Tuesday, June 16, 2009

Economic Stimulus: Part 4 – Reducing Debt vs Increasing Consumption

This recession was caused by debt from banks financing their lending operations, from families taking on mortgages beyond their ability to pay, and from individuals financing personal consumption with credit cards, home equity loans, and refinanced mortgages.

When the ratio of private debt to private income shrinks to its historical norm, private consumption will naturally increase from its new lows. Until then, the folks will save and pay down debt and, where they can, defer consumption to make room in their budgets for saving and debt service.

Government policy may be able to reduce the severity and length of the recession if it is directed at helping families reduce their debt and increase their savings. A successful policy would help people restore their personal debt-service to income ratios faster creating the conditions necessary to sustain economic growth sooner.

Stabilizing the banking system was and is necessary to continue financing viable businesses, especially small businesses. But increasing government consumption will not end the recession. Government spending, as opposed to tax cuts or rebates, is necessarily targeted at things government can spend money on.

Projects that receive government money will prosper while the rest of the economy continues to founder because the people still must pay down their debt. Families and individuals must reduce their debt payment obligations and save money for the proverbial rainy day.

For some the rain has already arrived and they were caught without an umbrella. These folks are reducing their debt through bankruptcy and foreclosure. The rest of the folks can see the storm coming and are trying to restore their debt-service to income ratios before the rains reach them.

Links to Other Topics in the Special Report: Economic Stimulus

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