The Drag Caused by American Household Debt

Today I would like to reference an article by William Galston on the website of the New Republic (http://www.tnr.com/blog/77215/getting-out-the-recession-stimulus-spending-debt-banks).

Galston’s point is this: the value of assets on the balance sheets of households in the United States has declined relative to the amount of money owed by these same households.

To quote Galston: “As the value of assets used as collateral collapses, so does borrowing. This depresses consumption (because the real net worth of households has declined), and the real economy dips, making it much harder for businesses and households to service the debts incurred during boom times. Household consumption remains sluggish until debt is reduced to a level that can comfortably be serviced out of current income, a process that cannot proceed without an increase in the household savings rate. The larger the debt overhang, the longer it will take to work off the excess.”

The figures Galston quotes: in late 2007, household debt was $12.5 trillion which was 133 percent of disposable income. In the first quarter of 2010, total household debt had declined to $11.7 trillion around 122 percent of disposable income.

The Federal Reserve Bank of San Francisco has suggested, in a May 2009 analysis, that this ratio will need to fall to around 100 percent for households to feel more comfortable and begin to loosen up their pocketbooks a little bit more.

For this ratio to decline to 100 percent, the study argues, it would take up to a decade, even if the household savings rate were to rise to 10 percent. The household savings rate is now a little above 6 percent.

Government stimulus programs are not going to counteract this de-leveraging unless they were to create sufficient new inflation to get the value of assets rising rapidly once again!

It is not surprising that small- and medium-sized businesses are in a similar situation. Many of the smaller businesses in the United States used debt much as households did during the buildup of financial leverage because…they were the same people!

And, small- to medium-sized banks are having solvency problems (http://seekingalpha.com/article/222005-where-is-banking-headed-not-up).

Foreclosures, bankruptcies, and bank failures are a common part of such an environment (http://seekingalpha.com/article/222238-why-52-is-not-a-pretty-number).

Regulators and the courts are trying to work out the difficulties connected with such problems as efficiently and smoothly as possible. Galston is just pointing up the fact that correcting such a situation is not going to be accomplished over night. Even the program Galston suggests as a way out of this malaise, a “national infrastructure bank”, would not shorten the time span needed to once again achieve a robust economy with substantially lower unemployment.