Sunday, January 8, 2012

Household debt, part III: The road ahead, or I can't drive 55

My 3rd -and for now, final - post on household debt concerns its implications on our future. If we continue on our current trajectory, it could take people a decade or more to pay down their debts to a sustainable level. Perhaps Washington will do something to help speed this up, such as enacting a more effective mortgage modification program, but I'm not holding my breath. Meanwhile, the deleveraging process places a drag on our macro growth prospects as people will need to live below their means in order to repay their debts. (As an aside, while this may seem intuitive, it's not as broadly accepted as you may think. However, this fairly readable study from the Federal Reserve Bank of San Francisco makes a compelling argument).

Despite this, I'm optimistic. While we have a huge hole to dig out of, things are actually going better than I expected. For example, the chart below depicts the portion of after-tax household income that goes to servicing debts. It should first be noted that this data is very sketchy and is useful more for trend analysis than as an absolute measure. Still, incredibly, and no doubt aided by the Fed's maintenance of extraordinarily low interest rates, households are now operating at a level not seen since the mid-90's.

I expect this to be sustainable because the employment picture has been getting better recently and the Fed has been going out of its way to set expectations that it won't touch interest rates for at least another year. These two factors could also be somewhat inflationary, which would be helpful, despite what you hear from some corners. This is because wages generally track inflation, so, since the face value of the outstanding debt is fixed, higher inflation makes it easier for people to manage their debts.

Another cause for some optimism here relates to the actual impact the deleveraging is having on our growth. This chart indicates the rate of consumption growth after inflation over the last 15 years. We only have 2011
data through November, but still what we have shows that personal spending is now growing at more or less the same rate as it was before the recession.

Moreover, as the next chart shows, even after accounting for inflation personal spending is not only back above where it was at the start of the recession, but other than flat-lining during the "double dip" scare earlier in the year, it's been on a
pretty consistent uptrend
for a while now. When you
consider how much better
the employment picture has gotten recently, it would be reasonable to expect this trend to have legs.

Economic forecasts are generally horrible (what Obama would give to be able to take back "recovery summer"!). While we can project out from current trends, unforeseeable influences will undoubtedly emerge and could easily overwhelm the status quo. Still, while we know about threats from Europe's sovereign debt crisis and China's growth deceleration, to name two of the bigger ones grabbing headlines, it's perhaps harder to predict positive surprises, such as the potential for constructive action from Washington, or the impact of the human capital upgrade as people left the labor force to go back to school. Also, growth can be self-reinforcing -in a manner equal and opposite to the recession's vicious cycle- and we may already have enough momentum to make it more difficult for bad news to derail us.

However, in the interest of full disclosure I should point out that my optimism is far from the consensus view. Many economic forecasters are predicting a slow-down in the first half of 2012, with some even expecting a recession. I don't see it in the data I'm looking at but who knows; or as Sammy Hagar once sang for Van Halen, only time will tell if we'll stand the test of time.

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