Damage Done May Require Bigger Moves

I have highlighted what George Soros said about the end of American consumptions and leverage last Sunday. I saw a related article today, on the WSJ regarding the housing bubble and stock market evaporated wealth will change Americans for a while though not forever. You can see from the chart household debt/disposal income % is turning down. I have been sending subtle messages to all, our old investment models and paradigms need to be replaced.

(WSJ)So far in this recession, fiscal and monetary policy has been an effective antidepressant. But it may not be an effective stimulant, given the pain consumers have suffered.

The government is committing trillions of dollars in various bailouts and lending programs. The Federal Reserve has slashed its target interest rate and is buying debt to lower other rates, too.

These moves likely have helped prevent a depression. Together with sinking energy prices, some observers think they will eventually also spur a quick, V-shaped recovery.

If such a sharp rebound were on the way, then the 14% rally in the Dow since Nov. 20 might possibly be the start of a lasting bull market. It could also mean inflation risks are building that could send superlow interest rates on government debt soaring, as the bond vigilantes fear.

The response may not be quite so dramatic, however, in part because so much damage has already been done that might have lasting effects on the psychology of businesses, investors and, most importantly, consumers. That means the policy response has to be even bigger.

"We have created a very big hole," J.P. Morgan chief economist Bruce Kasman said on Friday. "The challenge is not just getting a recovery but one that allows us to dig out of that hole."

And it isn't clear how much stimulus will goose consumer spending, which makes up more than 70% of the economy. Consumers have already enjoyed tax rebates, low prices and other stimuli in this downturn but haven't responded with much gusto. This suggests the problem isn't just a lack of cash or spending power.

In recent decades, Americans eagerly borrowed and spent when policy makers gave them the chance and let bull markets and housing bubbles repair their balance sheets.

After two equity implosions and a housing collapse in less than a decade, they may be getting more cautious, and future stimulus measures might do little more than bolster savings.

"What we're undergoing is a generational change in risk preference," said Howard Simons, bond strategist at Bianco Research, "just like the generation that lived through the 1930s never could embrace risky investments again."

Battered stock and housing markets erased $2.7 trillion in household net worth between the fourth quarter of 2007 and the second quarter of 2008. Fed flow-of-funds data due Thursday will probably show net worth suffered again in the third quarter.

The Fed data will also likely show that household debt as a percentage of disposable income fell for the second straight quarter from a record of about 139%. That ratio may keep shrinking for some time as consumers cut spending and debt in response to falling income and net worth, and as lending remains tight. Perhaps it won't go as low as the 60% to 70% range it inhabited between the 1960s and the early 1980s, but the era of exorbitant leverage is over.

That is a healthy development for the long run, but it means the economy's healing process may not be quick.