We Can't 'Spend and Save' Our Way Out of This Recession

The news media reported the stunning decline in Household Debt last week, but they missed one of the key elements. While it is true that consumers saw the first quarterly decline in the level of debt in the history of the data series, it wasn't because people were paying down debt. Instead, the cause of the decline was mortgage defaults, where the debt is wiped out by transfer to the bank. No, it's not exactly like consumers, on balance, are paying down their debts. The overall growth in Household Debt (primarily mortgage and consumer debt) is stunning (click on chart to enlarge):

It is more fair to show the long-term history in terms of annual growth rates, which are still of concern (click on chart to enlarge):

We have enjoyed a period of accelerating and high growth in mortgage and consumer debt for many years, but it is now falling off a cliff.

The underlying data is available in the Federal Reserve's "Flow of Funds Accounts of the United States", most recently updated through Q3. This provides a great historical reference for all the sectors of our economy. While it is true that Household Debt fell from the previous quarter by $40 billion to roughly $13.91 trillion, it still rose $300 billion from a year ago. Interestingly, though, the overall indebtedness of our country (citizens, corporations and governments) increased by almost $600 billion from the prior quarter and by $1.9 trillion (6%) from a year ago. The main culprits: Federal Government and the Financial sectors.

Many financial pundits declared that consumers are adjusting to the current economic downturn, which is now true, but it wasn't really captured in the recently released data. Given what I have read about the recent moves by the credit card industry (jacking rates, slashing limits) as well as the overall shrinkage of the availability of other types of consumer loans (education, auto, installment), we are probably going to soon see an annual decline in Household Debt. Here is the complete breakdown of total debt outstanding (click to enlarge):

While it seems clear that we should expect to see continued heavy growth in government debt, especially on the federal levels, it should not surprise anyone to see all of the other sectors experience total debt decline (isn't that what we mean by deleveraging).

The amount of debt outstanding can be compared to incomes (which, in aggregate, should be falling soon), GDP or net worth. Net worth can be easily calculated (apparently) by the government for certain sectors, but what is the net worth of the U.S. Federal Government? I have never seen a balance sheet! While the amount of debt at the Household level fell, it should be noted that the Household Net Worth plunged by multiples of that small decline (stocks and houses were the obvious culprits).

I have been struggling with how we will eventually emerge from this morass, and I am more worried than ever. It seems clear to me that we can't spend any longer to buy our way out, as consumer credit and the housing piggy bank have all but shut down. It also seems clear to me that savings will be going up as well. Is the federal government big enough to absorb the restructuring of the balance sheets of households, businesses, state & local governments and financial institutions? Probably not. We risk higher taxes and higher interest rates, which could contribute to years and years of slow economic growth (or a shorter period of utter chaos).

I believe that we could see very negative Real GDP (and potentially nominal as well) over the next year (like -5%). In the past three months, retail spending, which is just a subset of overall consumer spending, has declined at an astounding annualized rate of about 25%. Stripping out autos, which allows me to share a chart (click to enlarge) with a longer history as well as remove a major swing factor, we have seen an off-the-charts decline that has eclipsed even post-9/11.

While I was extremely negative in late 2007, I was premature in becoming more optimistic as 2008 progressed. Clearly, I am not a "permabear", but I find myself more negative today than I was in advance of the metastisis of the "cancer" from just sub-prime to mortgages in general last year. We now have a full-blown late-stage "cancer", and the radiation and chemo this economy will need (massive government intervention like we have never seen) could leave us crippled for years to come. As long as we need to simultaneously spend as well as save, stocks are likely to be a losing proposition. Years from now, when interest rates are substantially higher and balance sheets are repaired, the next bull market will emerge. Until then, expect low PE ratios (for now, as earnings decline), weak fundamentals and continued pressure from outflows. There is no quick fix, which is ironic, since the quick-fix allure of debt to propel a slowing economy was the genesis of this crisis.

Disclosure: None

Comments

[Steven Hansen:]

"I find myself more negative today than I was in advance of the metastisis of the "cancer" from just sub-prime to mortgages in general last year. We now have a full-blown late-stage "cancer", and the radiation and chemo this economy will need (massive government intervention like we have never seen) could leave us crippled for years to come."

don't worry Alan, we are in good hands with Congress to lead us back on to the road of recovery. I am on my second Chivas now and already i feel better.

2008 Dec 15 05:22 AM

[ironpants:]

Can a member of the general public file a RICO case against the SEC and hedgefunds?

2008 Dec 15 06:22 AM

[bobomite:]

Well let's see... The banks are in trouble because they have taken on too much debt.

That's only because consumers have too much debt, such as paying too much for their houses and credit cards.

So to solve it all the government takes on additional debt, to get the banks out of debt, so they can make more loans to the consumers.

Which is ironic, since the private central bank of ours can make all the money it needs. Oh crap, we wouldn't want to collapse the currency by publishing M3 or anything. And since we create most money as debt, then creating cash to cancel out debt is deflationary. People might take the cash, (if they can get their grubby hands on it) pay their loans off, and save some money for the future. How on earth would banks make money if everyone was not in debt up to their eyeballs? Service charges? That's madness. What was I thinking?!?

I guess what is good for the individual hurts the money supply. Time to re-order my thinking... banks first, then everyone else.

Ok, I think I got it now...

Everyone will make more money in the future, by going further into debt now!

I see no reason to worry.

2008 Dec 15 06:25 AM

[Jack K:]

John Maynard Keynes was wrong. His concept is an easy out. But most Dems and a few Repubs like the idea of government being in control of everything

2008 Dec 15 06:30 AM

[chinamac:]

Interesting- it will take a number of years for the financial institutions to repair their balance sheet, (the joke is, US financial institutions' balance sheet? Nothing is right on the left hand side and nothing is left on the right hand side), then we will also have to repair the balance sheet of the consumers, eventually somehow repair the balance sheet of the Fed. Looks like it will be quite a while.

2008 Dec 15 08:17 AM

[bluesmoke:]

Good article. What a mess.

2008 Dec 15 08:33 AM

[dagnabbit:]

There is no quick fix, which is ironic, since the quick-fix allure of debt to propel a slowing economy was the genesis of this crisis.


There never was a quick fix. Only our leaders illusion of a quick fix.

2008 Dec 15 09:42 AM

[Lars39:]

Agree with all above. Scares me to think of all the still to be discovered problems ala Bernie Madoff's hedge collapse. Has the entire market become a giant Ponzi scheme?

2008 Dec 15 09:46 AM

[Alan Brochs...:]

Confidence game, yes, but not a Ponzi scheme. Trying to find earnings next year will be harder than winning Three-Card Monte...

2008 Dec 15 10:24 AM

[dw57:]

not sure that they all aren't a ponzi scheme. i see nothing that would say they aren't.


On Dec 15 10:24 AM Alan Brochstein wrote:

> Confidence game, yes, but not a Ponzi scheme. Trying to find earnings
> next year will be harder than winning Three-Card Monte...

2008 Dec 15 10:30 AM

[Smarty_Pants:]

Good summary Alan. This is a huge debt funded mess and things won't stabilize until the debt is liquidated or paid off.

The Austrians would point out that the years and years of debt funded spending would lead to mal-investments in production. Once the debt based funding dries up and spending based soley on earnings is the main driver, the sectors of the economy that the extra debt allowed consumers to support should wither away to nothingness.

Expect significant realignments in the economy until then.

2008 Dec 15 12:24 PM

[k9s-4-k8:]

I suppose it is assumed that with all the deleveraging occurring that their will be some inflection point when Americans revert to their old ways of shop, shop, shop. I would be one to agree that a true paradigm change is not generally very likely. We are a very materialistic society and a value change won't come easily. But we may be staring at the components to a change. Our government has been bailing out our financial system with mega billions as we await the next two rounds of bailout---the auto industry which should run over $100 billion within the next year alone and homeowners which will run into hundreds of billions at least. Additionally, the Obama administration and Congress are already designing a trillion dollar stimulus package that will be spread on pet projects throughout the land. What kind of shape will the economy be in after all this money is spent? Hard to say, but one thing is certain. The interest on the deficit will likely crowd out everything else for decades to come. We will need to cut back on every other program or we will lose any chance of a future in the developed world now.

2008 Dec 15 03:13 PM

[Trading to Win:]

Richard Koo of Nomura has called it a Balance Sheet Recession. It is well worth looking into his thinking.

Good fortune.

2008 Dec 15 03:56 PM

[Dr. John Ru...:]

Alan,
Great piece. Have been tracking balance sheets for many years. Re" your query about the government's balance sheet, here is an interesting fact. The Federal Reserve Board once regularly published a document called "Balance Sheet of the United States," including a detailed balance sheet for the federal government. They stopped publishing it in 1994. (One wonders why?) Those balance sheets revealed assets including over 700 million acres of land. GAO now published a substitute but classifies government land and other assets as 'assets held in trust', which could just as well describe my house. If we were to see a complete balance sheet, including land, a natural question would arise. Should the government restructure its balance sheet (sell assets) when confronted by a mismatch between assets and liabilities like everybody else. Answer is yes.
John

2008 Dec 15 05:03 PM

[Alan Brochs...:]

Thanks for your kind words, John. I have followed your work peripherally for years, and I appreciate your adding to the dialogue here.


On Dec 15 05:03 PM Dr. John Rutledge wrote:

> Alan,
> Great piece. Have been tracking balance sheets for many years. Re"
> your query about the government's balance sheet, here is an interesting
> fact. The Federal Reserve Board once regularly published a document
> called "Balance Sheet of the United States," including a detailed
> balance sheet for the federal government. They stopped publishing
> it in 1994. (One wonders why?) Those balance sheets revealed assets
> including over 700 million acres of land. GAO now published a substitute
> but classifies government land and other assets as 'assets held in
> trust', which could just as well describe my house. If we were to
> see a complete balance sheet, including land, a natural question
> would arise. Should the government restructure its balance sheet
> (sell assets) when confronted by a mismatch between assets and liabilities
> like everybody else. Answer is yes.
> John

2008 Dec 15 07:16 PM