How Will Consumer Debt Affect the Outcome of This Recession?

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The San Francisco Federal Reserve Board issued a report in May that painted a grim picture of the U.S. economy, and suggested that consumer debt may have a long-term impact on the economy's ability to recover from the current recession. According to the report, consumer consumption began in earnest in the 1980s and led ultimately to a point where consumer debt outpaced consumer income.

The ratio of debt to income in the United States reached a peak of 133% in 2007, when the personal savings rate fell below 0%. While this significant increase in consumer spending produced a hotter-than-hot economy, it also boosted household debt to previously unseen levels.

The report shows that real household debt in 2007 was 12 times larger than it was in 1960. During that same time period, real household income grew only by four times. The pace at which consumer spending has outstripped income leaves little doubt as to why more and more Americans are currently seeking out debt relief either through debt consolidation services and debt help programs like credit counseling, or simply by defaulting on their debt or declaring bankruptcy.

The report attempts to pinpoint the amount of time needed to "deleverage" the economy â€” the process by which household spending and household income are reconciled. Comparing the current state of the U.S. economy to a similar economic downturn in Japan that ran through the late 1980s and early 1990s, the report notes that today, 20 years after that low point in Japan's economy, Japanese stock and commercial real estate prices remain at less than 70% of their peaks prior to the recession, while residential real estate prices, including vacant land, are still below 40% of their peaks.

Further, the report indicates that if the U.S. economy is deleveraged at the same relatively aggressive rate as the Japanese economy following that country's 1989 recession, the U.S. economy would not achieve a debt-to-GDP equilibrium until 2018.

The report notes that while American consumers are likely to increase their personal savings and decrease their consumption as a means of reducing their household debt, the impact of a significant jump in savings combined with a decrease in consumer spending will effectively prolong the recession and create a weaker recovery.

If this deleveraging reduction in consumer debt comes as the result of consumer defaults rather than from increased savings, with Americans finding debt relief through write-offs, partial write-offs such as those negotiated in a debt settlement, foreclosures, short sales, and bankruptcy, the deleveraging process will be no less problematic: Rather than dealing with anemic revenue from diminished consumer spending, creditors would be absorbing losses from credit charge-offs and defaulted loans.

In either case, consumers should not expect to see significant returns on investments or a return of real estate values at any time in the near future.