Why It Could Take Years to Recover

We're drowning in debt, and no one wants to rescue us.

Morgan Housel
Morgan Housel
Jun 24, 2009 at 12:00AM

Economist Hyman Minsky studied how debt overload leads to economic catastrophe. A few years after his death, another economist used Minsky's work to coin the phrase "Minsky moment," which is when an economy gorges on more debt than its cash flow can bear. Once you hit a Minsky moment, all hell breaks loose as everyone tries to delever at the same time.

Needless to say, we've had a Minsky moment. Maybe a few. The punch bowl of endless credit has been replaced with the smelling salts of reality, sparking one of the worst recessions since the Great Depression.                                      

Thanks for stating the obvious
When will it all end? I have no idea. No one really does. But we do know that it can't end until we have the opposite of a Minsky moment -- when our debt load becomes reasonable and sustainable again.

Unfortunately, this is a larger task than many assume. See, the explosion of consumer debt is not a phenomenon that began with the housing bubble in 2003. It's a trend that started decades ago. Have a look:


Household Debt/Disposable Income



















Sources: Federal Reserve, Bureau of Economic Analysis, author's calculations.

Ask yourself what's changed since the '70s and '80s that allows us to handle a debt load nearly twice the size. Some might say lower interest rates, but this is a debatable point: Interest rates could, and likely will, be just as high again someday as the Federal Reserve mops up all the cash injected over the past year. By any historical measure, our debt load is horrifyingly large and will need to come down. By a lot.

What's important is the impact reducing debt has on the economy, which is what's happening right now. Looking at the past several quarters, here's how much of a dent households have made on debt loads:


Household Debt/Disposable Income

Q1 2009


Q4 2008


Q3 2008


Q2 2008


Q1 2008


Quite pitiful, I'd say. In a year when consumers shut their wallets so severely that it drop-kicked the entire economy, household debt inched back merely a few percentage points.

With that in mind, think about what kind of retrenchment it'll take to get household debt from the current 128% of disposable income to the 35-year average of 88%, or something just reasonably close. Now I think you'll see why a sustainable economic rebound could be years, not months, away.

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What now?
To get back down to a few randomly chosen debt/disposable income levels, here's how much money has to be pulled from consumers' pockets:

To Get Debt/Disposable Income Down To:

Would Divert This Much From Consumer Spending:


$1.4 trillion


$3 trillion


$4.6 trillion


$6.8 trillion

Anyone got a few trillion sitting around? Me neither. The money obviously has to come from future savings.

Thankfully, people are saving again in a big way. The personal savings rate has shot up from slightly negative in 2005 to about 4% today.

But even a 4% savings rate equates to just $476 billion per year -- a fraction of what we need to get household debt down to safer levels. If we took every penny we're saving today and put it toward paying off debt, it would take more than six years to get household debt back to 100% of disposable income -- about where it was in 2001. Using the same savings rate, it would take nearly 10 years to reach the 35-year average of 88%. Giddyup!

Who will this long-term debt deleveraging affect the most? A few industries in particular:

  • High-end consumer discretionary companies, such as Coach (NYSE:COH) and Best Buy (NYSE:BBY). More debt servicing means less conspicuous consumption.
  • Banks that relied on debt growth. Citigroup (NYSE:C), Bank of America (NYSE:BAC) and American Express (NYSE:AXP) made gobs of money financing anything and everything households wanted; what happens when they face the first long-term credit contraction in a generation? Shrinking balance sheets will be an unwelcome surprise, especially as they slog through losses on existing assets.
  • Real estate companies like Pulte Homes (NYSE:PHM) and D.R. Horton (NYSE:DHI). The majority of household debt is comprised of mortgages. Deleveraging naturally reduces demand, which could compress prices for years to come.

Moving right along
These shifts are necessary and will eventually lead to a more stable economy. But that doesn't mean they come without pain. The idea that recovery is right around the corner relies on the assumption that consumers will start spending like they did in previous years. But when the average household is choking on a generation's worth of debt, that can't happen right away.

Problems that take decades to create aren't solved in a matter of months. It really is that simple.

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Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. American Express is a Motley Fool Inside Value pick. The Fool owns shares of American Express and has a disclosure policy.