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Sunday, April 8, 2012

The U.S. Economy: Private Deleveraging and the Slow Return to Growth

The first stop in our journey of the world economy is the United States. And to understand the current economic condition in America, we first have to look back to 2007 and before to understand the causes of the 2008 financial crisis.

Too Much Debt Before the Financial Crisis

One of the underlying causes of the Great Recession is the high leverage (i.e. too much debt) before 2008. In the two to three decades before the crisis, America’s consumption/GDP ratio steadily climbed up to 70%, compared to the 2008 world’s average of 61% (see Figure 1). Household debt as a percentage of disposable income, a more accurate measure of the level of financial leverage, rose dramatically, from around 70% in the mid-1980s to a peak of 140% in 2006.
The country’s current account balance, of which the trade balance is a major component, recorded rapidly growing deficits before 2007 (see Figure 2). A current account deficit means the U.S. consumes more than it produces, which is made possible because the United States is borrowing from the rest of the world.

A Credit Boom Gone Wrong

(Comment: Prior to the financial crisis, there was too much easy credit in the U.S. For example, Americans could obtain zero down payment mortgages for home purchases, and it wasn’t uncommon for homeowners to take out a 2nd mortgage or a home equity loan. Saving rates were as low as 2% in 2005 and 2006, in contrast with a rate of 10% back in the early 1980s. After years of high leverage, in 2006 and 2007 some debt-laden homeowners, especially those with subprime credit ratings, ultimately failed to repay the loans. As a result, home prices dropped, the housing bubble burst, and banks are hard hit by bad debt.)
(Comment: You may ask, what motivated the excessive borrowing of the Americans? Geoff Colvin, a senior editor at Fortune, provided one hypothesis. Under the stagnating living standards since the turn of the century, Americans wanted to create the illusion of prosperity through debt-financed consumption. This applies to the Europeans as well.

Similar to this argument is a new research study cited by The Economist, which attributes widening income inequality and trickle-down consumption as the explanation. It suggests that prior to the crisis the non-wealthy were spending more in order to match the upper class’s consumption level, even though incomes of the non-wealthy were rising much more slowly than upper-class incomes.)

Forced to Reduce Debt

We can use an analogy and compare the economy with a balloon. We want to make the balloon bigger, but a balloon will explode if its size crosses a certain threshold. Similarly, we want to increase the size of the economy through credit creation, but the economy becomes unstable when the leverage is too high. Sooner or later, the economic bubble bursts, and the economy is forced to deleverage (i.e. to cut down the level of debt).

Using another analogy, a consumer who borrows on credit cards can continue to accumulate more debt until she can no longer afford to make the minimum payment, after which she is forced to cut down debt. The financial crisis acted as a similar signal for the United States, which was left with no choice but to cut down debt.

The Road to Recovery

The United States has been deleveraging in the past three to four years. While public debt is still on the rise, with the federal deficit around US$1.3 trillion last year, the private sector has been deleveraging at a satisfying pace comparably faster than many other developed economies.

(Comment: Since households and firms have to deleverage and consume/invest less, the economy takes longer to recover after a financial crisis. Given the rapid deleveraging of the private sector, America has started a slow but stable recovery. Unemployment rate has dropped and the housing market has improved, in the midst of the worrying polarization of American politics that threatens the economic recovery.) 

The central bank responded to the financial crisis with quantitative easing (QE). Some dispute the effectiveness of the policy, but at least it seems useful to boost the U.S. stock market. The S&P 500 went up significantly after both rounds of QE, though the stimulus effect of QE2 was not as huge as QE1.

(Comment: A rising stock market may be the result of a better economic climate and thus expectations of higher future corporate profits, but it’s no conclusive evidence of an improving economy. Even with the same dividends, asset prices may increase due to an increase in liquidity, where higher prices decrease the expected returns of all assets. Still, a buoyant stock market is helpful for recovery since it stimulates consumption through the wealth effect.)

(Entry 1 of 6 in The Global Economic Landscape in 2012 series)

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