The De-leveraging of America

by Menlo College President G. Timothy Haight

Much has been written about the high degree of leverage used by our financial institutions in search for higher returns. Indeed the use of extreme financial leverage in place of equity contributed to the demise of Bear Stearns, Lehman Brothers, Merrill Lynch, and similar financial institutions. As a result, financial institutions throughout the globe are in the painful process of de-leveraging as they pursue new paradigms to sustain their entities.

There seems to be little if any attention paid to another segment that may have learned a painful lesson during this historic financial crisis: the American Consumer. For decades, economists have pointed to the lack of savings by the American consumer as a detriment to sustained economic growth. The classic argument was that increased savings leads to increased investment which in turn fuels economic growth. Routinely, the U.S. consumer savings rate was compared unfavorably to that of the Japanese consumer. Although the comparison has lessened since Japan experienced its own financial meltdown and deflationary fallout, the U. S. low savings rate has continued to be criticized. That is up until now.

To be sure, consumption represents more than 2/3 of the United States Gross National Product. Not surprisingly, as consumer sentiment fell, so did consumption. Evidence of consumers reluctant to spend can be seen in failure of last summer's government stimulus and most recently the dismal Christmas selling season. Not surprisingly, President Obama is calling for a massive stimulus package with government spending serving as the catalyst to jump-start the economy.

Until recently consumer consumption had been fueled by current income and, for lack of a better term, “perceived wealth.” Thus, in economic terms we might say that Consumption equals Income plus an additional amount of spending associated with the increase in Perceived Wealth. Early on this perceived wealth was derived from the rising stock market. As the market increased, the value of our 401Ks increased and we felt wealthier. Unfortunately, markets move in both directions.

Not to worry. When the stock market bubble burst, Federal Reserve Chair Alan Greenspan came to the rescue with a relaxed monetary policy that fueled the price increases in the housing market. Credit terms were relaxed and our euphoria continued. Consumers this time refinanced their homes and/or took out home equity loans to take advantage of this new source of perceived wealth. All this time consumption far outpaced what could be supported by current income. That is, however, until the housing bust.

Now consumers find themselves in a situation where their perceived wealth has greatly diminished if not vanished. Furthermore, their ability to continue to earn a living may be in question and predictably consumption is collapsing. Many are quick to blame the financial institutions for not continuing to provide funds to fuel consumption. Indeed, lenders should be reluctant to extend credit when sources of repayment are uncertain and collateral is nonexistent. In essence, commercial banks are now doing what the Federal Reserve should have done much earlier. They are taking away the proverbial punch bowl. While it is convenient to blame financial institutions for the current economic state, perhaps the problems are much more complicated than this. Maybe consumers have finally learned a lesson.

Whether or not the reluctance of consumers to spend is a temporary or permanent change in behavior remains to be seen. It may be recognition on the part of consumers that they too must begin to delever and begin living within their “means.” If the latter is correct, then we will be entering a new era where consumer expenditures reflect the true purchasing power. This de-leveraging will result in reduced consumer demand and, in the absence of government filling the vacuum, a lower sustained GNP. This will have profound implications not only for the current recovery, but well into the future. One must ask how we will prepare for the coming “De-leveraging of America.”