How to get out of Debt: Can it be the American Consumer is Contributing to Deflation by Paying off Debt?

The Federal Reserve flow of funds report was issued this week and for the first time since 1951, when records started being kept household debt has actually declined.  The larger meaning of this?  Many Americans simply cannot take on anymore debt.  What it also means is that many Americans are more reluctant to take on more debt onto their balance sheets.  That is an important shift in consumer psychology.  Even if the government tries to encourage spending by giving banks and lenders easy access to money this does not necessitate that people actually use the money or use the money to spend.

The retail sales numbers came out today and once again they have declined for the 5^th straight month.  People are simply not spending as much.  That is why when I talked about 10 reasons we will have a minor depression, I noted that retail sales will play a big factor in determining a point where we may hit a bottom to our current economic problems.  Until we get employment and retail sales back up, we will not be out of the slump.

Take a look at this chart showing consumer debt topping out:

*Source:  CNN.com

Even though the drop of 0.8% is tiny, it does signify a shift in what is going on but more importantly it is another factor showing us that we are clearly in a deflationary environment.  The Federal Reserve and U.S. Treasury are doing all they can to avoid deflation because deflation unlike inflation, causes people to pull back on their spending more furiously.  Think of the Great Depression.  Why would you purchase a home today when you know it will be cheaper tomorrow?  Why would you go out and buy a car today when next year it may be significantly cheaper?  That is the consumer psychology making the rounds right now.

With inflation, there may be an incentive to purchase now.  As perverse as the housing bubble was, if you were to believe housing prices always went up you had an incentive to buy today.  If you felt the home would be more expensive next year, you’d go out and spend today.  As bad as inflation is, it is more manageable at least from a monetary perspective.  If inflation gets out of control, they can simply raise rates.  With deflation?  They have very little in their arsenal to combat it.  That is why the effective rate on the market is near zero already.  That is why the government is not only the lender of last resort now, but it will also be the spender of first resort.  The data in this recent report tells us people are not spending and actually paying down current debts.

Part of this also comes from U.S. households losing $2.8 trillion in the third quarter in their net worth:

That is a painful decline.  This is a drop of 4.7% and the largest decline in the 57-year history of the report.  It also marks the fourth straight quarter of declines.  You also have to keep in mind that this report does not include October, November, and December which have been even tougher months.  Where did the markets end on September?:

Dow:               10,850
Nasdaq:           2,091

S & P 500:       1,166

What you can expect is the net worth of many Americans will show significant declines again for the fourth quarter of 2008.  I would also suspect that given the debt destruction by people defaulting on mortgages and credit cards, that you will see debt decline once again.

So what can you do in this climate?  If we are to remain in deflation for a short period, the best thing you can do is pay down any debts you may have.  This should be a primary target.  In fact, you should go after credit card debt first.  Why carry a balance of 15 percent or higher when a savings account is only yielding 2 percent?  Pay down that 15 percent and you’ll at least know that you are “earning” a 15 percent return right now in this market which is practically unheard of.

The balance sheet of many Americans may look weaker but there are things you can do.  If you are planning on buying a home or a car, don’t.  These two sectors are deflating at incredible rates and all economic fundamental data is pointing to further declines.  What do you think automakers are going to do next year?  They are going to have inventory overload and will look at ways to moving the items.  In economics the best way to move something is through price.  Lowering the price.

I wish I could say the same about the U.S. government but we are going to be in debt for some time.  It doesn’t look like in the short term we are going to do anything to address our massive debt.  Given the current employment situation and fragility of the credit markets, I just don’t see anyone advocating a balanced budget approach.  But that doesn’t mean you shouldn’t try to get your house in order.  You should.  Even people that make $46,000 for their household can find ways to save.  It takes flexibility and adaptation but it can be done.  Hopefully this gives you a few ideas on how you can prepare.

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