24 August 2009

Cutting debt: Great for you, bad for the economy

The following is extracted from today's edition of “globeandmail.com”.

Canadians with ready access to credit cards have created an economy based on high and expanding consumer debt. But what happens when John and Mary Smith and millions of other Canadian families decide to get out of debt or to reduce their debts? Can Canadians be weaned off this burgeoning debt cycle without affecting economic growth, jobs and stability?

Deleveraging - reducing debt rapidly, often by shedding assets - is an ugly term. Its economic consequences can be even uglier. …

There is a consumer counterpart to deleveraging that may be even more important. During recent boom times, households in most advanced countries sharply leveraged their finances, taking on more debt to pay for housing and consumer goods. When consumers delever, they stop buying on credit and try to pay down their debts, just as businesses do. When assets such as housing and stocks fall in value, as they have in the recent past, the debt burden is even more likely to cause problems. …

… Corporate and consumer deleveraging shrinks economic activity. Indeed, massive deleveraging usually causes, or certainly exacerbates, recessions. At the corporate level, cutting back on borrowing often means reducing capital spending and laying off staff, or freezing new hires. When consumers reduce their borrowing, it usually results in fewer housing sales, fewer purchases of cars and major appliances, less spending on travel and entertainment, and so on. In turn, the corresponding sectors slow or come to a halt. …

At the household level, leveraging occurs when consumer spending grows faster than disposable income. Deleveraging reverses this process and results in an increase in the personal savings rate - and a prolonged slowdown in consumer spending growth….

[D]eleveraging at the consumer end has unintended and perverse economic consequences. The "paradox of thrift" mechanism, often attributed to John Maynard Keynes, suggests that if all households are more careful with their money and save more, this will lower aggregate demand, which in turn will lead to a decline in economic activity. Because the economy and the number of jobs shrink below where they would otherwise have been, total savings also declines.

Thus the paradox: Increased savings for the individual, which may be prudent and sensible, can be collectively bad for the economy. In other words, unless increased saving is matched by an increase in investment by business or governments, the economy will stay in recession.

The paradox of thrift is clearly at work now. Personal incomes and consumer spending are still declining, and precautionary savings are soaring. But business investment is lagging. The only way to bring about recovery from the slump is for governments to fill the gap with increased investment and other stimulus spending. Government infrastructure programs - such as investments in roads, schools, hospitals - take time to get going, but once they are under way, they have strong multiplier effects on job creation and economic growth. …

Make no mistake: The increased emphasis on consumer saving will make the recession worse and will retard economic recovery. Indeed, this major shift toward frugality is expected to be one of the lasting legacies of this recession.

In sum, despite the unprecedented amount of monetary and fiscal stimulus being injected into the U.S. and Canadian economies, deleveraging by households and businesses alike limits the prospects for a quick recovery. …

… [T]he need for an expanding government sector to keep Canada's economy on a growth path will be an essential component of a full economic recovery for some time to come.