US Economy: There is only one way out of the recession according to a political scientist at the Washington DC think-tank, the Brookings Institution.

William A. Galston, Senior Fellow, Governance Studies at the think-tank and former adviser to President Clinton, says average Americans are noticing what wise economists have been arguing for quite some time: Bubble-driven economic downturns differ qualitatively from standard business-cycle recessions. Not only do they go deeper; GDP (gross domestic product) takes longer to rebound, and job creation proceeds more slowly.

Galston says the mechanism is straightforward. As the value of assets used as collateral collapses, so does borrowing. This depresses consumption, and the real economy dips, making it much harder for businesses and households to service the debts incurred during boom times. Household consumption remains sluggish until debt is reduced to a level that can comfortably be serviced out of current income, a process that cannot proceed without an increase in the household savings rate. The larger the debt overhang, the longer it will take to work off the excess.

Finfacts reported in August that Prof. Robert Frank of Cornell University had said that the median size of a newly constructed single-family house, which stood at 1,600 square feet in 1980, had grown to more than 2,300 square feet by 2007. Since the median wage was essentially stagnant during this period, this growth cannot be explained by growth in income.

Dr. Galston of Brookings says that as recent as the late 1990s, total household debt stood under $5trn, roughly 90% of disposable income. After a decade-long borrowing binge, debt peaked in late 2007 at about $12.5trn - - a stunning 133% of disposable income. According to the latest report from the Federal Reserve Bank of New York, the total had declined to $11.7trn by the first quarter of 2010, a reduction of $812bn (6.5%) from the peak. During the same period, not surprisingly, the household savings rate rose from 2% to more than 6%.

While these are sizeable changes, Galston says there is good reason to believe that the process of household debt reduction is still in an early stage. Writing for the Center for American Progress, Christian Weller points out that total debt now stands at 121.7% of disposable income, still higher than at any point before the second quarter of 2005. In an analysis published in May of 2009, the Federal Reserve Bank of San Francisco (FRBSF) suggested that the household debt/disposable income ratio might well have to fall much farther, to around 100%, a process that could take much of the decade, even if the household savings rate were to rise to 10%.

This extended deleveraging would have a substantial effect on the economy. The FRBSF estimates that it would reduce annual consumption growth by three-fourths of a percentage point from the stable-savings baseline, which would “act as a near-term drag on overall economic activity, slowing the pace of recovery from recession.”

Dr. Galston says this is exactly what we’re now seeing. "In a superb piece, the Washington Post’s Neil Irwin gets outside the Beltway and beyond its stale arguments to probe the real reasons companies aren’t hiring. His conclusion is worthy of extended quotation:

Many Democrats say the economy needs more stimulus. Business lobbyists and their Republican allies say it needs less regulation and lower taxes.

But here in the heartland of America, senior executives say neither side’s assessment fits.

They blame their profound caution on their view that US consumers are destined to disappoint for many years. As a result, they say, the economy is unlikely to see the kind of unbroken prosperity of the quarter-century that preceded the financial crisis. . . .

They see Americans for years ahead paying down debts incurred during the now-ended credit boom and adjusting spending to match their often-reduced income.

'It’s a different era,' says Daryl Dulaney, chief executive of Siemens Industry, which has 30,000 US employees who make lighting systems for buildings and a wide range of other products. 'Our hiring and investment decisions have to be prudent and reflect that.'”

A different era ... Dr. Galston asks how long will it take our policy makers and political parties to absorb the implications of that stark, undeniable phrase? When they do, he says they will realize that we have only two strategic options: Either America accepts years of sluggish growth and high unemployment, or the country shifts to a new model that mobilizes the record level of private capital now sitting on the sidelines for public investments that will boost economic activity and employment in the short term, and economic productivity and growth in the long term, while generating rates of return sufficient to interest investors.  

"This is why we need a national infrastructure bank as the linchpin of a public investment strategy driven by economic analysis rather than congressional politics," he concludes. "Rather than bridges to nowhere, we need a bridge to the future. It’s time for hide-bound appropriators to get out of the way."  

On Sunday, Sept 05, the Bank for International Settlements published a study of 20 systemic banking crises and the authors say that debt reduction may not seriously impact growth. however, recovery following an individual crisis case has often happened in recent decades against a positive international backdrop.

Bank for International Settlements study says pre-financial crisis debt will continue to fall; May not seriously impact growth