Add household debt management to fix-it list

By James McCusker

It has been said that misery loves company, and that might be so. In most cases, though, company will not love it back. Experience tells us that misery does not lend itself to good companionship, let alone mutually rewarding relationships. In fact, when it comes to economic matters, the blues singers got it right: “Nobody loves you when you’re down and out.”

America is a long way from down and out, but we have a significant problem: debt, both public and private. It will eventually make us miserable, and as our economy is propelled by political currents into a classic debt-inflation whirlpool we should remember that nobody is going to bail us out. We have to do it ourselves.

A recent report by the McKinsey Global Institute examined the origins of the global debt burden that is being carried by the United States, by Europe, and by the majority of the world’s nations. It also looked at what the implications of debt reduction, or deleveraging, would be for our economic growth and economic policy choices.

The report is a particularly useful one since it gives us a broad perspective on debt by looking at the movements of public, corporate and private debt over the past few decades.

One of the things they found was that “Leverage levels are still very high in some sectors of several countries — and this is a global problem, not just a U.S. one.” One of those sectors is in our own economy: households.

That is significant for two reasons. The first relates to McKinsey’s analysis of the economic history of financial crises. It discovered from the data that “empirically, a long period of deleveraging nearly always follows a major financial crisis.”

In our economy’s case, though, that historical pattern was not followed in the financial dust-ups of the 1990s and early 2000s. In fact, our economy seemed to be more “resilient” than ever; able to withstand substantial shocks without disturbing our growth trajectory. Neither the bubble collapse nor the Long Term Capital Management failure, for example, seemed to cause our economy serious problems and did nothing to slow households’ appetite for debt or the eagerness of financial institutions to feed it. Even the terrorist attacks of 9/11 failed to reveal the underlying weakness wrought by excessive debt.

The second reason their findings are significant is that the households in the United States, and elsewhere, are trying to reduce the amount of debt that they are carrying, but they still have quite a ways to go to return to the kind of financial strength that can take a hit. As the McKinsey report puts it in one of their headings, “Deleveraging has only just begun.” And as long as households remain over-leveraged, our economy is at risk for a second, or double dip, contraction.

How we measure household debt, or leverage, turned out to be a factor in the run-up to the financial bust — and remains an issue that must be addressed in financial regulatory reform.

In businesses, for example, we commonly use two ratios: debt-to-equity and debt-to-income, and these two together give a fairly good picture of a firm’s leverage.

Household leverage can be measured in much the same way, looking at the ratios of debt-to-equity and debt-to-income … but we didn’t. We made the classic mistake of looking almost exclusively at one household ratio, debt-to-equity. Unfortunately, that was the one that looked just fine, thank you, as long as housing prices continued their crazy climb, for they inflated market value equity even faster than debt.

Instead, we should have been looking at the ratio of household debt to disposable income. As the McKinsey report states, “Rising housing prices meant that the ratio of household debt to assets appeared stable in the years prior to the crisis. But household debt compared with disposable income increased significantly, which should have raised a red flag long before the crisis hit.”

Households run on disposable income, which is intricately wired into three elements: employment, debt service (mortgage and credit card payments) and taxation.

Faced with the instability and financial duress of this recession, households are acting first in the area they can best control: debt.

Eventually, this household debt reduction will produce a more solid economy. From an economic policy standpoint, though, we can ruin all that by reducing household disposable income — either directly through higher taxes or indirectly by inflating the costs of necessities such as medical care and health insurance.

Our failure to understand the significance of debt-to-disposable income led us into this mess. If we are careless with the stability of household debt management, the probability of a second, double-dip recession would change from unlikely to a virtual certainty.

James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Snohomish County Business Journal.