One of the main reasons efforts to stimulate the economy have failed to date is that consumers aren't borrowing.
Consumer spending constitutes about two-thirds of the U.S. gross domestic product. Consumer credit helps pay for new appliances, cars, furniture and vacations. Mortgage debt, including home equity loans, supports the purchases of bigger houses and finances other expenditures, such as landscaping and home improvements. In past recoveries, robust increases in consumer spending often pushed economic growth above 5 percent per year. Not this time.
This is the first time since World War II when people have reduced rather than increased their total outstanding debt following a recession. What this means is that the low-interest rates supposed to stimulate the economy are having little effect -- because low-interest rates fuel economic growth only when they encourage people to borrow and spend more.
Against the backdrop of substantial debt reduction, the economy is actually doing pretty well. Output has been growing continuously for nearly three years and has surpassed its pre-recession level. Production is expanding: The index of industrial production has been growing since July 2009 and is approaching its pre-recession level. And the economy continues to add jobs, albeit slowly.
The economy also looks healthy structurally. Growth is being driven entirely by the domestic private sector. This is a far more reliable way to grow the economy than with government spending on temporary stimulus initiatives or through artificial export growth fueled by exchange rates.
Unfortunately, significantly faster growth is unlikely until households become comfortable with borrowing again. Only borrowing allows consumer spending to grow faster than incomes, which is required to accelerate economic growth.
In all previous post-war recoveries, households increased their borrowing throughout the recovery. This applies both to mortgage debt, including balances on home equity loans and lines of credit, and consumer debt, such as car loans, credit card balances, student loans and store credit.
In the past, two years into a recovery people increased their mortgage debt by an average of almost 15 percent and consumer debt by an average of more than 12 percent. By three years into a recovery, which is close to where we are now, mortgage debt was usually 23 percent higher and consumer debt 21 percent higher than they had been at the start of recovery.
That is not happening now.
Because the recession and the financial crisis of 2008 exposed the dangers of excessive borrowing, many people realized that they needed to reduce their debts. Some did so voluntarily, paying down existing loan balances. Others were forced into debt restructuring through bankruptcy or foreclosure.
At the same time banks became more cautious in extending credit, making it more difficult for people to borrow, even if they wanted to.
Through August 2011, as people focused on reducing existing debt, consumer credit shrank. Since then it has increased somewhat, but it's still 4.5 percent below where it stood when the recovery began in June 2009.
The recent increase in consumer debt also has been swamped by large reductions in mortgage debt, which continues to fall. Household mortgage debt is about four times as large as consumer debt. The latest available data, for December 2011, show that mortgage debt is 10.7 percent lower than it was at the start of recovery.
Without the traditional spike in borrowing, household spending has increased on average only about 2.2 percent per year since the start of the recovery -- about half the rate of previous recoveries. This explains the lackluster GDP growth, which has averaged 2.4 percent per year during the current recovery, compared to a 4.9 percent average by this time in other postwar expansions.
It's difficult to know when borrowing might rebound. Recent increases in consumer credit may be the first sign of such a rebound. But mortgage debt is still heading down, indicating that we still have a way to go before the economy starts perking up again -- with a lot of obstacles along the way.
Polina Vlasenko is a research fellow at the American Institute for Economic Research.