Before the U.S. economy can get on the road to recovery, consumers and businesses have some wrenching adjustments to make. Households are trying to free themselves of debt they have accumulated in recent years, and they are saving more, even as the recession ravages incomes. Meanwhile, companies are working to align their capital spending, inventories, and payrolls with the realities of weaker demand, both at home and abroad, with no real sense of when business will improve. All this is contributing to the longest and steepest recession since the 1930s.
However, the sharp drop-off in the economy in recent months also implies consumers and businesses are wringing out their excesses with surprising speed. Following the fourth quarter's 6.3% plunge in real gross domestic product, economists expect declines of about 5% in the first quarter and 2% this quarter. The rapid pace of adjustment offers some hope that, with help from Washington's major efforts to lift demand, the economy can begin to stabilize in the second half.
Households have already substantially boosted their saving rates. The $12.7 trillion loss in the value of household assets since the summer of 2007 has decimated nest eggs and created the imperative to save more. Savings as a percentage of income averaged 4.3% in January and February, the highest two-month average in more than 10 years, and up from a mere 0.2% in the same two months last year.
Perhaps more important, the liabilities side of households' balance sheets shows consumers have also made a significant start toward deleveraging. For the first time since data were initially collected in 1952, the volume of outstanding household debt shrank in the fourth quarter of last year. Mortgage debt, which is three-fourths of all household debt and the lion's share of the deleveraging problem, has declined for three quarters in a row.
There's a long way to go. The ratio of overall debt to income remains more than 30% above its long-term trend prior to the nearly 12%-per-year explosion in the growth of mortgage debt from 2002 to 2007. Economists believe efforts to pay off debt and lift savings will keep consumer spending, this year and next, well below its long-run growth rate of about 3% annually. That will be a big factor weighing on the strength of the recovery.
However, the numbers are saying that deleveraging is on a fast track. Housing demand is already weak enough to restrain new borrowing, even as solvent homeowners continue to pay down debt and rising defaults and debt forgiveness effectively cancel obligations. The net effect: a further, perhaps faster, drop in household debt.
Less borrowing and more saving by consumers has, in turn, forced businesses to make adjustments, but companies have reacted rapidly. Amid shareholder pressure, falling profits, and uncertain future demand, cost-cutting has accelerated in recent months. These cuts are now well advanced. Companies have slashed payrolls by some 5 million workers since the end of 2007. They have pared inventories for five quarters in a row. They also have cut equipment spending in each of the past four quarters, including a 28.1% drop in the fourth quarter, the largest in 50 years.
The financial sector has had a disproportionate impact on key aspects of the business adjustment. In recent years financial corporations have contributed about 30% of all domestic profits, but since the summer of 2007 they have accounted for 70% of the earnings declines. They also accounted for half of the big fourth-quarter drop in capital spending.
Companies outside finance are fast becoming well positioned to benefit from even a modest pickup in demand, especially given their steep cuts in labor costs. Although nonfinancial businesses expanded cautiously in recent years, they still have accounted for 90% of all payroll reductions. With Washington stimulus boosting demand, sales gains should flow quickly to the bottom line, even as consumers rein in debt and save more.