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

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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.

A waning of optimism could reshape American politics--and not for the nicer.

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?

THE MESS WE'RE IN

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.

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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.

WHEN BORROWING STOPS

And what if it does? Although consumers may not have kicked the borrowing habit for good, they give every indication that they're ready for a hiatus. And when consumers turn frugal, the entire economy shudders. A 1-percentage-point rise in the personal-savings rate works out to $100 billion in foregone spending, consulting firm McKinsey & Co. has calculated. That's bad news to makers of brand-name household goods, such as Procter & Gamble, which have lost sales to cheaper store brands. Carmakers also get dinged, because consumers stick with their old wheels longer, according to automotive researcher R.L. Polk & Co.

All too often, lower living standards follow close behind. That isn't the case for households whose incomes are rising, because they can pay down their debt while maintaining their accustomed level of consumption. But the millions of families who borrowed to supplement stagnant or shrinking incomes must choose between spending and reducing their debt. If they keep paying down debt, they'll postpone visits to the doctor, take fewer vacations, and wear the same clothes for another year. "In an idealized economic model," Wesleyan University economist Bill Craighead said, "interest rates, prices, and wages can adjust downward in such a way that demand remains steady enough to sustain economic activity." But in the real world, those adjustments don't happen immediately. Incomes fall faster than prices, and consumers, businesses, and government all tighten up on spending. "Without demand, there's no growth," he said, "and if there's no growth, living standards have to slip."

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There's an upside to consumers leaving their credit cards in their wallets, however. Because so many consumer goods are imported, the U.S. trade deficit falls, as Americans take a pass on Korean widescreen TVs and Malaysian jeans: In July, it dropped by 13 percent to $45 billion, the federal government reported.

What remains to be seen is whether consumers' frugality will last beyond the current downturn. "Consumption is part of our DNA," said Jenny Darroch, a marketing professor at Claremont Graduate University in California. But consumers lose the urge to whip out the plastic, Darroch suggested, when they learn that Bank of America plans to lay off 30,000 and the U.S. Postal Service may dismiss 120,000 workers.

Among corporations, deleveraging is happening before our eyes. Moody's reported recently that the corporations it tracks were sitting on $1.2 trillion in cash at the end of 2010--money that could be used to develop new technologies, invest in promising start-ups, upgrade equipment, and hire workers. Instead, they're parking their money in safe short-term securities while they wait for business to pick up. In contrast, loans to small businesses fell by $2.5 billion this spring, according to federal estimates, although a new $30 billion federal lending program has loosened up the market a bit.

WASHINGTON'S QUANDARY

If consumers keep shedding their debt while businesses continue to hold--or are held--back, that leaves only one economic actor with enough clout to funnel cash into business's coffers and put people to work: the federal government. Or so the conventional--that is, Keynesian--textbooks say. Without government spending at a time of high unemployment and tight credit, Keynesian economists argue, business can't create jobs and people can't meet their expenses or pay down their debt. "Deficit reduction is the last thing we need to focus on," University of Texas economist James Galbraith said.

No, it's the first, counters Stanford University economist John Taylor, who worked for both Presidents Bush. Far from spurring private-sector demand, Obama's debt-financed programs--cash-for-clunkers, first-time homebuyers' tax credit, public-works spending--"lowered investment and consumption demand by increasing concern about the federal debt, another financial crisis, and threats of inflation or deflation," he wrote in The New York Times. Only when the government demonstrates "a clear commitment to America's living within its means," he argued, "will business regain the confidence to hire, expand, and invest."

Evidence in Taylor's favor is that hundreds of billions of federal dollars haven't restored a thriving economy, reassured business, or lowered unemployment much. In any case, given the prevailing political mood and the creation of a congressional super committee tasked with reducing the federal deficit, a slowdown in government borrowing seems inevitable. The conservatives' theory that less government intervention means a healthier economy will be put to the test.

If they're wrong, the consequences could be dire. In South Dakota and Michigan, some counties are replacing battered roads with gravel, because local governments can't afford to repave them. Cuts in federal and state aid have forced cities and towns across the country to sharply curtail social services and to lay off police officers, firefighters, and teachers.

"These cuts are completely unnecessary and destructive," Galbraith said. He called on governments to incur debt for undertakings that will pay dividends into the future--repairing roads and bridges, conducting research on alternative energy, and, above all, creating jobs.

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AUSTERITY ABROAD

Does reducing the government's footprint work as advertised? The experience abroad offers clues. In Europe, where public-debt cuts have been government policy for more than a year, the results don't inspire confidence, at least so far.

Consider Greece. The debt-ridden country was saved from defaulting last year on its bonds when the European Union, the International Monetary Fund, and financial institutions supplied a $155 billion bailout in exchange for a strict timetable of spending cuts, tax increases, and sales of government-held assets. But so far, Greece's deleveraging has backfired. The Finance Ministry predicts that the economy might shrink by as much as 5.3 percent in 2011, depressing the tax receipts that the country needs to repair its finances. And its debt is a bigger problem than ever. With its creditors unable to agree on bailout terms, many investors expect Greece to default on its loans.

The rest of Europe's economies have performed better, but not by much. In Britain, more akin to the United States, the Conservative-led government's austerity program hasn't revived the economy. The Institute for Fiscal Studies, a respected London think tank, predicted recently that British living standards will decline by 10 percent over three years, with price increases far outstripping the growth in incomes.

Most other European governments, though less in debt than Greece, have imposed austerity measures of their own. Growth in the 17 countries that use the euro averaged an anemic 0.2 percent during the second quarter of 2011. Germany, the Continent's strongest economy, has grown only half that much. The slump prompted a warning from Christine Lagarde, the IMF's managing director, that "slamming on the brakes too quickly will hurt the economy and worsen job prospects."

Conservative economists may argue that the austerity in these countries hasn't gone on long enough to work its dark magic. Japan's experience, though, is more discouraging still. What the United States experienced in 2008, Japan suffered in 1989. A debt-fueled real-estate binge went bust, leaving banks stuck with loans for land and buildings that were suddenly worth a fraction of the amount borrowed. The stock market fell 48 percent.

Japan's central bank, unlike the Fed, waited 17 months before lowering interest rates and balked at forcing banks to acknowledge their losses on loans or to rebuild capital depleted by bad debts. Nearly three years passed before the government spent money on public works to bolster the economy, and it turned off the spigot before the private sector became self-sustaining. Now, 22 years after the crash, growth is still at a crawl, and the stock market has yet to regain its earlier heights. Prime ministers and their governments have come and gone, none of them able to muster the will and vision to lift the economy from its doldrums. Sound familiar?

LOWER EXPECTATIONS

The impact of deleveraging in Japan has been more than economic. It has produced a generation of chronically discouraged young workers. When McKinsey & Co. surveyed Japanese ages 18 to 35 last year, only 10 percent deemed themselves ready to compete in the global economy; two-thirds of them doubted that their country could.

This gloom hasn't spread to the United States--yet. The popular culture has remained relentlessly upbeat--comic-book escapism in the movies, nostalgia (à la Mad Men) on TV. A rare new series on this fall's primetime schedule that will tackle the foreclosed futures of the young is, tellingly, a sitcom, CBS's Two Broke Girls. "The tale of our times is mostly being told by our unwillingness to tell it," cultural commentator Jaime O'Neill wrote in the Los Angeles Times.

Like the Depression-era movies that showed butlers in marble foyers, this avoidance suggests how much is at stake. It goes to the heart of American expectations that every generation will enjoy a higher standard of living than the one before it. This expectation isn't dead yet, but it's in danger. Fifty-five percent of respondents to a Gallup Poll last spring thought it unlikely that young people today will live better than their parents. An Associated Press poll found that more than half of 18- to 24-year-olds anticipate having a harder time buying a home and saving for retirement than their parents did.

Their pessimism may be warranted. Unemployment is one of the prices of a deleveraging economy, and young people are paying more than their share: The jobless rate among workers ages 16 to 24 is 18 percent--double the national average. Even the lucky ones who find work can expect that as long as deleveraging--or anything else--stifles growth and keeps the job market fearsome, they'll earn less when they join the labor force, and they'll have fewer opportunities to hop from job to job and from raise to raise. Lower starting salaries and limited mobility will blight their earning power for years to come. Yale University economist Lisa Kahn has found that people entering the workforce during an economic contraction earn about 10 percent less during the first 17 years of their working lives than those who start when there are jobs aplenty. What's more, they tend to stay in each job longer, resulting in incremental wage gains instead of the jumps in salary that often accompany a new position.

Expect any waning of optimism to reshape American politics--and not for the nicer. A recent poll by the Pew Research Center for the People and the Press found Americans almost equally split over whether Washington, to speed the economic recovery, should spend more or cut the deficit. This ambivalence drove the summer's toxic debate over the debt ceiling that further poisoned the tone of U.S. politics.

Deleveraging could also pit the young against their elders. If older Americans, finding their retirement savings depleted, stay in their jobs longer and thereby block younger workers from advancing, resentment between the generations could erupt. So, too, if Washington curbs Social Security benefits or raises the age of eligibility. "We face the real possibility that this century will be marked by harsh generational conflicts over limited resources," says David Yamada, director of the New Workplace Institute at Suffolk University Law School in Boston.

Or possibly young people will just learn that "life isn't what you expected," as Barry Schwartz, a psychology professor at Swarthmore College, put it. He sees a chance that Americans would emerge from a long and deep recession with a worldview like the one that prevailed before World War II, when people accepted straitened circumstances with the confidence that their children would fare better.

After the war, "that stopped being good enough," Schwartz recounted. "Parents started to expect that their own lives would get better." Fulfilling these expectations required a steady rise in incomes that only a thriving economy could provide. Lowering those expectations, after a half-century of seeing them rise, could get ugly indeed.

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Harris Collingwood is a business writer living in New York.

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