THE GREAT DELEVERAGING IS UNDERWAY.

Both households and businesses are fast wringing out past excesses. Those efforts, plus the government stimulus, offer hope the economy will begin to stabilize in the second half of 2009.

Before the U.S. economy can get on the road to recovery, consumers and businesses have some wrenching adjustments to make. Households are trying to free themselves of debt they have accumulated in recent years, and they are saving more, even as the recession ravages incomes. Meanwhile, companies are working to align their capital spending, inventories, and payrolls with the realities of weaker demand, both at home and abroad, with no real sense of when business will improve. All this is contributing to the longest and steepest recession since the 1930’s.

However, the sharp drop-off in the economy in recent months also implies consumers and businesses are wringing out their excesses with surprising speed. The rapid pace of adjustment offers some hope that, with help from Washington’s major efforts to lift demand, the economy can begin to stabilize in the second half.

Households have already substantially boosted their savings rates. The $12.7 trillion loss in the value of household assets since the summer of 2007 has decimated nest eggs and created the imperative to save more. Savings, as a percentage of income averaged 4.3% in January and February, the highest two-month average in more than 10 years.

Perhaps more important, the liabilities side of households’ balance sheets shows consumers have also made a significant start toward deleveraging. For the first time since data were initially collected in 1952, the volume of outstanding household debt shrank in the fourth quarter of last year (see chart).

There is a long way to go. Economists believe efforts to pay off debt and lift savings will keep consumer spending, this year and next, well below its long-term growth rate of about 3% annually. That will be a big factor weighing on the strength of the recovery.

However, the numbers are saying that deleveraging is on a fast track. Housing demand is already weak enough to restrain new borrowing, even as solvent homeowners continue to pay down debt and rising defaults and debt forgiveness effectively cancel obligations. The net effect: a further, perhaps faster, drop in household debt.

Less borrowing and more saving by consumers has, in turn, forced businesses to accelerate cost cutting efforts in recent months. Companies have slashed payrolls and pared inventories. The 28% reduction in equipment spending was the largest quarterly drop recorded in 50 years.

How the mighty have fallen. In recent years financial corporations have contributed about 30% of all domestic profits. However, since the summer of 2007, they have accounted for 70% of the earnings declines.

Companies outside of finance are fast becoming well positioned to benefit from even a modest pickup in demand, especially given their steep cuts in labor costs. With Washington stimulus programs designed to boost demand, sales gains could flow quickly to the bottom line, even as consumers rein in the debt and save more.

Excerpts taken from April 23, 2009 issue of BusinessWeek Magazine, Business Outlook Article written by James Cooper.

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