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Household debt reduction: We've only just begun

July 25, 2011: 10:33 AM ET

Consumers have made great strides in reducing their debts, but spending hasn't picked up. Is the borrow and spend mentality gone forever?

FORTUNE -- Since the recession officially ended, U.S. households that racked up too much debt have worked vigorously to improve their finances. But while the financial health of consumers has improved, the question now is how much more must they deleverage before they can really start spending more.

It's an important issue, given that roughly two-thirds of the economy is driven by consumption. With unemployment still hovering above 9%, corporate executives repeatedly say they can't justify hiring more unless they see consumer demand for their products and services pick up in a meaningful way.

As of the end of March, consumers had reduced debt by more than $1 trillion in the previous 10 quarters. Credit scores, a predictor of the likelihood that lenders will be repaid, rose to 696 in May – the highest in at least four years. And loan delinquencies have dropped by 30% during the past two years.

And yet, needless to say, this hasn't translated much to more spending.

One of the most unusual features of the Great Recession and the slow recovery from it has been the decline in spending on discretionary services, which includes education, entertainment, meals at restaurants but excludes food, health care and housing, according to a recent report by the Federal Reserve Bank of New York. The fall of such spending was a big factor in the decline of real GDP during the latest recession. In this slump, it is down nearly 7% -- more than double the percentage decline seen in the early 1980s recession.

So if consumers were in their death bed during the depths of the latest recession, then it looks today as if they'll be in intensive care for a while, say economists who predict a meaningful recovery is still years away as the process of deleveraging has only just begun.

"Consumers know they've overspent, they know they've under-saved and they know they've over-borrowed and they're adjusting," says Stephen Roach, non-executive chairman of Morgan Stanley Asia and a faculty member of Yale University's School of Management. "My guess is that we're 14 quarters or a little over three years of what will easily be a 5 to 10-year [deleverage] process. That's what it will take to repair the damage."

Household debt as a percentage of disposable income has steadily fallen since the latest recession. However, it still has a ways to go before recovering to 2000 levels – what Chris Christopher, a senior principal economist at forecasting firm IHS Global Insight, believes to be the benchmark for when consumers will finally feel comfortable enough to spend more and take on more debt again. In 2000, the debt to income ratio was approximately 100%. It peaked at 140% in 2007 and is at 120% today.

How quickly households will return to such levels will depend largely on how much income they take in. And at least thus far, with a real estate market still in shambles and a stock market under pressure, the chances of incomes growing substantially is slim.

The latest recession caused households to lose much of their net worth following the plunge in stock and home prices. Net worth relative to income was at 595% in 2000, according to IHS. It peaked at 625% in 2007 as home prices surged to record highs and then spiraled down when the real estate market crashed. Household net worth to income is currently at 500% and clearly has much more to recover.

All this has changed consumer attitudes.

"In many respects prior to the recession households were able to achieve their savings goals by putting a little money away and watching it grow," says Scott Hoyt, senior consumer economics director at Moody's Analytics. "We clearly learned over the years that that doesn't always work -- that savings now are more essential than ever in achieving goals. I don't think we're going to see the borrow and spend mentality that we had in the middle of the last decade."

However long it takes consumers to fully deleverage, it appears their view of debt and credit has fundamentally changed.

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About This Author
Nin-Hai Tseng
Nin-Hai Tseng
Writer, Fortune

Nin-Hai Tseng covers economics and finance. Before joining Fortune, Tseng was a reporter at The Orlando Sentinel and a public affairs associate at GE. She holds an MPA from Columbia University and a BS in Journalism from the University of Florida. She lives in New York City.

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