The Recovery's Silent Assassin: How Debt Deleveraging Killed the Economy

When U.S. consumers, businesses, and government all pay down debt at the same time, the inevitable outcome is lower growth, higher unemployment, and lower standards of living.

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Heather Anderson ruefully admits that she should have known better. A veteran of nearly two decades in the credit-union industry, she had spent her career warning would-be borrowers about the perils lurking in home-equity loans, bells-and-whistles mortgages, and the seductive fantasy that debt was interchangeable with wealth. But the housing boom was roaring ahead, and "I started to feel left out," Anderson recalled. So in 2005, she and her boyfriend bought a house in San Diego with a no-money-down, interest-only mortgage and a home-equity loan.

Less than a year after the couple moved in, they broke up. Unable to sell the house, even at a loss, and ground down by the strain of living with her ex, Anderson moved out, although she kept up her share of the mortgage payments. "I had to," she said. "My credit score was my safety." But her sacrifice was in vain. Her former boyfriend moved out as well, leaving no forwarding address for the mortgage company. Unable to persuade her lender to renegotiate, Anderson, now 41, watched helplessly as the house slipped into foreclosure, dragging her credit score down with it. When the interest rate on her sole credit card jumped 50 percent in a month, she started paying for all her purchases in cash.

What followed took Anderson by surprise. Instead of the unrelenting anxiety she expected as her income and credit rating went into a free fall, she felt relieved. It wasn't just that she no longer worried about scraping together enough cash to pay the monthly mortgage. It wasn't only the satisfaction she felt as her credit-card balance went into remission. It was the serenity she felt after she unplugged from the consumption economy's machinery of desire. Anderson had canceled her cable-television subscription after moving out of her house, and, without the constant din of commercials hawking the next must-have kitchen gadget and the fashion tips that left her itching to update her wardrobe, she found herself with ample time to launch a sports-jersey business--financed without credit, of course. No longer tempted to roam the mall in a fog of hankering, Anderson felt a newfound clarity about what really mattered in life. "Instead of consuming in my spare time," she said, "I started producing."

Millions of Americans are taking similar steps. Some 8 million U.S. consumers stopped using bank-issued credit cards in 2010, according to the credit-reporting agency TransUnion. The average credit-card balance has fallen 10 percent this year from 2010, to $6,472; U.S. consumer debt has dropped for 12 consecutive quarters, from a peak of $14 trillion in early 2008 to $13.3 trillion last spring, mainly because of mortgages repudiated or abandoned. People are cutting visits to the hairdresser, buying used cars without financing, and living on surplus cheese as they trudge toward the promised land of a debt-free existence.

Suppose everyone did what Heather Anderson is doing? And that the federal government, just as virtuously, did the same? And Europe too? What if everyone deleveraged at once? Guess what--that is exactly what's happening in the wake of the Great Recession. For better or worse.

Probably worse.

Ponder what economists call the paradox of deleveraging. This occurs when economic actors on all sides--consumers, business, government--all retire their debts at once. Unless their incomes are rising, they can pay off debt only by cutting what they spend. This, in turn, reduces the demand for goods and services, which drives prices down, further trimming businesses' revenue and thus their ability to pay employees, who in consequence spend less. The cycle continues, until incomes fall so low that there's no longer cash available to reduce the debt. And as incomes and business profits decline, so do government tax receipts, resulting in fewer police officers, more unfilled potholes, and greater pressure on pensioners.

A deleveraging nation, economists say, risks higher unemployment and years of subpar economic growth and could trigger a deflationary spiral in which consumers forgo spending, anticipating lower prices in the future. "When economies are deleveraging," Atlanta Federal Reserve Bank President Dennis Lockhart said in a recent speech, "they cannot grow as rapidly as they might otherwise."

Ye gods, what to do?

Economists offer two (or more) contradictory answers. Keynesians believe that government can break the downward spiral by borrowing money and injecting it into the economy, replacing the income lost when jobs disappear and consumers don't spend as before. The government-driven uptick in demand, the thinking goes, instills confidence that economic activity will pick up, spurring hiring and giving consumers the means to spend while paying down their debt. Once the economy starts to grow faster than the government's borrowing, the debt will decline as a percentage of economic output.

Ain't gonna happen, even if the Keynesians are correct. Not in the current political environment--and not only in the United States. All over Europe, austerity has broken out, as governments rein in borrowing, raise taxes, and cut payrolls and pensions--while their economies stall or even shrink.

Let's hope, then, that the conservative economists are right about a deleveraged nation and its ultimate rewards. They see government spending as only a short-run "sugar high" that extracts two intolerably high costs in return. One is that investors, worried about the government's ability to repay the additional debt, will drive up interest rates. The other: Business owners, spooked by the higher taxes to come, will pull in their horns. "There's tremendous uncertainty about what government is going to do to meet its liabilities," George Mason University economist Richard Wagner said. "So businesses hesitate to invest."

But in the long run, these economists say, the short-run pain will give way to long-term gain. If the government stops soaking up most of the available credit, "that frees up money that business can use to hire and invest," Wagner said. Similarly, he said, if working people know that future Medicare and Social Security payments will decline, they'll have more incentive to work hard and save for the future.

Not that this age-old debate between Keynesians and conservatives will ever truly be settled. All those graphs in economics--of supply and demand, etc.--rely on assumptions about mass psychology, about how consumers, employers, and workers will react in particular circumstances. And who can ever feel sure about that?


Such is the bind in which the United States finds itself, three years after the world financial system nearly collapsed amid the collective realization that governments, businesses, and households had all borrowed far more than they could possibly repay--far more, in fact, than there was collateral to secure it.

The federal government led the way. Its debt swelled from $907 billion in 1980 to $14.7 trillion in September 2011. The rise wasn't slow or steady. Powered by tax cuts plus two wars and a Medicare prescription-drug benefit, all financed by borrowing, the debt rocketed during George W. Bush's administration, from $5.7 trillion in 2001 to $10.7 trillion. Under President Obama, the federal debt has soared by another two-fifths, mainly because of the debt-financed public spending that was meant to stabilize the economy after the 2008 meltdown.

Until recently, consumers borrowed almost as avidly. As lenders crafted credit products for borrowers of every need, consumer debt exploded after 1980. The largest increases came from 2000 to '07, when total household borrowing more than doubled--to $13.8 trillion, mostly for mortgage debt--while consumer prices rose by only one-fifth. Consumers, some economists say, were trying to compensate for stagnant incomes, which gained by only a tenth on average (adjusted for inflation) from 1973 to 2010. Business joined in, especially in housing-related industries, borrowing half again as much in 2007 as in 2000. Small businesses availed themselves of cheap money.


All this debt was more than the system could stand. Housing's perpetual-profit machine worked only as long as homebuyers and their lenders believed that housing prices would continue to rise. When their confidence cracked in 2007, amid rising payment delinquencies and defaults, the entire mortgage edifice collapsed. Wall Street, which had benefited mightily from the bubble, imploded too.

The contraction since 2008 has been as sharp as the boom. As the cracks in the mortgage market widened, consumer borrowing fell off a cliff, falling by $1.1 trillion from 2007 to 2009. The financial sector, meanwhile, has unloaded $3 trillion in debt. Only the federal government increased its borrowing, from $237 billion in 2007 to an astonishing $1.24 trillion in 2008, then to $1.58 trillion last year.

Much of the deleveraging has been involuntary. Small businesses, even profitable ones with good prospects, have found it hard to get loans. Although overall corporate borrowing began to rebound in late 2010, much of the increase was spent on investment--and jobs--beyond U.S. borders, especially in the faster-growing economies of Asia and Latin America.

Mortgage lending remains crippled, despite record-low rates and relatively low housing prices in much of the country, because lenders have tightened their borrowing standards. Applications for new mortgages this summer fell to a 15-year low, and four-fifths of those were to refinance. The average household's debt, counting mortgages and credit cards, now stands at 114.6 percent of disposable income. That's a dramatic decline from its peak of 130 percent in 2008, but still far higher than the 84 percent that prevailed in the 1990s.

Maybe more consequential in predicting the nation's economic course, consumers' deleveraging has increasingly been voluntary. They're not exactly beating down the doors of their local bank for loans. In a reversal from the not-so-distant past, households aren't merely refusing to take on more debt; they're using money they once spent to acquire more stuff to instead reduce what they owe. Moody's Analytics found last spring that consumers used credit to stretch their purchasing power by $330 billion from 2000 to '07 but, since then, have devoted $150 billion of it to paying down debt. That $480 billion turnaround might presage the kind of aversion to debt that the Great Depression instilled in a generation of its survivors.

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Harris Collingwood is a business writer living in New York.

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