Why This Recession Will Be A Doozy

The last recession was mild. The stock market and corporate profits tanked, but consumer spending danced merrily on through. This time it's different.
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The last recession was mild. The stock market and corporate profits tanked, but consumer spending--long the major engine of our economy--danced merrily on through. In recent decades, it has ever been thus: bearish analysts and strategists have been underestimating the voracious spending habits and resilience of the US consumer for 50 years.

Unfortunately, at risk of invoking the four most expensive words in the English language, "this time it's different."


Because the US consumer is finally broke. For thirty years, we piled on debt and then spent almost every new penny we got. This borrowing spree was made possible by a smorgasbord of no-money-down lending products and ever-appreciating asset prices. Unfortunately, the situation has now changed. The lenders who created those products have now been demolished, and asset prices are falling fast. And this is leaving American consumers with no choice but to cut back.

A few exhibits:

US debt has risen from 163% of GDP in 1980 to 346% in 2007. Household debt, a subset of this, has risen from 50% of GDP to 100%. (Please click here if you would like to see charts that illustrate the points I'm making here)

Have we been dependent on this growing debt to finance our spending? You bet.

Analyst John Mauldin explained this week how growing consumer debt in the form of Mortgage Equity Withdrawals allowed consumer spending to power right on through the last recession (What's home-equity withdrawal? When your house price rises, you borrow more, keeping your debt to house-value percentage the same. Then you spend these "earnings.").

Thanks to the housing crash, consumers have less and less mortgage equity to withdraw, so this source of cash is rapidly disappearing. As consumer net worth shrinks, other sources of financing--credit cards, home equity loans, car loans, student loans, etc.--will follow a similar path, and consumers will increasingly be limited to spending what they make.

Jeremy Grantham's quarterly letter takes a more macro view. Specifically, he explains the difference between the growth of an economy in which consumer debt is continually growing as a percent of GDP and one in which it is shrinking. Jeremy's bottom line is that household borrowing has added 1 point to annual consumer spending growth for the past 25 years. It won't be doing that anymore.

Jeremy's explanation of this effect is complex but important, so here it is:

We were all spending... as if we were much richer than is in fact the case. Particularly here in the U.S., increasing household debt temporarily masked some of the pain from little or no increase in real hourly wages for 20 to 30 years. Household debt since 1982 has added over 1% a year to consumer spending. Unfortunately, this net benefit does not go on forever.

In the first year in which you borrow 1% of your income, the interest payment barely makes a dent and your spending is close to 101% of your disposable income. But each year you borrow an incremental 1%, your interest load grows. After 15 years or so in a world of an average 7% interest rate, the interest on the accumulating debt fully offsets the new borrowing when one looks at consumers collectively.

Well, we in the U.S. are closer to a model of 30 years of borrowing an incremental 1%, meaning that we passed through break-even years ago and now pay much more in interest than we borrow incrementally. This is a situation favorable to an overfed financial structure as long as everyone can and will pay their interest, but it is no longer benefi cial to aggregate consumption compared with the good old-fashioned way of waiting until you had actually saved up to buy a TV set. Indeed, a visitor from Mars examining two countries, one with accumulated consumer debt of 1.5 times GDP and the other with zero, would, I am sure, notice no difference except for the reduced number of consumer lending outlets.

This generally unfavorable picture gets worse when you consider that we are likely to have, for the next 10 years or so, a modest annual reduction in personal debt of, say, 0.5% of gross income per year as well as a continued interest payment. So the debt accumulation effect reverses as does the illusion of the wealth effect from overpriced stocks and
housing, especially the illusion of a decent accumulated

As we said two years ago (embroidering on Buffett), when the tide of overpriced assets goes out, it will be revealed not only who is not wearing swimming shorts, but also who has a small pension! Our silly joke has become a sick one in just two years.

This reversal of the illusory wealth effect added to deleveraging will be felt worldwide, but especially in theso-called Anglo-Saxon countries, and will be a permanently depressing feature of the next decade or so compared with the last decade. It is indeed the end of an era.

Bottom line, the outlook for consumer spending over the next couple of years is lousy. On a real (inflation-adjusted basis), it went negative in Q3 for the first time in decades. September's awful retail sales suggest that the pain is just beginning.

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