Commentary: Debt Deleveraging and the Economy: The “Morning After” in America

Ronald Reagan’s successful 1984 campaign slogan, “It’s morning again in America,” summed up the mood of a nation emerging from a deep recession. A quarter of a century later, America is at another major turning point, but this time it feels more like the morning after. SEI’s Global Portfolio Strategies Team has published a paper looking at potential economic changes.

Summary

• We believe a major change away from strong growth in debt to a slower pattern reminiscent of the post-World War II period up to the early 1980s is likely. The composition of debt could also change radically as government spending counteracts the unwinding of private sector borrowing.
• The dramatic surge in corporate and household borrowing from the 1980s, although due to many factors, was primarily driven by financial deregulation. Two events were especially influential: the phasing out of interest ceilings on deposits in the early 1980s; and the development and rapid growth of the secondary mortgage market that followed. These were helped by the repeal of the 1933 Glass-Steagall Act separating commercial and investment banking.
• The financial sector experienced the most explosive growth, including commercial banks, investment banks, hedge funds and other financial intermediaries. At the same time, the composition of financial debt shifted dramatically towards securitization—the packaging of multiple smaller debts into investment pools that are then subdivided and sold to investors.
• The process of financial institutions unwinding their debt has been very painful so far and weighed heavily on the overall economy. Assets like homes and commercial real estate have been impaired and depressed incomes are leading to record consumer and business defaults.
• Banks’ preference for increasing capital at the expense of lending (an echo of its behavior during the Great Depression), uncertainty regarding future regulatory reforms and the overhang of excessive private debt all argue for continued constraints on new borrowing. Rebounds in consumer spending and overall economic activity are therefore expected to be relatively mild.
• While massive intervention was necessary to prevent a wholesale collapse of the financial system, the fall-out from government and central bank action will reverberate for a long time. The American model of capitalism will not disappear, but it will likely undergo some important changes, such as a more activist government role and higher taxation. These will add to the challenges investors are likely to face as the economy recovers.
• A paper¹ presented recently at the Kansas City Federal Reserve’s monetary policy symposium at Jackson Hole noted that systemic banking crises usually coincide with a sharp economic contraction from which it takes several years to fully recover, and the recent credit crisis is unlike any that has occurred in the past 30 years.
• Among the key potential drags on future growth cited in the study is a long lasting rise in the cost of borrowing. An extraordinarily large government deficit could also “crowd out” private investment, as heavy government debt issuance pushes up market interest rates.
• We agree. Given the outlook for a reduction in private borrowing, a more activist government and the push toward tighter regulation, we expect below average growth from the U.S. economy.

¹ Cecchetti, S., Kohler, M., and Upper, C., “Financial Crises and Economic Activity,” Working Paper, Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming.

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