Congratulations to President Obama on his victory last week. I hope he really wanted it because he faces some stiff economic challenges in his second term-chief among them the slow private debt deleveraging that will hamper economic growth for at least the next few years.
While painful, this is a necessary correction to the unstable economic boom of the past few decades that was partly financed through binge borrowing by individuals and businesses. With nominal home values rapidly rising in the 1990s and 2000s borrowers leveraged their homes, stopped saving, and used plastic for consumption instead of wages (which were not growing very quickly during the same time period). This behavior wasn’t sustainable, and the cheap money days ended along with the housing boom; leaving households deep in debt. The president will be tempted to propose some kind of private debt forgiveness to get through this deleveraging cycle faster, but that would be the worst response possible and would just set the stage for an even bigger and more painful correction in the future.
Of the challenges facing the president in his second term, many are considered long-run dangers-including the rising costs of health care, unsustainable Medicare and Social Security costs, and declining education quality. However, the private debt deleveraging of households and businesses is something that will unfold in the next two years and will affect every aspect of the economy from the employment level to household income. Consider the raw numbers, starting with changes in consumer credit in the graph below.
Consumer credit stands at a whopping $2.7 trillion-higher than at any point in history. It reached $2.58 trillion in the summer of 2008 as consumers briefly backed off using credit and loans to finance consumption when the housing bubble burst. However, starting at the end of 2010 the deleveraging cycle stopped. Credit card debt deleveraging (the largest portion of revolving credit) has flatlined. Non-revolving lines of credit from banks to consumers has similarly stopped deleveraging, though has held largely constant. However, following the federal government’s take over of the student loan business in 2010, there has been an explosion in student loan debt, which is the primary culprit for consumer credit growing beyond its 2008 height.
In contrast, household mortgage debt has maintained a consistent deleveraging pattern, falling from $10.6 trillion in 2007 to $9.6 trillion now. While good, in context this is actually very slow and private debt needs to drop a lot further. Consider that housing values – as measured by the widely respected S&P/Case-Shiller home price index – have fallen to early 2003 levels. However, in the first half of 2012 (the most recent data available) total mortgage debt remains 67 percent higher than at the same time in 2003. That is a wide gap to cross and a lot of deleveraging to process.
So what does all this mean for the near-term economy and President Obama’s second term?
If you are a Keynesian, then consumers shedding their existing debt means a reduction in aggregate spending, stalling the key engine of growth. Families more interested in paying down their home mortgage debt than going out to dinner, taking a vacation, or buying a new hovercraft from Brookstone means less business activity, means fewer revenue streams for entrepreneurs and fewer employment opportunities. On the flip side, since the growth in consumer credit is mostly student loans, we will see little economic activity resulting from them and just more debt that will need to be paid down in the future. And the fact that credit card debt deleveraging has stalled out is not necessary a positive sign either, because it is just depending on the previous behavior that created all the debt in the first place. As a result, anything that looks like a recovery today is being built on a mini debt-fueled bubble.
The story isn’t much better if you prefer a more supply-side economics approach to jumpstarting growth, and want to reduce taxes and regulations on businesses so they can thrive. If businesses, particularly small businesses whose expenses are part of their household budgets, are more interested in deleveraging than expanding, then tax cuts and regulatory burdens will have only a small effect on economic growth in the short run. This does not mean these policies should be ignored, but rather that their true value will be to set the stage for a stronger long-term recovery as lower taxes and regulatory costs will allow these businesses to clear their balance sheets faster. The deleveraging cycle still needs to process.
From either perspective, private debt is going to put downward pressure on economic growth in the near-term. It is unlikely that private debt would trigger a double-dip recession, but the economy will not be growing at much beyond 2 percent over the next 18 to 24 months.
However, debt is not inherently a bad thing. It is the fuel that finances innovations and entrepreneurship that drive the capitalistic economy. The problem arises when borrowers take on more than they can afford, and when lenders give out money without considering the risk-worthiness of the creditors due to the amount of easy money at their disposal. Leading up to the Great recession households used their houses like ATMs in order to sustain consumption habits their incomes could not keep up with and irresponsible financial institutions let this happen – what has led to the debt problem we face today.
Since the labor market is weak now and housing has a long way towards recovery, there is little option but to push deleveraging or to feed a new economic bubble. As such, the only sensible course will be to wait out the storm. If the president wants to do something in the meantime, he should try and strengthen the fundamentals of the economy by reducing the regulatory burden on business, encouraging the Fed to stop devaluing the dollar any further through QEnfinity, rolling back housing subsidies so the market can recover, and resisting from starting protectionist wars in East Asia. This would go a long way towards getting the economy ready for takeoff once the underlying debt issue resolves itself.
A version of this issue of Ahead of the Curve first appeared at RealClearMarkets. Anthony Randazzo is director of economic research at Reason Foundation.