The Deleveraging Myth Part 2: Behind Consumer Deleveraging

by: Russ Koesterich, CFA

Earlier this week, I wrote about the “The Great Deleveraging Myth” – the idea that while some sectors of the U.S. economy have reduced debt levels, the notion that the broad U.S. economy is deleveraging is mostly a myth.

The McKinsey Global Institute recently released its own report on deleveraging, “Debt and deleveraging: Uneven progress on the path to growth.” It finds that the world’s largest economies “have only just begun deleveraging,” the private sector is leading in debt reduction and government debt is still on the rise.

The McKinsey report also argues that deleveraging often begins with a period of private sector debt reduction and rising government debt that is followed by a period of rebounding growth and reduced government debt.

While I agree with many of the report’s findings, there is one that merits a closer look. The authors write: “U.S. households have made more progress in debt reduction than other countries, and may have roughly two more years before returning to sustainable levels of debt.”

It’s true that U.S. consumers are making progress on reducing debt, and they are arguably two to three years away from returning to a sustainable debt level. But it’s worth noting that progress on the consumer balance sheet is somewhat reliant on deterioration of the federal balance sheet. Consumers are reducing their debt relative to income largely because the government is artificially supporting their income through transfer payments. Looking forward, while consumer debt may continue to fall, government debt and overall U.S. non-financial debt will likely remain on an upward trajectory for a long time.

I’ve written on this topic before, but it’s worth repeating in the context of the deleveraging discussion.

Since 2007 federal transfer payments - Social Security, unemployment benefits and other federal programs - have risen to more than 20% of disposable income from 16%. Put differently, since the end of 2007, overall U.S. disposable income has risen by approximately $900 billion. Of that increase, roughly $560 billion has come via rising transfer payments. In short, more than 60% of U.S. household income growth since 2007 has been driven by the ever increasing generosity of the U.S. government.

As income has been supported by increased largesse from Washington, household debt-to-income levels have fallen to 114% today from a peak of 130% in 2007. This is still significantly above the long-term average of 80%, but, as McKinsey points out, it does represent progress.

Still, a good portion of that drop only occurred because personal income was inflated by rising transfer payments. Had government transfer payments simply remained at their level from four years ago, debt-to-disposable income would still be at 120%. The debt-to-income ratio looks marginally better partly because the government is doing everything it can be inflate the denominator of that equation, i.e. income.

This is the paradox. The rise in transfer payments can, and probably should, continue in the near term as wage growth is still anemic. However, if previous credit bubbles are any guide, it will take a long time for the labor market to rebound, meaning the consumer is likely to remain dependent on help from the government in the long term.

While this will allow consumer deleveraging to continue, it comes at the expense of more government debt and a net effect of more U.S. non-financial debt.

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