Recession's root cause is consumer debt, expert says

March 31, 2008 -- There's no magic bullet, says Steven Fazzari, economics professor at Washington University in St. Louis. The root cause of the current economic slowdown in the U.S. goes back several decades. There has been a concurrent wave of increasing consumer spending and rising consumer indebtedness. In the past, consumer spending actually helped the economy as it raised firms' sales and encouraged more hiring. But the associated rise in household debt, most obviously in the recent housing bubble, has come back to haunt the U.S.

"For more than two decades we had consumer-led growth, which actually mitigated the recessions of the early 1990s and 2001," Fazzari says. "Part of the reason we had mild recessions was due to consumer strength. But we kept building up debt. It was also a period of falling nominal interest rates. This meant that every cycle of low interest rates was another opportunity for people to refinance on better terms and extend their spending further."

The economy is changing, however, and we can't rely on consumer spending to keep rising beyond its already inflated level; households can no longer push the debt limit because the credit isn't there. Even the Federal Reserve Bank's move to lower interest rates doesn't give Fazzari much hope for a turnaround.

"Bernanke deserves credit for creative approaches to containing instability in financial markets," Fazzari says. "But the source of the recession comes from structural problems that need to be changed. Bail-outs may help prevent everything from cascading further, but the Fed does not have the tools to solve these problems.

Steven Fazzari

"Unfortunately, the cost of letting institutions fail is worse than the cost of bailing them out, but ultimately, the Fed will not be able to stop the downturn in consumer spending. The household sector just has to retrench and repair its balance sheet. In the meantime, the result is a weak economy," he says.

Fazzari notes that the stimulus packages proposed by Congress and the presidential candidates could be useful as well, but even those policies aren't nearly large enough to prevent a deep recession.

"With those proposals, we're talking about something that is a quarter of the size of what's necessary to turn things around."

Editor's note: Professor Fazzari is available for live or taped interviews using Washington University's free VYVX or ISDN lines. Please contact Shula Neuman at (314) 935-5202 for assistance.