argument for austerity being the likely mode of deleveraging.

In the United States, contrary to conventional wisdom, the greatest increase in leverage occurred among middle-income households, not the poorest. Most borrowers who did not qualify for the prime mortgage category, in fact, were middle- and higher-income households. …

Middle-income households have much lower default rates and instead deleverage by saving more and consuming less, a process that avoids credit losses but slows economic growth.

Overall, then, this analysis strongly suggests a lower level of household spending for perhaps 5-10 years.

On the positive side, do note that debt reduction requires only a lower level of spending, not lower growth in spending. Suppose, just for example, that households (in aggregate) make a one-time shift in policy to use 5% of income to pay down debt. Over several years, that 5% can reduce debt significantly, while the other 95% will continue to grow and contribute to normal growth in spending. So the outcome being suggested here is a one time shift to a lower level of spending, but then a normal growth rate from that lower level.