Unprecedented Household Deleveraging since 2007

For decades, American families espoused the not-quite-Cartesian ontology: I go into debt; therefore I am. Household debt climbed ever higher through good times and bad. Since the onset of the current recession, however, household debt has contracted substantially for the first time in more than half a century.

After reaching a peak at $13.82 trillion in the first quarter of 2008, household debt outstanding fell to $12.87 trillion in the third quarter of 2012, down by about $1.0 trillion, or almost 7 percent.

During the past year, the rate of decline has slowed considerably, so the outstanding debt may be converging on a minimum. But should the economy’s sputtering recovery falter even further or a new downturn occur, households appear primed to continue their deleveraging.

The unprecedented decline in household debt outstanding during the past five years joins many other variables in attesting that the economic expansion between 2002 and 2007 consisted in large part of an artificial boom—a credit bubble—fueled by the Fed’s easy-money policies, which spilled from the mortgage-financed housing bubble and the stock-market run-up, to rising commodity markets and bloated housing-related sectors, and ultimately to the entire economy’s unsustainable expansion.

The sloughing off of household debt in recent years also signals, for the first time since World War II, a change in people’s long-term outlook. As long as people had faith in the continuation of economic progress in the long term, they did not hasten to pay down debts when recessions occurred. This time, however, they seem to have lost their faith in the economy’s long-term performance. This change at the household level goes hand in hand with the regime uncertainty that has brought about extraordinary reluctance to make long-term investments among investors and entrepreneurs.

It is a common failing for pundits and others to overreact to short-term economic changes, mistaking them for watersheds that alter the character of the economy’s long-run dynamics. The evidence in regard to the household deleveraging and the still-depressed net private investment in recent years, however, may be seen as consistent with an interpretation that the post-2007 economy may indeed have changed in a more fundamental way. If so, we may rightly trace its enduring sickness to the extraordinary government and Federal Reserve actions of the past five years. In the immortal words of Leonard Cohen’s song “Everybody Knows”:

Everybody knows that the boat is leaking

Everybody knows that the captain lied

The policy makers, sad to say, appear to have operated in this period according to the rule, no economic event is so bad that we can’t make it worse if we try hard enough.