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The gravity-defying debt problem

Asset prices are falling. But until stubbornly high debt levels do the same, an economic recovery will remain a mirage.

Colin Barr, senior writer
February 25, 2009: 4:30 AM ET

NEW YORK (Fortune) -- The prices of real estate, stocks and many commodities continue to plummet this year.

But one figure appears unlikely to decline substantially anytime soon, to the great distress of consumers, companies and taxpayers alike: the amount of debt piled on top of the U.S. economy.

For now, most of the attention on debt stems from the prospect of a big rise in the federal debt burden. The Congressional Budget Office recently projected a 2009 deficit of $1.2 trillion, and a cumulative deficit over the next 10 years of $3.1 trillion.

But if rising government debt is worrisome, at least it comes off a relatively low base. U.S. public sector debt was 38% of gross domestic product in 2008, a number that compares favorably to most other developed countries.

What's more, economists believe the government spending should help cushion the worst effects of the current recession.

"Debt is more burdensome if it occurs in a fully employed economy," said Northern Trust economist Asha Bangalore. "Debt from recessions and wars are viewed more favorably because it is incurred for establishing peace and stability."

Consumer and corporate debt has ballooned

By contrast, there is little to applaud about private sector debt, which hit 365% of private sector gross domestic product in the third quarter of 2008, according to government data. That's well above its 1990s average of around 200%.

And while skeptics have been warning for years that Americans were borrowing too much, questions about overleveraged consumers have spread well beyond academic circles.

"The private sector of our economy has borrowed too much money, businesses and consumers alike, fueled by ... some notion that housing prices would go up forever, that you could borrow money cheaply," Microsoft (MSFT, Fortune 500) CEO Steve Ballmer told House Democrats earlier this month at a retreat in Williamsburg, Va.

The massive expansion of Americans' debt burden reflects their embrace of credit during the early years of this decade, when policymakers countered a mild recession with years of low interest rates, generating an enormous housing boom.

House prices more than doubled in major cities, creating a so-called wealth effect that briefly made homeowners feel richer than they really were and boosted consumer spending as a proportion of economic output to near historically high levels.

Housing isn't the whole story, however. Many underperforming companies borrowed to fuel their expansion as well, in many cases opening new stores or rolling out new products in hopes of turning their fortunes around.

But when the credit markets cratered in the summer of 2007, that posed many problems for still-struggling companies that were now stuck with lots of debt set to soon come due.

That led to the recent bankruptcies of retailers Circuit City, Linens N Things and Goody's Family Clothing, and the protracted debt-restructuring struggles at General Motors (GM, Fortune 500) and Sirius XM (SIRI), among many others.

"There have not been enough people on the side of prudence," said James L. Clayton, a retired history professor at the University of Utah and author of the 1999 book "The Global Debt Bomb." "We have been moving toward this crisis for a long time."

Since the recession started at the end of 2007, Americans have changed their behavior. Household debt fell for the first time ever in the third quarter, as consumers cut up their credit cards and started saving money.

But the modest decline - household debt fell 0.8% from second-quarter levels - comes after years of rip-roaring growth. At $13.9 trillion, household debt has more than doubled over the past decade, according to the Federal Reserve's most recent quarterly flow of funds report.

The big debt burden for American households has implications for policymakers. President Obama earlier this month proposed a $75 billion plan to slow foreclosures and Treasury Secretary Tim Geithner has spoken of a plan to restore the health of big banks, but many observers say the administration needs to act more forcefully - and soon.

"From a social point of view people cannot be thrown out of their homes," said Bangalore. She said that when reduced mortgage rates and refinancing assistance aren't enough to make monthly payments affordable, "writedowns of the principal of mortgages will be necessary, as was done in the 1930s."

Bangalore isn't the first to call for mortgage writedowns, a process in which the loan principal - the value of the debt - is reduced. Vulture investor Wilbur Ross said last week he believes principal reductions will be necessary to break the housing crisis.

But any program that relies on creditors giving up some of their claims naturally won't be popular with those who are owed money.

Indeed, plans to nationalize banks and force bondholders to share in their losses risk recreating the market panic that followed last fall's collapse of Lehman Brothers, Pimco investment chief Bill Gross wrote in a recent commentary.

"The goal of future policy should be to recapitalize lending institutions while maintaining the basic infrastructure of credit markets," Gross wrote. "Outright nationalization and haircutting of creditors will do just the opposite." To top of page

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