Why It's So Slow

Hedge fund billionaire Ray Dalio has a simple way to explain why the economy is so slow. Imagine someone who makes $100,000 a year and has a net worth of $100,000 with no debt. That person can safely borrow about $10,000 a year for several years, meaning they can spend $110,000 a year, even though they only make $100,000. The flip side to all that spending is that someone else is earning $110,000 a year. "For an economy as a whole," Dalio writes, "this increased spending leads to higher earnings, that supports stock valuations and other asset values, giving people higher incomes and more collateral to borrow more against, and so on."

But it can only last so long. Eventually, debt service payments take up too much of income, and the tide shifts. "The person spending $110,000 per year and earning $100,000 per year has to cut his spending to $90,000 for as many years as he spent $110,000" to pay down the borrowing spree, Dalio says. That means someone else can now only earn $90,000.

It's called deleveraging, and it's by far the largest reason our economy is so slow.

Some of the debt figures are truly staggering. According to hedge fund manager Kyle Bass, global credit rose from $80 trillion in 2000 to $210 trillion today. In America, household debt rose from $6.5 trillion in 2000 to almost $14 trillion by 2008. As a percentage of disposable income, household debt rose from 59% in 1960 to 130% by 2007.

It all adds up to an incredible amount of consumers like those in Dalio's example, spending more than they earn, which allows others to enjoy a higher income, which allows even more borrowing, and so on. That created an illusion of prosperity: Without drawing down on home equity loans, the economy would have been in or near recession for most of the last decade.

None of this is new -- it's well-known that too much debt got us into this recession. But the impact it has on our recovery is less appreciated. If a debt binge caused the recession, and a debt hangover is keeping the recovery tepid, then one of the most important numbers in today's economy is how long it will be before enough debt is paid off to allow us to get back to normal.

There are a few ways to look at that question. The last time household debt as a percentage of net worth touched current levels was in the early 1930s, as the Great Depression devoured asset prices. The ratio then dropped consistently for 20 years before bottoming in the 1950s at around one-third its previous peak. Deleveraging by the same amount today would require household net worths to more than double, rising by around $60 trillion. That might seem implausible, but it's actually feasible. Even with the housing crash, nominal household net worths are currently double 1997 levels. If net worths continue the same growth rate going forward and debt levels stay flat, households could be fully deleveraged by around 2025.

The Federal Reserve looked at it another way. In a 2009 study, it looked at how high our personal savings rate would need to be to bring debt-to-income ratios down to 100% in 10 years -- roughly what Japan accomplished in the decade after its debt bubble burst. The Fed's answer: a savings rate of 10%, up from 3.5% today. Even with a 10% savings rate, debt-to-income ratios wouldn't fall to average historic levels until well into the 2020s.

In either case, the answer to the question of how long deleveraging could persist is frightening: about a decade longer, maybe more.

And these figures only look at household debt. When government and corporate debt is added in, the outlook is even bleaker. Total economywide debt as a percentage of GDP currently stands at 350%, up from an average of 150% from the 1950s through the 1980s. Households and businesses are indeed shedding more debt than the government is adding, but federal borrowing slows the overall deleveraging process -- exactly what it's designed to do. Over the last year, total debt to GDP fell by 8 percentage points. At that rate, it could be another 15-20 years before deleveraging brings us back to historic averages.

These are rough estimates at best, and all are simply extrapolations from current trends. Any number of things could speed the deleveraging process up -- faster economic growth, a touch of higher inflation, a higher savings rate, and maybe most importantly, more willingness by banks to write off debt that consumers will never be able to repay.

What's clear, however, is that the deleveraging must take place. Having too much debt is not a psychological problem that can be overcome by animal spirits, and it's not driven by uncertainty that will be cleared up with new leadership. As Dalio notes, "It is primarily driven by the supply and demand of and relationships between credit, money and goods and services. If everyone went to sleep and woke up with no memories of what had happened, we would all soon find ourselves in the same position."

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.