The End of the Beginning? The Household Sector is a Problem

In a recent post, I presented some mixed signals on the prospects for a near-term recovery of the U.S. economy. In the end, I came down against a recovery being imminent but different eyes could have made the call in the other direction; indeed, once again I am in the minority and most forecasters are seeing a preponderance of green shoots in the data.

I view the world through different eyes than most economists. At least in policy circles, economists see the current downturn as driven in its entirety by a financial crisis. I don’t think this is a financial crisis (here’s why). I think this recession was caused by a shock to the manufacturing sector but it is the bad household balance sheets that have driven the dynamics of this recession: too much debt transformed a small productivity shock into a full blown solvency crisis. The asset side of the household balance sheet (household income) has fallen slightly; the high level of liabilities transforms this to a crisis.

The global economy cannot return to health until households have worked off at least part of their excess debt. So far they have made little progress.

The picture below shows the ratio of total consumer credit outstanding to personal income. From the late 1950s through the early 1990s, this ratio was stable on average between 0.14 and 0.16. Then in the 1990s the ratio took off, increasing to 0.19 by early 2000. The fall in income and no decline in debt drove the level even higher through the summer of 2003 where it peaked at 0.23.

Like the current account balance, like consumption’s share in GDP, this ratio is too high and will have to adjust before the economy can return to health. It may have to adjust to its 2000 level or it may need to go all the way back to its long-run average, but it has to move down.
But, household debt alone does not give a sufficient accounting. Government debt is essentially an off-balance sheet liability of the household sector. And government debt has grown apace over the last 10 years. In January 2001, the federal debt was $5.7 trillion. An increase in the growth rate of government spending, combined with slower revenue growth raised the growth rate of government debt. By December 2008, federal debt had reached $9.2 trillion. Since then, the debt has increased more than 20 percent, exceeding $11 trillion dollars and approaching the value of nominal GDP.
Adding the federal debt to consumer debt raises the household debt to income ratio to more than double is pre-1990 level. As bad as these numbers seem, they are actually much worse. Household demographics do not support the increase in debt. Over the next five years, the proportion of American households over the age of 65 hits a record. There is a reason people retire at 65; beyond that age morbidity rates rise sharply, implying lower productivity. Social pension programs are a side show. The true problem is the fall in labor input and the loss of human capital and making people work longer is not the answer: there is a reason people tend to retire at 65 (morbidity). The household sector is living beyond its means and its means are not going to grow.

Long-term Adjustment: Short-term growth?

So, over the long run, the household sector needs less debt (see the previous post). What about short-term indicators? Is the household on the brink of recovery despite my dire predictions? No, but let’s take a look.

Surveys provide the timeliest insight on the health of the consumer sector and consumer confidence has ticked up. Both the Michigan survey and the Conference Board are at or near record lows, but both series have stopped falling and may be poised for a rebound. But consumer confidence is volatile and does not strongly lead the cycle. The small increases in the series so far this cycle are indistinguishable from random noise.

A better direct indicator of consumer-sector health is the state of the housing market. Residential investment leads the cycle by one to four quarters and it tends to lead vigorously, falling rapidly from the peak and rising robustly from the floor. Housing starts have shown no inclination to rise and it looks like they still want to fall.

We will hit a floor in housing starts in the next few months. (There is a binding zero nominal bound for starts.) Rather than being good news for the housing market, hitting the floor in starts may trigger a more virulent phase of the downturn. If the economy can no longer adjust through quantities, it must adjust through prices. If starts can no longer absorb part of the adjustment, house prices must fall faster. If house prices fall faster, more households will opt for foreclosure, adding an independent source of pressure on prices.
And of course, household incomes are not going to support recovery. The graph below shows a stunning (and familiar) picture of continuing claims for unemployment. Continuing claims for unemployment insurance are at a record; claims as a percent of the workforce are rapidly approaching the earlier peak as well.
So, long-term fundamentals are negative for consumption and near-term indicators have yet to turn. I just don’t see hope of a full-blown recovery. What I see right now is a short-term respite from the dreariest days followed once more by a period of contraction.