Is Debt Overhang What's Preventing a Strong Recovery?

Don’t expect stronger growth, some say, until deleveraging is complete.

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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.