Thrift paradox: Is America's debt repayment slowing GDP?

After a decade of hyper-consumption, in which Americans bought and consumed at unsustainable rates, consumers cut back massively in 2008 and 2009. Some of this was due to cyclical belt-tightening that inevitably had to occur, and some of it was driven by a record 6.5 million layoffs that were part of the worst U.S. recession in at least two decades.

The consumption drop wasn't completely unexpected; earlier this decade, most economists saw that lower consumption period coming. However, what few economists or policy forecasting firms foresaw was the magnitude of the belt-tightening. Americans are paying down debt at a record rate, according to data compiled by Goldman Sachs (GS).
The total debt of individuals, non-financial companies, and federal, state and local governments grew at a 4.3 percent annual rate at the start of 2009, down from a peak growth rate of 9.9 percent in Q4 2005

"We've never seen a pullback like this," Goldman's chief U.S. economist Jan Hatzius told Bloomberg News. "We are seeing an adjustment, and it's very painful and there's a lot of collateral damage."

U.S. consumer credit declined at an annual rate of 1.6 percent in May to $2.52 trillion, according to data compiled by the U.S. Federal Reserve, with household debt contracting 0.7 percent in Q1. This is the first time that this kind of decline has occurred since 1952, or when the federal government started keeping records for the statistic.

Admittedly, one would be hard-pressed to find an economist who wouldn't cheer the U.S. household debt reduction. In general, economists argue that developed economies with modest, serviceable household debt free-up more domestic capital for investment, which leads to lower real interest rates -- a plus for commerce and for innovation. In other words, advanced, self-reliant economies amass enough capital to meet the needs of business.

However, debt reduction has a down side. If coupled with a high savings rate, it can lead to a large drop in demand, which is essential for GDP growth. Unfortunately, that is exactly the U.S.'s status right now: along with paying down debt, the U.S. savings rate is at 6.9 percent, a 15-year high. PIMCO Strategic Advisor Richard Clarida argues the United States is now in a place no developed economy wants to be: in need of an increased savings rate (to make up for the hyper-consumption era) and in need of consumption to stimulate GDP. He believes that the high savings rate will continue, presenting another hurdle for a U.S. economy that already has many to mount.

"In an economy where consumption has been the driver of normal growth, that will be an enormous headwind," Clarida wrote in letter to PIMCO shareholders. Historically, consumer spending has accounted for approximately 60-65 percent of U.S. GDP.

This situation, which could be called the "debt/savings overhang," is a byproduct of a decade of public policy errors. It's a variant of the paradox of thrift (or savings), first conceptualized by economist John Maynard Keynes, and right now there are few credible policies to resolve it. First, Americans are paying down debt: that's good. Also, after a decade of overconsumption, and with their nest eggs depleted by the stock market and housing slumps, Americans are saving more, as evidenced by the high savings rate: that's also good.

At the same time, however, the U.S. economy needs at least selected consumers to spend, in order to stimulate the economy. The dilemma, then, lies in finding a way for an economy can simultaneously increase its savings rate and consumption to increase GDP. There's scant economics literature to suggest a nation can successfully pull it off. Hence, what likely awaits American consumers, executives, and investors is the so-called "new normal": a U.S. GDP growth rate in recovery stage of about two percent. While reflective of growth rates in Europe, this is still far below the five to seven percent GDP growth that developed economies typically register in the early stages of a recovery.

What could offset the contraction effect of debt reduction/increased savings and support U.S. GDP growth? the best answer lies in wage gains, which would translate into increases in real, median incomes. However, as most investors are aware, labor markets are slack, and there is little wage pressure, save for a few, high-demand job segments, mostly in the professions. Therefore, unless and until the job market recovers, the U.S. economy is unlikely to experience the demand needed to drive robust GDP growth, which of course will weigh on corporate revenue and earnings results.
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