The great debt drag
America looks likely to avoid a second recession. But with households still overburdened by debt, years of slow growth lie ahead
Sep 16th 2010 | WASHINGTON, DC | From The Economist print edition
IN THREE decades of selling cars in southern California, David Wilson has been through countless ups and downs. So when sales at his 16 dealerships, mostly around Los Angeles and Orange Counties, fell by a third in 2008, he naturally expected them to go up again. They still haven’t.
Mr Wilson now realises that his boom-year sales were a by-product of the state’s housing bubble. Dealers reckon that before the crisis a third of new cars in California were bought with home-equity loans. “Now there’s no home equity,” says Mr Wilson, “there’s no down-payment for cars.” He foresees no sales growth for another two to three years. “The country is not optimistic. If you’re not optimistic you don’t buy a new house or new car.”
He’s right: Americans are not optimistic. Official statistics say that the economy has been growing for nearly 15 months, but so sluggishly that most people seem to think it is still in recession. For a few months it looked as if the economy might even shrink again, as growth slowed to a mere 1.6% (at an annualised rate) in the second quarter, job creation almost stopped and home sales plunged.
Admittedly, the second quarter may have been unlucky, as Europe’s debt crisis and the BP oil spill sapped business confidence and an anomalous surge in imports ate into growth. More recent indicators on jobs and trade have all but put to rest fears of an imminent return to recession. A burst of corporate mergers, including several bidding wars, suggests business’s animal spirits are returning. Nevertheless, in the third quarter the economy has probably been growing at a rate of only 1.5-2%. A pace of 2-2.5% is likely in the fourth.
Since the recovery began, the economy has grown at a rate of less than 3%. That is faster than its long-term potential, of about 2.5%, but America has woken from past deep recessions at rates of 6-8%. Job creation has thus been too feeble to bring down the unemployment rate, which at 9.6% is much as it was at the start of the recovery. “Progress has been painfully slow,” acknowledged Barack Obama on September 8th—not what a president likes saying less than two months before an election.
What makes this recovery different is that it follows a recession brought on by a financial crisis. A growing body of research has found that such recoveries tend to be slower than those after “normal” recessions. Prakash Kannan, an economist at the IMF, examined 83 recessions in 21 rich countries since 1970. In the first two years after normal recessions growth averaged 3.7%. After the 13 caused by crises, growth averaged 2.4%. America has been doing slightly better than this (see chart 1).
The Federal Reserve brought on most post-war recessions by raising interest rates to squeeze out inflation. When the Fed cut rates, demand revived. Financial crises interfere with the transmission of lower rates to private borrowers. People can’t or won’t borrow because the value of their collateral—in particular, houses—has fallen. Banks are less able to lend because their capital has been depleted by bad loans, or less willing because customers can’t meet tighter underwriting standards.
“Where we are in the economy shouldn’t be surprising,” says Vikram Pandit, chief executive of Citigroup. Mr Pandit sees only two sure things ahead: that American consumers will continue to cut their debt (deleverage, in financial argot) and that emerging markets will grow quickly. At Citi, transaction-service revenues, such as foreign-exchange and cash management for multinationals, are growing healthily while revenue from American consumer loans is shrinking.
This reflects the economy as a whole. Exports have kept growing this year—but so have imports, so net trade has not contributed much to growth. Indeed, the IMF, which thought a year ago that trade would add to growth over the next four years, now sees it subtracting, in part because of trading partners’ slower growth. Business investment in equipment, brisk early in the recovery, has slackened. Firms may be reluctant to invest and hire partly because of uncertainty over Mr Obama’s regulatory and tax initiatives, but concern about consumer spending seems more important. Government spending has helped fill the hole, with direct federal injections of cash and cuts in taxes. But much of the federal effort has been neutralised by state and local cuts. And the stimulus is winding down. The end of a tax credit has caused the housing market new pain.
So if the economy is to grow much faster than its 2.5% trend, consumers must start borrowing and spending again. What is holding them back: are they reluctant to borrow, or are banks unwilling to lend?
Atif Mian of the University of California at Berkeley and Amir Sufi of the University of Chicago have found a close correlation at county level between car sales and household debt. The heavier the debt in a county at the start of the recession, the weaker sales have been since (see chart 2). Mr Sufi says large national banks have customers everywhere. So the sales gap suggests that debt-laden households are unable or loth to borrow.
This tallies with Mr Wilson’s experience. Leasing, which requires little or no down-payment, has grown from 25% of his business before the crisis to 40%. A customer who has defaulted on his mortgage but not his car payments can still get a car loan. But his interest rate and down-payment will be much higher—and may be unaffordable. And the heavily indebted need time to repair their finances. Melinda Opperman of Springboard, a credit-counselling agency with offices in five south-western states, says a typical debt-management plan takes three to five years to complete.
Tight-fisted, or frightened?
On the other side of the table, banks seem to have plenty to lend. Their capital equals almost 12% of assets, up from less than 9% in 2006. Recently analysts asked Mr Pandit why he was letting capital “build to ridiculously high levels” and why cash and other sources of liquidity “seem to keep going up all the time”. Moody’s, a ratings agency, has estimated banks’ total loan charge-offs between 2008 and 2011 at $744 billion, of which $476 billion has already been recognised in their accounts. They have enough loan-loss reserves to cover 80% of the remaining $268 billion.
But no one is really sure whether banks have adequately disclosed, or even know, their ultimate exposure. The IMF estimates that 11m properties are worth less than the mortgages secured on them, and that 7.6m of these are heading for foreclosure or are at risk of it. Banks have probably not recognised the likely losses on many of these loans, but there is no way of knowing. Christopher Whalen of Institutional Risk Analytics, a research firm, thinks charge-offs are understated by a third.
How long will deleveraging take? In a recent paper Carmen Reinhart of the University of Maryland and her husband Vincent Reinhart of the American Enterprise Institute looked at 15 crises since 1977. They estimate that on average deleveraging lasted seven years, during which growth was a percentage point lower than in the decade before a crisis. If America follows this pattern, its GDP will grow by 2.4% for the next four to seven years. Because that roughly equals potential, job creation should only just match population growth: the unemployment rate won’t fall.
Few economists are that gloomy. Most think a prolonged period of easy monetary policy and a slow release of pent-up demand for durable goods and homes can yield growth of at least 3%. Some also think that deleveraging is ahead of schedule. Richard Berner of Morgan Stanley predicts that, thanks in part to falling interest rates, debt service will be back to a “sustainable” 11-12% of disposable income later this year. Peter Hooper and Torsten Slok of Deutsche Bank reckon that if saving stays at about 6% of income, write-offs remain near today’s elevated level and household income rises by 4.5% a year, household debt will fall from 126% of disposable income now to around 85%, where it was in the early 1990s, by 2013 (see chart 3).
These calculations will be wrong if incomes stumble or consumers seek to save more than expected. The IMF notes that saving rates in Finland, Norway and Sweden ultimately rose by five to ten percentage points after housing busts in the late 1980s. America’s saving rate has gone up by four points so far.
More cheerfully, the Reinharts find that once economies start to grow after a crisis they tend not to slide back into recession without suffering some new shock. Spain, whose banking crisis began in 1977, was dragged back by global monetary tightening in the early 1980s. Countries recovering from the East Asian crisis of 1997-98 were hit by avian flu, the bursting of the American tech bubble and the economic effects of the terrorist attacks of September 11th 2001. Japan is a special case. It was shoved back into recession partly by its own policies: an ill-timed tax increase in 1997 and the (temporary) ending of the Bank of Japan’s zero-interest-rate policy in 2000.
American policymakers seem determined to avoid Japan’s mistakes. Unless the outlook improves dramatically the Fed is likely to resume quantitative easing (buying bonds with newly printed money in an attempt to drive long-term interest rates even lower). The subject will be on the table at its meeting next week. Fiscal policy is more of a problem: more stimulus is unlikely and it is unclear whether George Bush’s tax cuts, due to expire in December, will be extended. Senate Republicans want to keep them all; Mr Obama wants rid of those for the rich.
Without more action, though, deleveraging could drag on for a long time. South Korea and Sweden owed their relatively robust recoveries to policies to remove bad loans from banks’ balance-sheets. That was the original purpose of the Troubled Asset Relief Programme (TARP), before it was used to recapitalise banks, bail out carmakers and subsidise loan modifications.
America could hasten deleveraging and improve workers’ ability to move to new jobs by being more eager to cut the principal on mortgages to sums closer to homes’ actual values. That would often both be cheaper for lenders than foreclosure and let owners keep their homes. But cuts in principal have been rare—applied to a mere 120 of the 120,000 mortgages permanently modified through the federal government’s programme between October 2009 and March 2010. Banks don’t want to let borrowers who can really pay off the hook, to give others an incentive to default, or to recognise more losses.
Bankruptcy laws could be changed to allow courts to reduce principal, much as they can for the debt of a company in Chapter 11. John Geanakoplos of Yale University has argued for special federal trustees, empowered to insist on modifying or foreclosing impaired loans. They would choose the course giving the lender the highest return.
However, forcing banks to recognise losses would erode their capital. Some could raise more if they needed it, but others might fold. Since the TARP was wound down, the federal government has no money for buying the loans or recapitalising banks—and there is no political appetite for doing so. Indeed, arguably the opposite is happening as Fannie Mae and Freddie Mac, the two nationalised mortgage agencies, seek to compel banks to buy back loans of doubtful quality they had sold to the agencies.
There are, in theory, many ways to hasten recovery after a crisis. But Mr Reinhart says that policymakers are usually too “timid” to pursue them. In that respect, America is following the script.
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