Credit Contraction Leads to Diminished Spending: Consumption Won't Drive Recovery

Earlier this year, Meredith Whitney, the prominent banking analyst who foresaw the 2008 Citigroup meltdown, predicted that credit card lenders would cut the lines of credit to borrowers by a total of $2.7 trillion through 2010.

That would amount to a 57 percent reduction in the credit they made available two years ago at the height of the boom.

Aside from being a problem for the banks (who create money through lending it), this significant credit contraction will also be a problem for the rest of us since it will continue to shrink the economy.

How? Whitney puts it this way:

"90 percent of US consumers revolve their credit card at least once a year, meaning that they won’t pay their full balance at least one time a year. So, they think 'I’m using $1,000 of my credit line, but I have an extra $4,000. So my total credit line outstanding is $5,000. And I’ve only used $1,000. That unused $4,000 is my rainy day fund – if my dog gets sick or my kid needs braces or I lose one of my jobs.' With so many Americans relying on their credit cards as a source of liquidity, reduced credit lines would be like a major pay cut."

The latest news backs Whitney's contention, and it should give pause to any suggestion that we will simply "grow our way out of this."

The Federal Reserve just reported that outstanding consumer credit fell by $21.6 billion dollars in July from June, the highest dollar-value decline since tracking of the data began in 1943.

Analysts had forecast a drop of $4 billion, but the contraction was more than 500% worse than predicted.

It continued an ongoing pattern; credit fell for a sixth month, the longest series of declines since 1991.

Consumers, facing job losses, fear of job loss, and declining personal wealth, are saving more and spending less.

The economy has lost 6.9 million jobs since the recession began in December 2007, the biggest drop in any post-World War II economic downturn.

Meanwhile, plunging home values and stock prices have fueled a record $13.9 trillion loss in US household wealth since the middle of 2007.

This latest Fed data is a very clear signal that consumers won’t be leading us out of this recession. And that is obviously a great concern to the government, which can no longer be so reliant on consumer spending to fuel the GDP.

It also provides further evidence that GDP is tumbling.

Count on this; with a limited export base and declining domestic consumption, things will continue to get worse before they get better.