-By Dr. Carl Steidtmann, Chief Economist and Director, Consumer Business, Deloitte Research

Despite a currently bleak economic outlook, the reversal of trade and spending imbalances should lead to a recovery later this year.

The origins of the current recession are often described as the breaking of an asset bubble in housing. A more accurate characterization of the recession’s origins would be the deflating of a debt bubble. From housing to cars, from leverage buyouts to structured investment vehicles, the fuel that drove the economy for the past eight years was debt -- and lots of it. What we’ve discovered since August 2007 is that much of that debt was lent to borrowers who had no hope of servicing the debt, much less repaying it.

Since the summer of 2007, banks, hedge funds and insurance companies have been furiously writing off bad debt. While it’s hard to get a precise number, roughly $1 trillion in losses have been booked over the past 18 months. These losses, in turn, reduce shareholder equity, which, barring no other changes, results in an increase in financial leverage.

As the banks and other nonbanks take these losses, they have to offset them on the asset side of their balance sheets by pulling back on lending. Depending on the degree of balance sheet leverage, every dollar loss of equity requires a 10x to 30x reduction in lending just to maintain the pre-loss degree of leverage. As the banks reduce leverage, the reduction in lending has to be even greater.

Private-Sector Debt Creation
In trillions of dollars, seasonally adjusted annualized rates


Source: Federal Reserve Board

Starting in the mortgage market, and then spreading to other credit markets, the contraction of credit creation has been abrupt and dramatic. In the commercial paper market, banks began pulling back in August 2007, refusing to roll over asset-backed commercial paper that many banks were using to fund their off-balance sheet purchases of mortgage-backed securities. In commercial paper alone, the contraction of credit has been in excess of $800 billion. In the mortgage market, the pullback of credit has been even more severe. After peaking in late 2005 just shy of $1.4 trillion, new mortgage debt creation has almost completely disappeared. The contraction in mortgage debt has forced consumers to cut back, a process that will continue until the market for mortgage debt can be revived.

The contraction of credit is in many ways a destruction of money supply. And with the destruction of money has come a dramatic fall in virtually all asset prices and a growing problem with deflation. Since the summer, commodity prices have plummeted, putting downward pressure on food prices. Asset prices are down around the world. Deflation is beginning to show up in both consumer and producer prices.

The Retail Stake
The Great Depression of the 1930s didn’t start off as a depression, great or otherwise. The Great Depression became a huge disaster as a direct result of not-so-great economic policies. With trillions of dollars in credit facilities, deposit guarantees and bailouts, the Federal Reserve of 2008 has shown that it’s willing to bear any burden and pay any price to maintain the integrity of the banking system.

The government efforts of the past year mean that we’re in the midst of a great transformation of the U.S. economy. As was the case in the 1930s, the economic crisis of our day is increasing government control of the economy. The great trade and spending imbalances of the past decade are in the process of being reversed. Consumer spending as a share of the economy is going to shrink, and with it the retail sector. Consolidation will be the order of the day.

A small consumer sector will reduce U.S. imports, putting new pressures on Asian exporters and Middle Eastern oil producers, and forcing them to look elsewhere for growth. While it’s easy to despair in this season of economic discontent, it is hard not to see that with nearly $10 trillion in various shades of stimulus in the pipeline, a reasonably strong economic recovery should arrive sometime before the end of 2009.

To comment on this article or pose another topic for this columnist, contact Dr. Carl Steidtmann at csteidtmann@deloitte.com.