"Shrinking Consumer Debt = Lower GDP Near Term, but Higher Longer Term - Gvernment Permitting"

Sydney M. Williams

Thought of the Day

“Shrinking Consumer Debt = Reduced GDP Growth Near Term,

But Longer Term it is what the Doctor Ordered – Government Permitting”

June 10, 2010

Tough times call for tough measures. As the financial crisis and recession deepened, corporations were quick to cut costs, so that despite one of the most devastating recessions in the past one hundred years, according to Bob Doll of BlackRock writing in Tuesday’s Wall Street Journal, real GDP should reach an all-time high by the third quarter of this year. In contrast, during the Depression, it took fifteen years for GDP to return to its previous level. In the 1970s, it took three years. Mr. Doll, in the same article, writes that corporate profits could reach a new record high in this year’s third quarter – an incredible achievement, especially when the National Bureau of Economic Research has yet to call an end to the current recession. While federal and state debt has been soaring (discomfiting, but not surprisingly), corporations have been hoarding cash. Cash on balance sheets, at close to 11% of assets, is, according to Mr. Doll, at a 60-year high.

Consumers, more slowly perhaps, have also been reducing their leverage. Speaking at the Consumer Banking Association meeting in Hollywood, Florida, Fed Board Governor made a statement of the obvious, that a positive outcome from the [financial] crisis will be that consumers are likely to be wary about taking on debt. Data released Tuesday from the Federal Reserve suggests that is already happening. While consumer borrowing rose in April by 0.05%, the real story was in the revision of the March numbers from a small increase to a decline of $5.44 billion. During the nineteen months since consumer debt (both revolving and non-revolving) peaked in September 2008 at about $2.70 trillion it has declined in seventeen of those months to a current level of about $2.44 trillion – an “unprecedented stretch,” in the words of Kelly Evans writing in the Wall Street Journal, “in the series’ 67-year history.”

During the Bush years, total mortgage debt rose from $6.9 trillion to $14.6 trillion, an increase of 110%, while GDP rose 33% - implying a substantial portion of GDP growth could be attributed to increased home ownership and rising prices. Two factors acted as principal accelerants: an accommodative Fed and federal policy which actively encouraged home ownership. The result, as we all know, was an overleveraged consumer who ran out of places to hide.

The bad news is that total consumer debt remains uncomfortably high and future economic growth will reflect a continuing deleveraging consumer – and consumers represent two thirds of our economy. The good news is that the consumer, without a nudge from Congress, is addressing his unbalanced balance sheet. Revolving and non-revolving debt has been declining for the past year and a half. Mortgage debt, likewise, is in retreat. Mortgage applications have declined. As my friend, Vince Farrell, wrote yesterday, “The purchase index (as opposed to refinancings)…is now at its lowest level since 1997.” Foreclosures have set records in the past two months, not a positive sign, but further alleviating the mortgage situation. Nevertheless, in one of the great mysteries, which make economics as much an art as a science, home prices, according to the Case-Shiller Index, while down 0.5% in March, were up 2.3% versus a year earlier.

Crystal balls are not provided by my firm, so I have no idea as to the direction of home prices. What seems to be true, however, is that consumers, on their own, are addressing their own recent excesses. That will likely mean slower GDP growth, but it also suggests, in time, a healthier consumer. It is also worth noting that this trend will have been in place almost two years before any financial reform bill passes Congress. As Bob Doll wrote,”...the spirit of innovation and entrepreneurship that has defined America in past crises will prevail again…”

It is government, not corporations and not individuals that stands in the way of economic growth. At a time of crisis, it is necessary for government to step in and lend support, but as Federal debt rises to unsustainable levels we risk losing government assistance as an option should the economy falter. Federal debt now approximates 92% of GDP – the highest level since World War II. Much of the spending (while admittedly necessary in times of economic distress) has been for programs that inhibit job growth such as transfer payments, social welfare and regulation. Has all this spending been necessary? A year and a half ago, and even a year ago, the answer would have been yes. But the taste of big budgets has infected much of Washington and it remains to be seen if they can go “cold turkey” on pet projects which provide so much from so many to so few.

Thomas Friedman, in a recent New York Times op-ed, “A Gift for Grads: Start-ups,” quoted Curtis Carlson, the chief executive of SRI International, a Silicon Valley-based innovation specialist: “This is the best time ever for innovation…our global economy opens up huge new market opportunities [and] technologies are improving at rapid, exponential rates…opening up one major new opportunity after another.”

The federal government, though, persists on a contrary course. Our government is becoming increasingly mercantilist, more protectionist and overly interventionist, as the call by Congress for BP to suspend its dividend – generally the purview of a company’s board of directors.

So, while growth may slow, as the consumer weans himself from the incarcerating effects of debt, we may well be setting ourselves up for renewed and better growth from producing products and services and generating ideas that an expanding global economy needs. It will work, government permitting.