Unwinding Over-Consumption – What will it Cost?
February 2009
By: ChartingTheEconomy.Com
The U.S. economy has had a great run since the early 1980s with a few brief corrections. However, this run was not
sustainable. It was supercharged by: 1) easy credit (and lots of it), and 2) a lack of savings. The country took on
massive leverage, and ended its habit of saving. Essentially, we as a country went on a huge spending spree. This
over-consumption provided for higher Gross Domestic Product (GDP) growth, but it could not last forever.
What we are seeing now is the unwinding of this trend. In coming years the trend will be very different form the last two
decades. Instead of being supercharged by increased household debt and consumption, the economy will be held
back by the reduction in household debt and the increase in the personal savings rate.
In this paper, we quantify the effect that reduced consumer debt and increased personal savings will have on the U.S.
economy. There is about $2 trillion of consumer debt that needs to be worked out, and personal savings need to
increase by about $850 billion per year. This reflects a reset of the household debt service ratio (DSR) to 12% of
disposable income and the personal savings rate to roughly 9% of disposable income. I say “reset” because the new
trends in debt and savings will not be temporary. The trends will be more in-line with historical averages and will
become the new standards.
Debt
First, let’s discuss household debt. Much of the pain we are feeling today is the beginning (yes, the beginning) of the
unwinding process of the massive debt we have taken on to fuel our over-consumption. As you know, debt can be
unwound in two ways. It can be defaulted on (or restructured), or it can be paid off. Household debt service ratios are
at record levels. The unwinding of this debt will be a difficult process at best, but a necessary one.
The government is trying to help fight the economic crisis with many of its programs. However, under the government
programs much of the bad debt is just being transferred from the private sector to the public sector. So, the problem
still exists.
Even under the best case scenario all the programs the government is throwing at the economic crisis will just provide
for slower growth. I believe the government is hoping that it can: 1) take all the bad debt public, 2) stabilize and
stimulate the economy and lending, and 3) pay the debt off over the coming decade as the economy enters better
times. This is the best case, and it still provides for slower GDP growth as the debt is eventually worked off.
The Impact of Household Debt
What is the impact of the contraction in household debt? Let’s look at a couple of charts. Chart #1, shows how the
annual household DSR has grown since 1980 compared to the average household DSR over the same time period.
Note that the DSR calculation includes both consumer and mortgage debt.
As you can see, the household DSR exceeds the long-term average by about 200 basis points. To get the household
DSR back in line with historical averages we need to see it drop from 14% of disposable income to about 12%. This
means that total household debt must decline by about 14% from current levels (the move from 14% to 12% is a
decline of just over 14%). Let’s do the math:
14% X 14% = 1.96%
14% -1.96% = 12.04%
There are several ways that the household DSR can reset to its historical average. First, lower interest rates can
reduce debt payments. Second, disposable income can grow faster than new debt. Third, the debt can be payoff or
default on. The first is unlikely because short-term interest rates are already at zero, and consumer and mortgage
interest rates are at historical lows. If anything, there is more of a risk that in coming years interest rates may rise
causing the household DSR to increase. Therefore, the DSR will most likely decline through lowering debt loads
relative to incomes. This will produce slower growth for the economy.
How much slower? Let’s look at Chart #2. As you can see total household debt is nearly $14 trillion. If you take a
14% reduction of the total household debt, you get almost $2 trillion. This is the amount of household debt that has to
be worked out in order to get the household DSR back to the historical average. Once the household DSR resets to
the historical average it needs to be maintained. The good news is when this happens consumers will free up about
2% of their disposable income which is currently going to service their debt. However, this will take time, and it will be a
difficult road in the meantime.
Savings
Now, let’s turn to personal savings. The U.S. consumer has historically saved about 7% of disposable income.
However, the personal savings rate has been below that average since the early 1990s. In recent years it has been
hovering around zero (and even negative at times on a monthly basis). As personal savings declined and
consumption increased, in the past decade, it supercharged GDP growth. Why? It is because consumer spending
accounts for roughly 70% of U.S. economic growth. In February 2005, I wrote an article entitled “Getting Rich – Stock
Valuations.” In the article I state, “the growth in personal consumption expenditures cannot continue to outpace growth
in personal income indefinitely.” Well, the day has come, and growth in personal consumption has begun to slow as
the personal savings rate moves back toward its historical average (see Chart #3).
The Impact of Higher Savings Rates
Chart #3 shows us several things. First, over the past few years the annual personal savings rate has been near 1%.
Second, the trend toward increased savings actually started in 2008 as we began to see positive movement in the
savings rate for the first time in years. Third, the historical average personal savings rate is about 7% of disposable
income.
To compensate for their lack of savings (savings gap) since the early 1990s consumers will likely move to savings
rates that are above the long-term average. The “savings gap,” as I refer to it, can be seen in Chart #3 as the area
between the average savings rate and the annual savings rate that has developed since 1993. Based on this, a move
in the savings rate from 1% back to a level of 8%-10% for a sustained period would be reasonable. This move,
therefore, could represent approximately 8% of disposable income being eliminated from the consumption expenditure
portion of GDP. Given that disposable personal income was $10.6 trillion in 2008, according the U.S. Bureau of
Economic Analysis, this represents roughly $850 Billion. It is important to remember this is not a one time hit to GDP.
Personal savings rates will need to reset at this level for many years, so this represents an annual reduction in GDP.
In the past decade consumers relied on asset appreciation and capital gains not savings to add to their net worth.
(Note: capital gains are not included in the government’s personal savings calculation). Now that the asset bubble
has burst, consumers will have to begin saving again. As the consumer moves back toward the historical average
savings rate, this move will slow U.S. economic growth.
Conclusion
In this paper, we show why there will be a new trend toward lower consumer debt loads and increased personal savings
rates. Also, we quantify the effect this new trend will have on the U.S. economy. Through this analysis it is determined
that about $2 trillion of consumer debt needs to be worked out, and personal savings need to increase by about $850
billion per year.
Over the past two decades the U.S. has enjoyed an economy supercharged by easy credit and over-consumption
which could not be sustained. What we are seeing now is the unwinding of this trend.
In the near term the government will attempt to offset the shrinking economy and slower growth by: 1) taking the bad
debt in the economy public, and 2) passing massive stimulus packages. Remember that by buying up bad debt the
problem is not solved. The debt is still out there. It is just transferred from the private sector to the public. It must be
worked off over time, in a diligent manner, as the economy recovers. If not, it will likely come back to create worse
problems in the future.
With regard to stimulus packages, they too could be a mixed bag. The stimulus package that is currently being put
together will inflate growth in the near term. But, it may not be enough to overcome the effects of a lower household
DSR and higher personal savings. In the long run all stimulus packages need to create value-adding assets, services,
and/or goods. Otherwise, they will just create more debt that will eventually slow the economy more.
So, even if the government’s plan to stem the economic crisis works, don’t expect a return to the consumption led
boom of the past decade or two. Those times are gone.
Sources:
Chart #1: Data is from the Federal Reserve. The number for 2008 is the average of the data for the first three
quarters. The household debt service ratio (DSR) is an estimate of the ratio of debt payments to disposable personal
income. Debt payments consist of the estimated required payments on outstanding mortgage and consumer debt.
Chart #2: Data is from the Federal Reserve Flow of Funds report. The number for 2008 is the average of the data for
the first three quarters.
Chart #3: Data from the Bureau of Economic Analysis