US consumers making progress in paring debt

With the U.S. economy showing signs of life, here is another reason to think the recovery may be for real: Americans are making rapid progress shedding debt, according to McKinsey.

Since 2008, all types of U.S. private-sector debt -- such as mortgage, credit card and corporate loans -- have fallen as a percentage of the broader economy, the management consulting firm says in a new report. Household debt in the U.S. has fallen a total of $584 billion over the last four years, a 15 percent decline relative to people's overall disposable income. Debt carried by businesses has also declined. McKinsey concludes:

Historical precedent suggests that U.S. households could be as much as halfway through the deleveraging process. If we define household deleveraging to sustainable levels as a return to the pre-bubble trend for the ratio of household debt to disposable income, then at the current pace of debt reduction, U.S. households would complete their deleveraging by mid-2013.

That puts the U.S. ahead of other nations trying to "deleverage" after personal debt soared during the housing bubble years. In fact, only three of the world's 10 largest economies -- the U.S., Australia, and South Korea -- have seen debt decline since the financial crisis began.

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By contrast, countries like the U.K. and Spain are having a much tougher time. Total public and private debt in Great Britain has risen slightly since 2008, reaching 507 percent of GDP as of mid-2011. Unlike in the U.S, where the largest chunk of private debt stems from household borrowing, the biggest share of debt in the U.K. comes from the financial sector.

No surprise there -- during the housing boom, British banks matched their financial peers in the states for sheer recklessness. The trouble now is that U.K. banks are highly exposed to the sovereign-debt crisis in the eurozone. Although government pressure has forced these institutions to boost their capital, a new round of losses related to the debt crisis could again soak the companies in red ink.

Why is the U.S. making strides in working down private sector debt, while European countries are struggling? For one, the latter are just getting underway in reducing their debt loads, according to McKinsey. But here's another part of the answer: Austerity. Countries like the U.K., Spain and Italy have responded to the debt crisis by aggressively chopping government spending. That may help keep inflation at bay, but most economists agree that it harms growth in the short-term. Predictably, then, these economies have lost steam.

In other words, European officials are attacking the wrong beast, says economist Paul Krugman says:

[T]he European Central Bank has been worrying about inflation -- even raising interest rates during 2011, only to reverse course later in the year -- rather than worrying about how to sustain economic recovery. And fiscal austerity, which is supposed to limit the increase in government debt, has depressed the economy, making it impossible to achieve urgently needed reductions in private debt. The end result is that for all their moralizing about the evils of borrowing, the Europeans aren't making any progress against excessive debt -- whereas we are.

Although it's a good sign that Americans are digging themselves out of debt, for many the process also amounts to a painful ratcheting down in their standard of living and economic prospects. Fully two-thirds of the decrease in household financial obligations in the U.S. is due to people defaulting on home loans and other consumer debt. Deleveraging is necessary, but for homeowners facing foreclosure, it hurts like hell.

Even when debt levels return to normal, meanwhile, U.S. consumers are unlikely to be the economic force they were before the housing crash, McKinsey emphasizes. From 2003 to 2007, people extracted more than $2 trillion from their properties in the form of home equity loans and cash-out refinancing -- about 20 percent of which went to fund personal spending. Those days are over. Understandably, consumers are likely to remain cautious about taking on debt for years to come. But that could slow economic growth.

The U.S. economy also faces major challenges over the longer term beyond households getting a handle on spending, such as stagnant worker wages and galloping income inequality. For now, gridlock in Washington is also exacerbating the country's economic malaise and hampering the adoption of solutions (infrastructure spending, anyone?).

Still, Americans are slowly but surely climbing out of the hole. That's good news.