The McKinsey Global Institute has just published "Debt and deleveraging: Uneven progress on the
path to growth." The report uses the cases of Sweden and Finland in the 1990s as a map for how recovery from too much debt, asset bubbles, and financial crisis might proceed. MGI writes:
"The examples of deleveraging in Sweden and Finland during the 1990s have particular relevance today. Both nations experienced credit bubbles that led to asset bubbles and, ultimately, financial crises. But both also moved decisively to bolster their banking systems and deal with debt overhang. And—after painful recessions—both nations went on to enjoy more than a decade of strong GDP
growth. The experiences of the two Nordic economies illustrate that deleveraging often proceeds in two stages. In the first, households, the financial sector, and nonfinancial corporations reduce debt, while economic growth remains very weak or negative. During this time, government debt typically rises as a result of higher social costs and depressed tax receipts. In the second phase, economic growth rebounds and then the longer process of gradually reducing government debt begins."
With this pathway to eventual recovery in mind, MGI makes an argument that the U.S. economy is actually further down the road to recovery than most other high-income countries:
"Since the end of 2008, all categories of US private-sector debt have fallen relative to GDP. Financial-sector debt has declined from $8 trillion to $6.1 trillion and stands at 40 percent of GDP, the same as in 2000. Nonfinancial corporations have also reduced their debt relative to GDP, and US household debt has fallen by $584 billion, or a 15 percentage-point reduction relative to disposable income. Two-thirds of household debt reduction is due to defaults on home loans and consumer debt. With $254 billion of mortgages still in the foreclosure pipeline, the United States could see several more percentage points of household deleveraging in the months and years ahead as the foreclosure process
Historical precedent suggests that US 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, US households would complete their deleveraging by mid-2013. ..."
Here's a figure showing the rapid increase in U.S debt by sector, and the recent change. In contrast to this U.S. pattern, MGI notes that in Japan private-sector debt levels didn't start falling until eight years after the bursting of the bubble.
What steps should we be seeing along the way in the next year or two that would reassure us that the U.S. economy is returning to health? The MGI report offers six "markers." Here, I'll focus on how the U.S. economy measures up on these markers, although the report offers many intriguing comparisons to other countries, especially the United Kingdom and Spain.
"Marker 1. Is the banking system stable?"
The U.S. economy does seem to have stabilized the banking system (at some cost!). "Net new mortgage lending only recently turned positive in the United States."
"Marker 2. Is there a credible plan for long-term fiscal sustainability?"
In terms of what Congress has enacted and President Obama has signed into law, the answer is clearly "no."
"Marker 3. Are structural reforms in place to unleash private-sector growth?"
"The United States should encourage business expansion by speeding up regulatory approvals for business investment, particularly by foreign companies, and by simplifying the corporate tax code and lowering marginal tax rates in a revenue-neutral way. Business leaders also say that the United States can improve infrastructure and the skills of its workforce and do more to encourage innovation."
"Marker 4. Are the conditions set for strong export growth?"
This step was especially important for Sweden and Finland, as small open economies. It's less crucial for the U.S., with its huge internal market and, by world standards, relatively low trade-to-GDP ratio. Still, the U.S. economy should be recognizing that the most rapid growth in the world economy in the next few decades is going to be happening outside our borders, and we need to be thinking about how we can tap into this growth, with everything from building connections for exporters to encouraging tourism.
"Marker 5. Is private investment rising?"
"Today, annual private investment in the United States and the United Kingdom is equal to roughly 12 percent of GDP, approximately 5 percentage points below pre-crisis peaks. Both business investment and residential real estate investment declined sharply during the credit crisis and the ensuing recession. While private business investment has been rising in recent quarters, total investment remains low because of slow housing starts." My own expectation is that real estate investment isn't going to be driving the U.S. economy forward in the next few years--at best, we can hope that it won't be a drag. So the key to U.S. investment is business investment levels.
"Marker 6. Has the housing market stabilized?"
"Both Macroeconomic Advisers and the National Association of Home Builders predict that new housing starts will not approach pre-crisis levels until at least 2013—coincidentally the year in which we estimate that US households may be finished deleveraging."
In my own view, the most important policy steps that flow from this analysis are the importance of building to an agreement on a credible middle-term plan for holding down the ongoing rise in U.S. government debt levels, and finding ways to encourage business investment.