Collapse of 25-year debt surge not just economic cycle

The nation's wrenching downturn is the flip side of a debt-fueled bubble, mostly in housing, that grew the economy to unsustainable levels.

Because of the historic extremes reached on the upside, the unfolding collapse may well be more than just another economic cycle.

Reflecting deep and widespread pessimism about the economy, the Dow Jones industrial average fell more than 5 percent yesterday. That left the widely watched indicator 47 percent off its peak in October 2007.

The Dow's close of 7,552 means it is trading at its lowest level relative to member-company earnings since the deep recession of the early 1980s - showing just how much deterioration investors expect in the economy.

"It's an ugly mess out there," said Randy Bateman, who oversees $15 billion as chief investment officer of the asset-management unit of Huntington Bancshares Inc., of Columbus, Ohio. "The economy is confirming it is very, very weak."

It is a frightening predicament, and there are no obvious ways out of it. Each day brings jarring evidence of a calamitous situation:

Jobless claims soared to a 16-year high, the U.S. Department of Labor reported yesterday.

An index of leading economic indicators fell in October for the third time in four months.

"We're still in the phase where things get worse and worse and worse," said Robert Dye, senior economist with PNC Financial Services Group, of Pittsburgh.

Especially disconcerting is that "a good percentage of the workforce has not lived through a severe recession in their professional life," Dye said. "I think we're moving in that direction."

Economists said that getting the economy growing again would be extremely difficult because it was coming out of a speculative boom fueled by tremendous innovation in financial instruments that failed miserably when tested by declining house prices.

That failure ended a Wall Street tear that started in the 1980s, which is when Americans started increasing debt faster than income for a sustained period of time. The surge was driven by the convenience of credit cards and the democratization of debt, giving almost all consumers the chance to borrow for cars, houses, and the stuff to fill them with.

Consumer spending is the lifeblood of the U.S. economy. Sharply limiting it is likely to make for a slow revival of that economy.

"Now we have a test," John Silvia, Wachovia Corp.'s chief economist, said. "Are we going to start to unwind . . . part of this 25-year buildup of consumer debt in terms of cars, housing and credit cards?

"You can see the major problem our society has if we were to reverse that" trend toward higher debt relative to income, Silvia said.

Doing so could mark a fundamental shift in the U.S. economy, with implications for how much consumers can do - largely by whipping out their plastic - to get the economy going again.

Furthermore, less borrowing could mean U.S. auto sales might never fully recover. That should raise serious questions for lawmakers considering an auto-industry bailout about just how many factories Detroit needs.

"It's not just a cyclical downturn," Silvia said. "I think we've got some interesting challenges here."

One is that the Federal Reserve has set the interest rate it controls so low that further downward moves are unlikely to help the economy.

Economists say the most important thing for the federal government to do is spend at least $300 billion on economic stimulus. "Now is not the time for half-measures," Dye, the PNC economist, said.

However, such spending will only worsen a federal deficit that is already projected to reach its highest level, relative to gross domestic product, since World War II. And that's before anyone even starts to talk seriously about looming costs for baby boomers' health care.

Despite all the dark clouds, there are some reasons for optimism, economists said. All the moves by the Department of the Treasury and the Federal Reserve will eventually have an effect. Declining energy prices are boosting pocketbooks by billions relative to costs over the summer.

But that's not much, given the difficult road ahead.

"What we're going through now," said Mark Zandi, chief economist at Moody's Economy.com in West Chester, "is scarring."