Americans (Finally) Learning Lesson on Debt

by: The Business Insider

The reason the whole economic world almost imploded two years ago was that Americans had racked up absolutely massive debts - the highest as a percentage of GDP in history, by a mile.

This 30-year borrowing binge, which began in earnest in the early 1980s, fueled the impressive economic growth of the 1990s and 2000s, and it helped push asset prices (stocks and houses) to staggering highs.

(It's amazing how your standard of living can improve when someone gives you a credit card and keeps lending you more and more money to pay off your balances, no matter how much you borrow.)

However, sometime in 2007, there came a day that consumers and businesses just couldn't borrow any more, and asset prices collapsed, taking the economy down with them.

Since that day, the government has been doing everything it can to encourage American consumers to start borrowing again, to go back to the happy free-spending days of the early 2000s and get the economy humming. But consumers, thankfully, appear to have learned their lesson (and if they haven't, lenders have).

Instead of just going back to borrowing and spending, consumers have started to work off their debts. In so doing, they are gradually rebuilding their "household balance sheets," a process that will eventually give the country and economy a much more solid foundation.

As the following charts from Asha Bangalore at Northern Trust illustrate, in the past two years, household borrowing has seen its biggest drop ever as a percentage of GDP.

Of course, as the charts also make clear, this "deleveraging" process has a long way to go. (And governments - federal, state and local - are picking up most of the borrowing slack.)

What consumers spend on debt repayment, they can't spend on stuff. So if this deleveraging continues - which it must if consumers are ever to return to a normal level of indebtedness - the repayment process will keep a lid on consumer spending for the foreseeable future.

The soft trajectory of consumer spending and continued reduction in residential investment expenditures reflects the sharp reduction in household debt. Outstanding home mortgages have dropped from $10.606 trillion in the first quarter of 2008 to $10.126 trillion in the second quarter of 2010 (see chart 1). Household credit card debt has fallen roughly $157 billion from the peak in the third quarter of 2008 to $2.41 trillion (see chart 1).

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Household debt

Image: Northern Trust

Total outstanding household debt as a percentage of GDP has fallen roughly six percentage points between Q1 2009 and Q2 2010 (see chart 2). This decline is the largest on record in the post-war period. The drop of household debt as a percent of GDP in the early 1980s (48.95% in Q2 1980 vs. 46.65% in Q3 1981) was significant but smaller than the current occurrence and it was the result of credit controls imposed in the inflation battle of that period. The lifting of credit controls led to a sharp reversal in the mid 1980s (see chart 2). The root cause of the current deleveraging is an entirely different story where severely indebted households are cutting back on borrowing to finance expenditures.

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Asha also takes a look at the level of overall private-sector debt (households and businesses), which has also fallen in the past two years. Like household debt, total private sector debt is still extremely high relative to the average of the past 60 years.

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