Sent: 14-04-2009 13:01:01
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Reducing Debt, Good or Bad? - Part 2
Last time I explained how US consumer spending had fueled economic growth in that country and as a result had a major impact on global growth. As the analysis from the McKinsey Global Institute (MGI) noted, the US accounted for one third of the total growth in global private consumption since 1990. Between 2000 & 2007 the growth in US imports increased aggregate global demand by almost US$1 trillion
But, as I pointed out last time, things changed dramatically in 2008. Household wealth fell as home values declined. This was exacerbated by declines in stock prices and easy credit was replaced by much more stringent lending standards, lower lending limits on credit cards and cancelled home equity lines of credit. Unemployment is continuing to rise causing widespread fear amongst even traditionally safe occupations such as nurses! Not surprisingly, consumer spending is falling rapidly and people are trying to save what they can.
I have personally witnessed this lack of consumer activity when I recently visited the outskirts of Philadelphia. I had some time on my hands so I went to a large shopping mall. I can honestly say I have never seen a shopping center so devoid of shoppers. It was literally spot the shopper. The staff at the big stores were standing, around talking, trying to look busy but actually looking lost and concerned (no doubt for their own jobs). Given that it was lunchtime one would have expected the food court to be busy, especially as the center services a number of very large business parks. But no, it was also nearly empty and eerily quiet.
One would think this is unsurprising given the economic downturn, but it is actually symptomatic of something far more serious.
According to the MGI, the value of US household net worth has fallen by almost US$13 trillion from its peak in 2007. That represents a drop of 23%, greater than the decline during the Great Depression!
This has effectively erased any gains since the mid 1990s and is more devastating than previous recessions as asset values have fallen across the board. During the dot com bust in 2000 for example, equity market declines were offset by rapidly appreciating home values. Not surprisingly, with falling wealth, growing unemployment and little credit available, consumer confidence is at a 41 year low. People are simply using what money they have to pay off debt as fast as they can rather than buy new goods.
Going forward, this debt reduction could have an enormous impact given that by 2007, the US household debt to income ratio was 27 percentage points above its long term trend. Now you start to get some idea of the magnitude of the situation.
The impact of the household debt reduction will be determined by just how it is financed. It may come about as a result of income growth or through higher savings, or some combination of the two.
If incomes stagnate for example, households can only reduce their debt levels by saving more. The MGI calculate that every percentage point reduction in the debt to income ratio would require nearly a one percentage point increase in the savings rate.
The US personal savings rate reached 5% in January, 2009 (from a low of -0.7% in 2005), if this level is maintained with little or no income growth, this would reduce the household debt to income ratio by five percentage points. Sounds like a lot but unfortunately it would not be enough to restore the levels of debt prevailing in 2000, before borrowing started to accelerate.
But if incomes rose, households could both reduce their debt burden significantly over time and continue to consume. By way of example, if US incomes grew by 2% a year, households could reduce their debt to income ratio by the same level but with a personal savings rate of only 2.3%.
Doesn't sound too bad, accept, as they say, the devil is in the detail.
If incomes do not grow, each percentage point increase in the savings rate translates into approximately US$100 billion less in consumer spending. So a 5% savings rate would mean in excess of US$500 billion less in consumer spending each year in the US.
If incomes rise by 2% a year, a 2.3 percent savings rate would mean something like $250 billion less spending, all else being equal.
In other words, it is incredibly important that incomes grow so that households can continue to reduce their debt burden and rebuild savings, and more importantly, allow some increase in consumption. But without significant income gains, reducing US household debt could undermine consumption and the global economy for years to come.
So this is one of those times when reducing debt could actually make things worse!
A Condensed version of the McKinsey report can be found at http://www.mckinseyquarterly.com/Economic_Studies/Country_Reports/The_economic_impact_of_increased_US_savings_2327
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