From the December-January 2011 issue of Treasury & Risk magazine

Thrifty Consumers Limit Growth

It has become almost trite to describe current U.S. economic circumstances in terms of the biblical prophecy that seven years of plenty will be followed by seven years of famine. But the analogy is still apt. The consequences of a debt-induced asset bubble last long after it bursts. The debt built up during the bubble is a burden that inhibits economic growth for years after memories of the good times have faded.

Consumers have decidedly changed their behavior, eschewing the use of credit and concentrating instead on reducing debts. As long as the tendency toward frugality persists, the growth of consumer spending will be restrained. And as the consumer goes, so goes the rest of the economy. Instead of the annualized 5% to 7% growth rates that were common after the end of recessions from the 1950s through the 1980s, a 2.5% to 3.5% GDP growth rate may be all that can be hoped for in the next few years.

The explosion in the use of credit by the household sector between 2000 and 2007 was unprecedented. Total household debt relative to disposable income rose from 90% in 2000 to 130% by 2007. Most of that debt was in residential mortgages, and it fueled a rapid rise in home prices until the bubble burst in 2007. Since then, average house prices have fallen about 27%. The debt remains, however, leaving millions of homeowners underwater on their mortgages, owing more than their homes are worth.

Historical studies suggest that the run-up in the debt-to-income ratio during an asset bubble is usually reversed in the subsequent bust. That means the debt-to-income ratio in the U.S., which has already dropped from that 130% peak in 2007 to 118% this year, still has some way to go to get back to the 90% level where it began in 2000. At the current rate of decline, it will be roughly 2014 before the ratio falls to that level?just long enough to match the seven-year symmetry of feast and famine suggested in the Bible.

The expanded use of debt encouraged a steady rise in household spending on durable goods. From 1997 to 2007, the share of durables in total consumer spending rose from 9% to 13%, fueled in no small part by the expanded use of home equity loans and "equity" extraction through mortgage refinancing. In a recent report on the use of credit, the Federal Reserve noted that mortgage and non-mortgage borrowing contributed $330 billion a year to consumers' cash flow from 2000 to 2007. In 2009, consumers reversed course and paid down $150 billion of debt. That's a reversal of nearly $500 billion in two years and helps explain why consumer spending has been so sluggish lately. Since outstanding debt remains high relative to income, the move toward a new frugality is likely to persist.

Despite the thriftiness of the household sector, corporate profits have risen smartly (up 27% from 3Q 2009 through 3Q 2010, according to U.S. Bureau of Economic Analysis data). The health of corporate profits is one reason not to expect a double dip in economic activity. Higher corporate profits usually lead to increases in investment spending and job growth with a short lag. When profits are high, it should pay to expand, although expansion is difficult when the growth of domestic final demand is weak. That suggests many businesses will have to look to overseas markets, especially the emerging market economies, where GDP growth is expected to average about 6% in the next few years, compared with only 2% in developed economies.

Businesses have other reasons to be cautious. Most of the rebound in profits has come through a drop in unit labor costs, which declined a record 4.1% in the past two years. That may not continue. As firms hire more workers to expand, outsize productivity gains will be harder to come by. Pricing power will become more important. Unfortunately, there is little of that in the U.S. right now. The average price per unit of output in the corporate sector has been roughly flat for the past two years.

This is another reason for businesses to look overseas, where inflation is trending higher in many of the emerging market economies. With the U.S. household sector likely to be on a spending diet for a few years, further healthy gains in corporate profits may depend partly on the steady increases in nominal spending to be found in export markets where excessive household debt is not a problem.