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 This provides a great historical reference for all the sectors of our economy.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