Wednesday, January 14, 2009

a protracted recession?

The American Consumer has been the engine of the last expansion. We have bought houses, cars, flat screens, beach condos, etc. and financed the purchases either by extracting the equity from our increasing home prices (home equity lines) or incurring additional debt through credit cards and other forms of consumer finance. In the average American's mind, as long as the bottom line of the balance sheet continued to increase (i.e., assets greater than liabilities) then all was well. But in 2008 something happened that had not happened to these Baby Boomers before: the value of all assets (stocks, houses, rental properties, etc.) declined. As a result the debt party began to unwind as the value of the assets declined while the debt (liabilities) remained, thereby shrinking the balance sheet. Americans are feeling poorer … much poorer.

If one considers that the average 401(k) is now a 201(k) and the average house (according to Case/Shiller) declined 26% from its peak value in 2006, then it's easy to understand why the Baby Boomer is feeling gut punched. The financial shock of watching the asset side of their balance sheets crumble while the debt side remained the same or actually grew has now forced the American consumer into a dilemma: How do I retire and live the same lifestyle that my parents enjoyed? Answer: I have to save money and reduce debt.

The consequence to the economy is, in my opinion, going to be a protracted, painful recession. Why? Because this recession is driven by asset devaluation, and that is different than a cyclical downturn. There is a need for institutions and households alike to reduce debt and restore equity to the balance sheet. For the consumer/individual this will only happen with an increase in his/her saving rate to reduce debt and fund future retirement. For example, if the average consumer goes from a 1.7% savings rate to a 5% savings rate, then that equates to $400 billion a year in either debt reduction or retirement funding. From the contra angle, that means there will be $400 billion less of American consumption. I label this the "Paradox of Thrift," in that we can't restore our balance sheets without additional savings, and our stock markets cannot recover without consumer spending and corporate profitability.

-- by Cliff Draughn

No comments: