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Is Debt Overhang What's Preventing a Strong Recovery?

Chris Gay

The Great Recession has revived interest in the late British economist John Maynard Keynes, but there's an American economist of Keynes's era that investors might want to read up on. Most people remember Irving Fisher, if at all, for his spectacularly mistimed declaration that stock prices had "reached a permanently high plateau." It was days before Black Tuesday.

Economists, however, know Fisher for his "debt-deflation theory" of recessions, which holds that high debt levels help cause--and prolong--a downturn. If Fisher was right, America's still-high personal and corporate debt levels could explain today's sluggish recovery: Households and businesses are too busy paying down debt to boost spending and investment, and until debt levels reach some moderate level, you shouldn't expect a strong recovery or a sustained rally in stock prices.

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"In simple terms, but accurate terms, [excessive debt] is the underlying problem now with the U.S. recovery," says Nariman Behravesh, chief economist for business-information provider IHS Global Insight.

So how far are we into the deleveraging process, and how far do we need to go? The short answer: partway, but moving in the right direction. McKinsey reported in January that all levels of private-sector debt (borrowing by households, financial firms, and non-financial firms) had since the end of 2008 fallen from $8 trillion to $6.1 trillion, or 40 percent of GDP--the same ratio as in 2000. Some of that has been forced, as when homeowners enter foreclosure. Household debt had fallen from about 125 percent of GDP to around 110 percent.

The critical ratio of household debt-servicing costs to after-tax income fell from 14 percent five years ago to 11 percent in the first quarter, according to Federal Reserve data. Economists say that is a significant improvement, even if it does partly reflect refinancing at lower rates, reduced borrowing and write-offs of mortgage and credit-card debt.

Credit-tracking agency Equifax reports that outstanding consumer credit-card debt shrank a year-on-year 1 percent in August in the U.S. cities that are recovering most slowly, even as it rose slightly nationwide.

"Historical precedent suggests that U.S. households could be as much as halfway through the deleveraging process," wrote McKinsey. "If we define household deleveraging to sustainable levels as a return to the pre-bubble trend for the ratio of household debt to disposable income, then at the current pace of debt reduction, U.S. households would complete their deleveraging by mid-2013."

Then, of course, there are other shoes to fall, like deleveraging among our trading partners and by our own federal government, whose debt naturally rises in a downturn. But let's not get ahead of ourselves.

Why is private-sector debt so important to begin with? Two main reasons: One is that it amplifies the adverse effects of financial shocks and market extremes that are bound to occur in capitalist economies from time to time. As Fisher put it in the 1933 paper that introduced the debt-deflation idea: "? over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money."

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The second reason is the one that concerns us now: Heavy debt burdens hinder recovery, for reasons related to what economics knows as "the paradox of thrift"--saving more may be good for individual households in the long run but bad for the larger economy in the short run.

Fisher's theory has a modern-day incarnation in the "balance-sheet recession," a term popularized by economist Richard Koo of the Nomura Research Institute.

Here's how Koo says it works: Imagine a household that has income of $1,000 and a savings rate of 10 percent. It spends $900 and deposits $100 in a savings account. Normally, the bank would turn around and lend that $100 to a borrower who spends it, bringing aggregate spending to $1,000. In a private sector that is focused on reducing debt, however, there are no borrowers for the $100, even at negligible interest rates.

And the $900 that the household spent? It becomes someone else's income, of course. But if that someone also saves 10 percent that won't be borrowed, total spending is $810. That $810 in income for another 10-percent saver begets only $730 in spending, and so forth in an ever-decreasing cycle.

Koo is careful to note the difference between a balance-sheet recession, which is largely impervious to monetary-policy fixes, and a financial crisis, which isn't. Alas, Koo notes, the Great Recession has involved both. What recovery there has been since 2008, he says, is the result of monetary authorities deploying an arsenal of weapons (capital injections, guarantees, asset purchases, and so forth) against the financial crisis sparked by what he calls the "policy mistake" of letting Lehman Bros. collapse.

But the balance-sheet problem is not so easily remedied. Speaking at a conference in Berlin in April, Koo noted that the U.S. monetary base had more or less tripled since mid-2008, and yet M2 ("money in circulation") had barely risen and credit available to the private sector was actually down.

"Why do we get these results?" asked Koo. "Because the private sector is no longer maximizing profits; they are actually minimizing debt."

Put more technically, the money multiplier--the process that turns a dollar deposit into more than a dollar of loans--"is actually negative at the margin," Koo told his Berlin audience. Private-sector deleveraging is "the key difference between an ordinary recession and one that can produce a lost decade," Koo wrote in a 2011 paper.

What breaks the cycle? The private sector, left to its own devices, can deleverage to the point where borrowing becomes attractive again. But that process produces lots of economic carnage, as aggregate spending falls to some irreducible level. "In fact, [Fisher's] discussion of debt-deflation doesn't really have much of a mechanism for recovery at all, without intervention," notes Brock University economist Robert Dimand, a student of Fisher.

What government can do in the meantime is supplant the borrowing and spending that the private sector has relinquished--though here, of course, the constraints become as much political as economic.

Whatever the government does, it has become accepted wisdom that deleveraging after a financial crisis is a long, painful process. President Obama took up the refrain recently when he told a Cleveland audience that what we're experiencing today is "not your normal recession. Throughout history, it has typically taken countries up to 10 years to recover from financial crises of this magnitude."

Obama's critics, like former Republican Sen. Phil Gramm--a champion of financial deregulation--say he's just trying to whitewash the results of failed policies.

But the weight of evidence seems to favor the president. Exhibit A for most economists is the work of Harvard's Kenneth Rogoff and Carmen Reinhart, who after surveying 20-Century financial crises around the world, 15 of them postwar, famously argued that the United States is following a familiar pattern: A huge build-up of leverage for a decade or so, an inevitable crash, then a decline in leverage comparable in size to the preceding expansion.

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Elaborating, Reinhart and her economist husband, Vincent Reinhart, wrote in 2010 that post-financial-crisis unemployment in advanced countries rose by a median of five percentage points, and in 10 of the 15 postwar crises never fell back to pre-crisis levels.

Real, per-capita GDP fell by an average of 1 percentage point in the decade following a financial crisis. The typical postwar U.S. recession lasted less than a year, and within two years, GDP regained lost ground and returned to the long-term growth trend. After the typical postwar financial crisis, by contrast, the economy has required an average of four and a half years to reclaim pre-crisis output levels.

Of course, to say that deleveraging is the key factor governing the speed of recovery is not to say that it's the only factor. There's the euro crisis, electoral uncertainty, the fiscal cliff, and many other things.

What explains the slow recovery is "not just the balance-sheet issue," says Beth Ann Bovino, deputy chief economist for Standard & Poor's. "Partly it's a crisis of confidence. People are afraid to borrow and spend."

But Bovino, for one, is relatively positive about prospects for 2013. She notes that household default rates are down across the board, home prices may be bottoming out, and job creation has been stronger during this recovery--financial crisis notwithstanding--than it was at the same point following the 2001 recession. "This so-called jobless recovery," she says, "might not be as jobless as people have been saying."

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