Thursday, September 29, 2011

Debt Adjusted For Income

One of the reasons many market observers believe this recession will be a long one is the growth in consumer debt over the years. As consumers now focus on paying down debt levels, they won't be able to spend to the same extent; thus, fewer goods will be produced, acting as a drag on GDP. But what is worth mentioning is that this argument is used in every recession by those who anticipate a depression, so are things really that different this time?

In an article in Forbes magazine in 1991, Ken Fisher responded to those who argued that the recession of the early 1990s was to turn into a depression because mountains of consumer debt had to be paid back before the economy could once again grow. In Fisher's view, this argument was nothing more than fear mongering, as it ignored consumer income. While absolute debt levels were high, debt as a percentage of income was not.

Today, we hear similar arguments about consumer debt levels. But as debt has risen over the years, so has productivity (thanks to education, innovation and investment). So let's consider these debt levels in relation to income. The following chart illustrates the US household debt service ratio (DSR) over the last 30 years. This ratio represents required mortgage and consumer debt payments to disposable personal income:

The DSR is clearly not out of line with what it has been over the last 3 decades. Though it is still higher now than it was in the early 1980s and early 1990s (also recessions), how is one to know what is the "right" level of consumer debt? Fisher argued that as long as there are assets that generate substantially more returns than the cost of debt, there will be people who exploit such opportunities, thus driving up the level of debt.

Whether the DSR will turn upward soon, or continue downward for some time is anybody's guess. The point is, debt levels are not way out of line with what they have been in the past; in fact, the ideal consumer debt level for this economy may well be higher than debt levels stand right now.

Of course, much of the debt burden has now shifted to the government. But when consumers stop deleveraging (and they have to at some point), their spending will go a long way towards reducing government deficits (both in absolute terms, through tax revenue, and in relative terms by increasing GDP).

Last time this topic was discussed, an astute reader pointed out that debt levels appear low in part because interest rates are so low. While this is true, it's worth noting that during recessions rates are always brought low. Furthermore, some portion of the debt owing is fixed-rate, meaning interest payments won't rise on some debt even if rates go up. Finally, if rates do go up at some point in the future, it is likely because incomes are also doing better, so both the numerator and denominator of the DSR equation will rise together.

Reading articles from previous recessions can offer investors perspective. Often, the same situations are seen again and again, but are claimed to be "different this time". Educating oneself is the best defense against spurious arguments. However, timing when debt levels will start to once again expand (or at least stop falling) is very difficult to do. As such, investors are better off keeping perspective with respect to the market, and putting their energy towards investing in companies trading at discounts to their intrinsic values.

source: Federal Reserve


balans said...

I always value your comments. I worry a lot about this curve which seems hard to explain away.
It really seems that 2007 and 1929 are special. But perhaps I have fallen into a some kind of thought trap. If so, help me out of it!

Paul said...

Great, great post, Saj. Made me think a bit! :)

Saj Karsan said...

Thanks, Paul and balans.

Balans, that curve does show household debt very well, but it is a bit old. Here's a newer one. Household debt as a percent of GDP is now down to 2006 levels, though it may continue falling further, who knows.

Anonymous said...

As far as the consumer goes, it seems to me that they're "down for the count" until wage growth resumes keeping up with the gains in productivity alluded to.

Old Trader (from Seeking Alpha)