A number of questions have arisen regarding a recent article by San Francisco Fed economists called “U.S. Household Deleveraging and Future Consumption Growth” (available at link below). The article argues that “households may need to undergo a prolonged period of deleveraging, whereby debt is reduced and saving is increased,” and that this “could result in a substantial and prolonged slowdown in consumer spending, relative to pre-recession growth rates.”

We agree with the conclusion that consumer spending growth will be more modest in the coming quarters than is typically the case during recoveries, but would disagree that the main cause of this is household deleveraging. Instead, we attribute the cause of that slower growth mainly to negative wealth effects from the housing and stock market declines. There are several reasons for this view. First, in market models of consumer spending, wealth and income drive consumption, and debt does not add predictive power to these models, so the common belief that high debt levels mean consumption needs to fall in the coming quarters is not supported by the data. Rather, debt is best viewed as a mechanism for liquefying and spending wealth rather than a cause of spending. This is why consumer credit is one of the lagging, rather than leading, economic indicators. Put differently, the ratio of household debt to income has been on an upward trend over the past 50 years, but has not been a good predictor of consumption fluctuations during that time. This is because there is no reason to think that debt-to-income ratios of earlier decades, which pre-dated credit cards, home equity lines of credit, and longer-term auto loans, were “optimal.”

In our view, the primary cause of the consumption boom of recent years was positive wealth effects from the boom in stock market and housing market values; this boom led households to consume and borrow more. Now that these prices have declined, we expect consumption and debt growth to be slower and the saving rate to move higher. However, in contrast to the SF Fed article, we would not identify debt as the main cause of these events.

http://www.frbsf.org/publications/economics/letter/2009/el2009-16.pdf