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It's the Debt, Stupid

By Morgan Housel – Updated Nov 7, 2016 at 6:37PM

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What's really slowing the economy.

Mark Twain's saying that "history doesn't repeat itself, but it rhymes," might be one of the most abused quotes of the past three years. The quip is grounded in solid logic, but some took its meaning to a faulty level. After most recessions in the past, the economy bounced back quickly. This time, it hasn't. Thus, we must be doing something wrong. "Had the U.S. economy recovered from the current recession the way it bounced back from the other 10 recessions since World War II," wrote former Sen. Phil Gramm in The Wall Street Journal, "11.9 million more Americans would be employed." He called this the "Obama growth discount."

Truth is, the recent recession wasn't like the 10 other recessions since World War II. Most recessions are caused by a little overheating in an otherwise sound economy. Businesses adjust quickly, rehire laid-off workers in the same jobs as before, and things spring back to life.

The recession that started in 2007 was different. It was caused by an inherently unsound economy driven by debt. That dynamic changes everything, as deleveraging is like molasses in an economy's veins. When you find yourself in a debt-driven recession, the result is always the same: a glacially slow recovery. As a McKinsey & Co. report noted, "Historic deleveraging episodes have been painful, on average lasting six to seven years." More money is going toward yesterday's bills, which means less for today's and tomorrow's.

A new study by the Federal Reserve sheds light on how big a role debt plays in our stalling recovery. The study was simple. It ranked the nation's largest 238 counties by the increase in household debt-to-income ratios between 2002 and 2006. It then looked at how each has fared over the past few years.

The results are clear as day. Regions that accumulated the most debt during the boom are in terrible shape, while those that steered clear of it are doing quite well.

For example, auto sales in regions where debt accumulation was the highest are down some 40% since 2005. In regions where debt accumulation was the lowest, sales are actually up about 30%.

Ditto for housing investment. Regions with the lowest debt accumulation have barely seen any dip in residential investment compared with the boom years. Regions where it was the highest have seen construction plunge as much as 60%.

Same for employment. Unemployment rose only slightly in low-debt-accumulation regions during the recession, those job losses peaked early, and jobs have been rebounding for nearly three years. In high-debt regions, jobs fell off a cliff, didn't stop falling until late 2009, and are still around 5% below prerecession levels.

Why did some regions go hog wild with debt while others avoided it? There could be a couple of reasons. The two states that accumulated the most debt are California and Florida, where geography makes it difficult to quickly increase housing supply, pushing up prices faster than in regions like Texas, where you can build as far as the eye can see. There's also a keeping-up-with-the-Joneses effect where legitimately wealthy people inflate the aspirations of the less well-off, enticing the latter to binge on debt just to feel ordinary. "Trickle-down economics may be a chimera, but trickle-down behaviorism is very real," Nobel laureate economist Joseph Stiglitz writes. This is why a 19-year-old barista in Los Angeles feels justified financing a new Mercedes -- something you'll rarely see in, say, North Dakota.

But here's what matters: "The evidence is consistent with the view that problems related to household balance sheets and house prices are the primary culprits of the weak economic recovery," the Fed writes.

That's incredibly important. The recovery isn't slow because of regulation, taxes, health-care reform, or some vague "uncertainty" boogeyman. It's slow because consumers are still deleveraging. And it's not going to get any better until they're done.

When will that happen? The good news is that deleveraging has already taken place in a big way. Household debt payments as a percentage of income have plunged to the lowest level in 15 years, driven largely by refinancing at lower interest rates. Total household debt as a percentage of income has fallen back to early 2004 levels -- down 12% since the peak in 2007. A good chunk of this is thanks to banks like Bank of America (NYSE: BAC), Citigroup (NYSE: C), and Wells Fargo (NYSE: WFC) writing off debt. What's painful for banks is often refreshing for consumers.

Some look at the economy's total debt load, including federal debt, and argue that it'll probably be around 2017 before things are back to normal at the rate we're now deleveraging. Since the recession began in earnest in 2009, that would be about eight years of deleveraging.

Which, coincidentally, is exactly what history shows we should expect after a debt-driven recession. So Twain was right: Today is rhyming with history -- if you look at the right history.

Fool contributor Morgan Housel owns B of A preferred. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Bank of America and Citigroup. The Fool owns shares of and has created a ratio put spread position on Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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