American hangover: unless income rises, the ongoing consumer debt reduction could cripple the recovery.

• Author: Baily, Martin N.

The U.S. consumer's seven-year borrowing binge has ended, and the economic hangover is painful. Millions of Americans have started paying down debt amassed during the days of easy credit and bubbling home values. And with joblessness rising and the economic outlook uncertain, many are borrowing less and saving more. While this new financial sobriety makes sense for individual households, the collective result has been a large drop in personal spending--a major reason for the sharp GDP contraction that began last year. Looking ahead, a key question is whether U.S. households will dig out of debt without further cutting consumption and crippling a U.S. and global recovery.

Several forces are behind the growth of U.S. household debt in recent years and the reversal now under way. Between 2000 and 2007, U.S. households led a national borrowing binge, nearly doubling their outstanding debt to $13.5 trillion. The pace was faster than the growth of their incomes, their spending, or the nation's GDP. The amount of U.S. household debt amassed by 2007 was unprecedented, whether measured as a share of GDP (96 percent), or as a ratio of liabilities to disposable income (136 percent).

But as the global financial and economic crisis worsened at the end of last year, a shift occurred: U.S. households for the first time since World War II reduced their debt outstanding.

The hit to consumption from this deleveraging will depend on whether it is accompanied by personal income growth. If household incomes stagnate, each percentage point reduction in the debt-to-income ratio will require nearly one percentage point more personal saving. And each extra point in the saving rate translates into at least $100 billion less spending--a serious potential drag on economic growth.

If incomes were to rise, households could reduce their debt burden without having to trim consumption as much. But policymakers cannot assume income growth will pick up once GDP rebounds. On the contrary, average U.S. household incomes, adjusted for inflation, have barely budged since 2000. And incomes are unlikely to pick up significantly in the short term, amid the financial crisis and economic recession.

THE RISE OF CONSUMER DEBT

Any change in U.S. consumer behavior could have profound implications for the U.S. and global economies. Over the past decade, rising U.S. household spending has served as the main engine of U.S. economic growth. From 2000 to 2007, U.S. annual personal consumption grew by 44 percent, from $7 trillion to $10 trillion--faster than either GDP or household income. Consumption accounted for 79 percent of real U.S. GDP growth during this period--high by comparison with both U.S. and international experience.

The spendthrift ways of the U.S. consumer have fueled global economic growth as well. The United States has accounted for one-third of the total growth in global private consumption since 1990. From 2000 to 2007, U.S. imports grew from an amount equal to 15 percent of U.S. GDP to 17 percent, boosting aggregate global demand by $952 billion in nominal terms. Moreover, U.S. consumer spending boosts global economic activity in...