There are many challenges facing the U.S. economy today, but one of the least understood is privately held debt. Household debt in America grew to record highs during the last decade, as the promise of forever rising housing prices, a bull market in equities, and low interest rates for several years made the costs of borrowing appear inconsequential. Unfortunately, after the housing bubble burst, the large private debt level has prevented the private sector from rebounding, as many individuals and businesses are saddled with having to pay the bill for their decades of fun.
Recent data from the Federal Reserve provided some positive news, with reports coming in showing that household debt service payments as a percentage of income have fallen about 20 percent from record highs in 2008 to levels not seen since the mid-1990s. However, the bad news is that aggregate household debt remains unsustainably high (see below figure).
Even worse, while there has been a decline in household mortgage debt (as would be expected in the decline of a housing bubble), household debt from consumer credit has actually been rising. After declining sharply from $2.56 trillion in July 2008 to $2.39 in July 2010, consumer debt is nearly back to record highs with a most recent reading of $2.54 trillion (see below figure).
When it comes to considering debt's impact on the economy, overall levels are more important than just considering servicing payments. Increased levels of monthly paychecks going to pay off debt and interest certainly reduce consumption and subsequently are downward pressure on economic growth. However, it is more critical to consider that high aggregate debt levels lead to less investment (particularly in small to medium sized enterprises), less demand for housing, less economic mobility, and depressed consumer sentiment.
The U.S. economy is not going to see real growth as long as entrepreneurism is stagnant. Nor can there be a robust recovery with the housing market still with at least three to five years left before toxic debt gets cleared out and housing prices bottom. Economic growth driven by consumption remains far off as well, as households feel the weight of historically high debt levels without a sense of rising wealth—incomes are stagnant, housing prices are not going up anytime soon, and most middle class households are not reaping the gains from America's current equity bubble.
The challenge America faces is that the only way a sustained recovery can take hold is through private sector household deleveraging, which is going to keep downward pressure on economic growth for the next several years. The deleveraging process started in 2008 but stalled in 2010 when there was hope for a recovery that turned out to just be a mirage.
American households could try to leverage their way out of economic malaise, using record low interest rates to doubling down on the debt-fueled economic growth strategy of the bubble years. But that would only perpetuate the bubble-bust "Doom Loop" of cheap financing leading to excessive debt growth followed by busts, bailouts, and more cheap credit to continue the cycle. When considering a long-term outlook for the U.S. economy, either America has to go through a depressed period of deleveraging, or it is going to rebound on an unstable foundation and repeat the cycle all over again.
Anthony Randazzo is director of economic research for Reason Foundation.