US recovery a decade away, at least

Financial Review

PUBLISHED: 30 Jun 2012

Anna Bernasek

The Federal Reserve dropped a bombshell recently. Two decades’ worth of wealth creation by the middle class had been erased in a mere three years as a result of the financial and economic crisis.

The Fed reported its findings in its June bulletin. What many American families had been feeling but couldn’t prove was in plain sight, an indisputable fact in black and white.

But what can we make of it? What does wealth destruction of that magnitude mean for the future?

First, look at the number that got everyone’s attention. Real median net worth fell almost 40 per cent to $US77,300 in 2010 from $US126,400 in 2007, according to the Fed’s 2010 Survey of Consumer Finances.  

The 40 per cent drop is unprecedented. At least since the Fed began keeping track of consumer finances in 1989, a fall in median net worth had never occurred, let alone of 40 per cent.

The median figure gets to the real middle of the nation, where the story is very different from the top. What that median figure says is that out of 114 million households, 57 million have a net worth of less than $US77,300. On average, a household represents about three persons. For families facing retirement, serious illness or unemployment, $US77,000 will only carry them so far.

The Fed also reported that median family income fell 7.7 per cent to $US45,800 in 2010 from $US49,600 in 2007. Put the median income and wealth figures together and you get a picture of the middle class that’s dangerously stretched. Instead of net worth approaching three times income, middle-class families now have accumulated net worth less than two times income.

What’s behind the sharp fall in net worth? The main culprit is the housing crisis and the historic drop in home prices. Yet there’s something more at work. While nominal home prices fell on average 30 per cent, real net worth fell almost 40 per cent.

The difference is due to leverage. Look at a simple example. If a person buys a $200,000 home and finances it with a $100,000 mortgage, that buyer has a home equity of $100,000. If the price of the home declined 30 per cent, the house is now worth $140,000. That person’s net worth, though, has fallen much more. The mortgage is still $100,000, but equity has dropped 60 per cent to $40,000.

The bigger drop in net worth than in average home prices has taught Americans a costly lesson. Leverage is great on the way up but vicious on the way down.

The downturn has exacerbated America’s wealth inequality. While the middle class mainly have their net worth tied up in housing, the wealthy tend to have more of their net worth in financial assets. While housing prices fell 30 per cent, stocks quickly rebounded and settled at a 12 per cent loss.
So while the middle class has suffered an unprecedented destruction of wealth, the top earnings households haven’t suffered as much.

For generations, the US relied on a virtuous cycle of wage growth and consumption to power the economy. How long it takes to rebuild household net worth may be a good indication of when the economy will return to strength. And it might be a long way off.

There are two main ways to rebuild net worth. One is through savings and the other asset appreciation. The personal savings rate is calculated as personal saving as a percentage of disposable personal income. At the current 3 per cent rate, it would take about 17 years to get back to the 2007 level of household net worth.

As for asset appreciation, it doesn’t look like that will happen soon. Home prices in some parts of the country are still falling.

Just to get back to where household net worth was in 2007, home prices need to rise by more than the 30 per cent nominal fall in prices. Using the example again of a $200,000 home and a 30 per cent drop in prices, it would take a 42 per cent rise in price to get back to the original $200,000. There’s no chance of this in the near to medium term.

So if anyone tries to tell you that an economic recovery is just around the corner in the US, go ahead and agree. But be prepared to wait at least a decade, if we’re lucky!