We are in a severe recession. The proximate cause is the massive financial deleveraging taking place in the U.S. and elsewhere.
Today we have a total credit market debt (households, business and government) of about $49 trillion and an annual gross domestic product (our income) of about $14 trillion.
Our debt stands at approximately 3.5 times our income. By virtue of the deleveraging process now under way and its effect on the real economy, it is clear that the current debt level is too high relative to our ability to carry it.
Using 1980 as a starting point, our ratio of debt to income was approximately 1.5, and we saved approximately 10 percent of our income. During the next 20 years, we experienced the longest and largest bull market in stock market history.
As we felt wealthier, the savings rate dropped to low single digits.
Beginning in the late 1990s, home prices began rising rapidly.
Since more of our household wealth derives from homes than the stock market, we felt even wealthier. Home mortgage debt exploded upward as new buyers (using lower down payment and easier credit standards) bought homes and existing home owners used their newly created home equity windfall as an ATM machine to finance their spending.
With these combined wealth effects, the savings rate dropped to zero and even turned negative. This helps explain the huge increase in credit card debt. When debt from government is added, we arrive at the leverage levels noted above.
Since mid-2006 home prices have declined about 27 percent, and stock prices have declined about 50 percent since late 2007. We feel, and are, less wealthy and react by reducing our spending, paying down debt and saving more. Our savings rate is rising and stands at 3 percent.
Driven by the drop in consumption, gross domestic product has declined in recent quarters. This decline in demand has more than offset the natural tendency for our economy to create additional jobs, so unemployment has increased. Judging from the ratios cited above, this process may have a long way to go.
The knee-jerk reaction, which is understandable, is: "Just don't stand there, do something!"
Unfortunately, neither increased government spending nor reduced taxes, when financed by incurring more government debt, does what is required - reducing our debt. In fact, it exacerbates it.
Alternatively, the government, through the Federal Reserve, could purchase the new debt and pay for it with newly printed money. However, the resulting higher inflation would be detrimental for all.
Finally, debtors could repudiate some of their debts, but those same debts represent assets to their owners - and that includes us. As a result, any decrease in debt could be substantially offset by a decrease in financial wealth. As you can see, there is no easy solution to our dilemma.
Well-intended people, through our government, may take actions that not only may not help but might actually hinder our recovery.
Further, government programs and taxes, once put into place, rarely seem to go away. As a result, over time, government spends and taxes an increasing portion of our income.
The best course of action, in my opinion, is to let our free enterprise economy, which has served us so well since the founding of the republic, fix itself.
We have had financial bubbles and panics before, and left to its own devices, our competitive market system made the necessary adjustments. Individuals, institutions, and government need to de-leverage. That means: spending less, saving more, and reducing debt.
Christopher Gable is a financial adviser with Wachovia Securities. The views above are his and not those of his employer.
