Consumer Debt - Still A Long Way To Go

I have seen numerous articles as of late discussing how the average American family has finally delevered their household balance sheet at last. This would be good news as lower debt levels means more personal savings which would lead to productive investment. It would also mean more consumption that would provide stronger end demand to businesses. Both of these outcomes are necessary for sustained economic growth. The chart below has been used repeatedly to argue the deleveraging case for the economy.

At first glance the case of such deleveraging is clear. Households have develeraged, however, household debt to GDP is a bit misleading because GDP includes all activity of the economy including corporations and government. What we really want to know is how has the average American family has fared in this process. This is important to know considering that Personal Consumption currently makes up more than 70% of the economy as shown in the first chart below.

I have also included the household debt to GDP analysis as well as the 10-year rolling change in GDP. The important point to this discussion is the breaking point of economic growth as noted by the dashed black vertical line. As shown, the rate of economic growth began its decline as personal consumption became fueled by expanding levels of debt. Since debt by its very nature is destructive to economic prosperity, as it reduces savings and productive investment, it is only logical that in order to start restoring economic growth rates to higher levels - debt must return to levels that support higher personal savings rates and productive investment.

The importance of savings rates, as shown above, is crucially important to long term economic prosperity. When individuals save money they have more to spend on discretionary items which bolsters end demand and encourages businesses to increase employment and expand production. Personal savings are also used by financial institutions to loan to businesses to increase production, plant expansion or make other investments. Without savings the ability to expand economic growth becomes constrained.

With this in mind we now return to the discussion of consumer deleveraging. It is true that the consumer has deleveraged its balance sheet since the end of the last financial crisis. This should be considered a positive event except for two primary issues. First, according to the most recent quarterly update on household debt balances the only deleveraging that has really occurred is within mortgages (as shown in quote below). The problem is that this has been achieved primarily through forced write downs, foreclosures, refinancing and shortsells. This is obviously not the healthy kind of balance sheet repair accomplished through rising wages and payment of debt. Secondly, if consumer debt was being worked off in a productive manner then personal savings rates should be rising. That is not the case which tells you that something else is occurring.

"Mortgages, the largest component of household debt, continue to drive the decline in overall indebtedness. Mortgage balances shown on consumer credit reports continued to drop, and now stand at $8.03 trillion, a 1.5% decrease from the level in 2012Q2. Home equity lines of credit (HELOC) balances dropped by $16 billion (2.7%). Non-mortgage household debt balances jumped by 2.3% in the third quarter to $2.7 trillion, boosted by increases of $18 billion in auto loans, $42 billion in student loans, and $2 billion in credit card balances."

The problem is that even with reduced mortgage debt levels consumers are still carrying debt will in excess of what their incomes can healthily support and allow for increased savings. Furthermore, they are now adding to those balances in order to maintain their current standard of living as real incomes have come under pressure and remain at the same level as they were in 2008. Rather than household debt to GDP - a better measure of household balance sheet strength is debt to income per capita.

The chart below shows real (inflation adjusted) total household debt as compared with real incomes. The dashed red line running below real incomes is the normalized growth rate of debt at levels that were previously supportive of higher savings rates. That level, between 1959 and 1980 was 89% of real debt to income. This lower level of debt allowed for higher savings rates and stronger economic growth.

The immediate argument is that lower interest rates can allow for greater leverage within the household and still foster savings and productive investment. While I would agree with the premise of that argument there is no historical evidence showing this to be true. The following chart shows the decelerating rate of economic growth, and falling savings rate, even as interest rates have been pushed lower. There have been arguments made that the Federal Reserve should promote higher rates in order to restore economic growth as it would lead to reduced debt levels and higher savings rates. This chart would be supportive of that statement.

Deleveraging To Continue?

This begs the question of how much further does the consumer need to deleverage in order to restore a healthy balance between debt and incomes? The chart below shows the deviation between the current real debt/income ratio and the median of the normalized trend which was shown in the previous chart above.

It is important to remember that reversions to the mean typically return an equal and opposite distance beyond the mean. Therefore, with debt still 80% above normalized debt levels, and consumer debt to income ratios still at a lofty 170%, the reversion back to levels that are constructive to economic growth still has a very long way to go. The problem is that apart from mortgage debt, whose decline has been facilitated by massive central bank and governmental intervention, other debt is still being piled on. The chart below shows the monthly change in consumer credit versus personal consumption. Whatever deleveraging there might have been post the financial crisis - it is now over.

These other debts are at substantially higher rates than mortgages and negatively impacts the consumer's ability to save. This is why savings rates continue to fall. As full-time employment remains elusive, the average American continues to resort to debt, and governmental support, to fill the gap between waning real incomes and their expected standard of living. This is a game that has a finite end.

The diversion of income from savings to support debt service requirements will continue to impede economic growth until such time as either debt returns to levels that are conducive for higher levels of personal savings or incomes rise. The problem for the latter is that the excessively large, and available, labor pool continues to increase competition for employment which suppresses wages. This leaves consumers trapped between the need to payoff of debts in order to free up cash flow but needing increased levels of debt to sustain their standard of living. In the end the consumer will delever, either by choice or by force, the only difference between the two outcomes is the length of time that the current economic malaise lasts.

Source: Street Talk Live

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