Housing Policy

Private Debt Is Crippling the Economy

There won't be a recovery until credit card and household debt levels come down.


America's economic pundits are not very creative. For the past several years, their gripes about economic growth have fallen into several staid categories: Monetary policy ("the Fed should do less" vs. "the Fed should do more"); the struggling housing market ("let housing bottom out" vs. "we must save housing"); income inequality ("it doesn't matter" vs. "it does matter"); and the federal deficit ("lower taxes, pretend to lower spending a lot" vs. "raise taxes, pretend to lower spending a little"). 

While most of these are legitimate causes of economic stagnation, there is another category that is having an outsized negative impact on growth: privately held debt.

The housing bubble should have been the warning needed to correct American thinking on debt, but the media's positive spin on reports that borrowing is "coming back" suggest the lessons have not been learned.

The concept of debt has a troubled history. Historically when debts accumulate to a breaking point, the associated social unrest can lead to revolution and insurrection. This sociological trend gave rise to the Occupy Wall Street movement, particularly regarding debt from student loans.

However, debt isn't inherently a bad thing. Innovation in the past three centuries has sped up societal evolution and technological breakthroughs at breakneck speed compared to the last 5,000 years, and much of this has been built on borrowing and lending.

Entrepreneurs with ideas often don't have the capital to launch their business, and organizations with capital often don't have the ideas to grow that money on their own. The beauty of finance is that we have developed tools to connect these two groups so that the entrepreneurs and capital investors have mutual benefit.

The biggest challenges of debt come when loans are taken out irresponsibly (like no income, no job mortgages), when money is borrowed for consumption rather than investment (like excessive credit card debt), and when lenders are guaranteed a return of their money by law even in the case of bankruptcy (like student loans that are not discharged in bankruptcy, one of the leading reasons for the Occupy complaints).   

Unfortunately, all of those examples of irresponsible borrowing and lending are from the past few decades in America. Since the mid-1990s, privately held debt has soared to record highs. Promises that housing prices would rise forever deluded households into taking out big mortgages. At the same time a bull market in equities and low interest rates for several years made the costs of borrowing appear inconsequential.

Many borrowers believed their debt was for a good investment (and therefore "good" debt), or weren't concerned about taking on a high mortgage or big credit card balances because perpetual economic growth would solve all the problems. But the bursting of the housing bubble left households with high levels of debt to deleverage or to take into bankruptcy court.

This part of the story is well known in towns across the country, but what is not widely recognized is that this debt level is also preventing the private sector from rebounding after the recession.

For those who believe that the problem in the economy is aggregate demand, high debt levels mean households are limited in what they can contribute to consumption. Even if stimulus was able to build a bridge through a recession, the historically high levels of debt have years of deleveraging ahead of them, keeping consumption off the table as a way of spurring recovery.

For those who believe that aggregate supply could boost growth, small businesses too are saddled with having to pay the bill for decades of fun since many are linked to individuals and households, and therefore don't have the capacity to invest at levels needed for a robust recovery.

Washington has tried to solve this problem by encouraging more borrowing to get the music going again. Public support for more quantitative easing is primarily focused on pushing down interest rates so that businesses and households will borrow again. The Federal Reserve's purchases of housing debt are about lowering mortgage prices so households will borrow again to buy homes.

This has led to the media buying into the idea that if only Americans could borrow again, aggregate demand and supply would bounce back. An article from Businessweek on Monday referenced recently increased bank lending as "supporting" economic growth.

This is totally backward thinking. Literally.

Recovery should not be defined as moving backward to the way the economy used to be structured. That was a bubble, built primarily on cheap credit and not long-term investments.

Moreover, much of the recent borrowing increases have been in revolving credit, primarily credit card debt, in order to meet basic needs. That is not the kind of consumption that will generate a recovery, especially since the costs of credit card debt are high and will weigh back down on household balance sheets in the months and years to come. A recovery built solely on expanding consumer credit and mortgage credit is simply another bubble and unstable economic foundation.

America had started the process of household balance sheet deleveraging after the bubble burst. Mortgage debt levels have fallen sharply. And consumer credit—all debt other than mortgage debt—was declining as well. But in the summer of 2010, as the post-recession faux-recovery created false hope that the good times were back and as savings decimated by the bursting bubble began to hit zero in the midst of a weak economy, consumer credit levels (led by credit card purchases) began to rise again.

The figure below shows that consumer credit fell 7.1 percent from June 2008 to June 2010, but since then has grown 6.9 percent to June 2012 (according to data released this month by the Fed).

Total Consumer Credit

The rising aggregate consumer credit level means that household balance sheets are not shedding debt like they need to in order to contribute substantively to economic growth. Unless this changes, we're pretty much screwed.

High household debt means less economic and labor mobility. Families cannot move to better employment if they are stuck in a house they cannot sell or have credit card bills crushing their credit score and making it harder to move. Private sector debt also means fewer family vacations, no upgrades on household appliances, and less investment.

Perhaps most damning is that households deep in debt mean downward pressure on entrepreneurial expansion. Many small businesses are family run, or are financed from household balance sheets. As long as entrepreneurism is stagnant, the U.S. economy is not going to see real growth.

Rather than public policy seeking to make borrowing cheaper, American leaders need to allow for household balance sheets to deleverage. That will mean short-term economic pain in exchange for a more robust economic growth period on the other side. And since the economy is in stall mode currently, the directly-associated pain will be muted anyway. Both President Barack Obama and his Republican opponent Mitt Romney are kidding themselves if they think they can inspire a recovery in the next several years without consumer credit levels falling and household debt levels coming down.

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  1. http://finance.yahoo.com/news/…..45522.html

    And debt loads are coming down. Recessions are like hurricanes. They suck but they serve a purpose. If the morons running the Fed and in government would ever understand that and just let recessions run their course, we would be a lot better off.

    1. That and not cause the bubbles in the first place.

      1. Asset bubbles happen.

        1. Not on the scale of the dot-com bubble or the real-estate bubble, or the boom leading up to the great depression. Those were all fueled by artificially low interest rates manipulated by the fed.

          1. ^What this guy said

          2. Right. Bubbles happen, but their size can be influenced by additional factors.

        2. Exactly, and there is no way to prevent them. An asset bubble is just the economic version of a fad.

          1. Yup. And you have to be willing to let them happen and then collapse. Sometimes people go broke.

        3. John, if you think asset bubbles are strictly independent of policy, you’re kidding yourself. Let me tell you a little story. I work for an asset manager. In the 2003-2005 period, I remember the former head of investments telling his team that their job was to “get money out the door”. That doesn’t leave a lot of room for due dilligence. Right now, one of our major concerns is finding investments with enough yield to pay our minimum rate guarantees. You’re kidding yourself if you don’t think that entails going out on the risk-reward spectrum.

    2. If you count student debt, I’m not sure household debt is actually declining.

  2. If the bank would just raise my credit limit again, I could go out and help boost the economy.

    It’s all the banks’ fault that the economy isn’t growing.

    1. When they turned of the HELOC spigot, Californians turned to 401k loans. Now that those are maxed out, there are a lot of ads on the radio for “auto title loans”, which would have helped, except that we Californians are all leasing our cars.

  3. Remember, monetary and fiscal policy is aimed at avoiding deflation.

    In the absence of stimulus, even employing the Keynesians’ own theory, what would have happened was a general collapse of asset prices, accompanied by a general liquidation of debts secured by those assets.

    That’s the “quick and dirty” way to shrink total private debt. But it wasn’t allowed to happen.

    The PTB are committed to supporting asset prices and existing asset holders. The only way to do that is to keep the debt cycle going. A general system reset, with prices, debt, leverage, and the money supply at substantially lower levels, was the thing they labored most passionately to avoid.

    1. IOW, the government will inflate Quantitatively Ease the debt away.

      1. The trap they are in is that inflating away debt destroys the balance sheets of institutions (banks, mutual funds, etc.) holding the debt.

        Inflation raises interest rates, which devalues existing debt at lower rates.

    2. The PTB are committed to supporting asset prices and existing asset holders.

      More specifically they are committed to preventing the liquidation of bad debt instruments that would ruin WS billionaires. Economic growth and everyone else be damned.

      1. Exactly.

        If you have enough money, you can buy yourself the government — which is exactly what has happened.

  4. Something I’ve been telling people since before the recession began. The national debt is a problem but FAR worse is private sector debt levels that we have seen.

    Another thing I would love to see some economist do is a study that correlates total national debt (All levels of government, Private debt, corporate debt, and financial debt) with economic growth. I would be willing to bet that the negative correlation is even stronger than it is with national debt.

  5. I recently came to the realization that if I paid off my house and car loans, I could get away with making half my annual salary.

    1. Buy a car used and keep it for ten years. Get it on a five year note. and never keep any credit card debt. A house loan and the odd car loan are the only debt you should have unless you just can’t avoid it.

      1. I take great amusement in all the BMWs and Audis I see on the roads. Like chains tied around the ankles of the drivers.

        Years ago I tended to consider some level of consumer debt ok. Now I have zero. I drive much less car than I can afford and transfer a fake “car payment” to my savings account every month. The feeling of freedom it brings is priceless. I laugh at people who live in fear of losing their job. Once you have no debt and a few years’ worth of savings in the bank, you can pretty much say fuck you to anyone, and it is great.

        1. The concept of “less car than I can afford” is even a problem.

          An expensive car isn’t a priority for a lot of people. There’s a lot more to life.

          If buying the car keeps you from doing anything that matters more than a car to you, you really can’t afford it, at least as a rational participant in the marketplace.

          I drive “much less car” than they’d lend me the money to buy. That’s a different question…

          Actually, I love the thing, for its own sake. But be that as it may, if I have to give up having those savings and the freedom you’re talking about, I can’t REALLY afford the car. No car is worth that.

        2. BMW’s? Feh! I have 2 Lamborghinis at home.

          And saving for their college funds is killing me.

        3. I drive a BMW. I got it when it was 7 years old and had 80,000 miles, and the “prestige” pricing had worn off. 3.5 years later, it’s at over 100K and will run great for another hundred. It’s not the brand of car, it’s the quality. But yeah, buying less car than you can afford is a great idea. Buying quality used is a better one.

      2. A house loan and the odd car loan are the only debt you should have unless you just can’t avoid it.

        Going to college/grad school sans student loan debt is extremely difficult these days, if not impossible. Yes, even on the, ‘CC for the first two years, state school the last two’, plan. But I otherwise agree with you.

        Taking on debt to fund pure consumption is absolutely silly.

        1. Very true, but if you play your cards right, your student loan debt will basically be equal to or less than a car loan. The people who get in trouble with five figures of student loans didn’t play their cards right.

          1. Not to mention, there is still too many people out there who go to school for the experience and not an education. Yeah, drinking everyday and not working sounds like fun, but don’t bitch when you have to pay that experience back.

    2. I recently came to the realization that if I paid off my house and car loans, I could get away with living on my wife’s salary.

    3. I read Dave Ramsey’s “Total Money Makeover” book recently, not because I needed one, but I was curious as to why he has such a strong following of debt free people.

      While his advice is not perfect (see his debt snowball step) I am going to start suggesting it to every idiot I know who groans about how unfair their student loan debt is.

  6. Personal debt is a big reason why stimulus efforts have done nothing. Americans are maxed out. They need time to repair ruined balance sheets. This has to happen and it has to be painful. We keep pretending there is some way around it when there isn’t.

    I do think it will also change because the boomer “me” generation borrowed to immedaitely fulfill just about every desire. I think there is some evidence that their kids generally have a more responsible view. This is good, because a society that is not in debt up to its eyeballs is not prone to shocks on the order of 2008.

    1. We keep pretending there is some way around it when there isn’t.

      Sure there is.

      Emergency bankruptcy laws to facilitate rapid deleveraging are possible and would work.

      1. Except for one thing…

        When so much of the economy is dependent on people borrowing ever more money to buy consumer goods, having a lot of people with a BK will not do a damned thing to make it grow.

        These people won’t be able to borrow anything for a while, and everyone else will be even wiser about doing what they saw driving their neighbors to bankruptcy. Boats and cars don’t look so sexy when the sheriff is hauling them off.

        1. Yes, but it will stop the deflationary aspect of declining total debt and it will set the stage for real reform from a consumption driven economy to a production driven one.

          The thing is that it will happen anyway. The only question is whether it is better to have it play or over a few years of many decades.

          1. How will erasing mountains of total debt be anything but a decline in total debt?

            “The only question is whether it is better to have it play or over a few years of many decades.”

            That’s true, but the argument that reducing the total debt by a huge chunk will not be the same as, well, a huge reduction in the total debt, doesn’t hold up. We’re going to have to suck it up.

            1. The difference is in who bears the burden and how quickly we can return to a normal growing economy.

              Rapid deleveraging, through some form of bankruptcy, will hit the creditors that caused the preceding inflation and lead to a return to normalcy in relatively short order(a year or two).

              Prolonged deleveraging via some form of currency devaluation will benefit the same creditors at the expense of everyone else and lead to prolonged stagnation.

              The thing is that we would have had rapid deleveraging if the government had stayed out the situation in 2008. The fact that government intervention prevented that from happening is one of the source of the current stagnation. And has also undermined respect for free markets and private property in the general public. The moral hazard created by all of the preceding is much greater in my mind than the moral hazard created by government action to restore the status quo ante circa 2008 of financial industry failure and deleveraging via some form of emergency bankruptcy.

              IMO the situation is further complicated by the fact that over-regulation is more than 50% of the current problem with our economy. Buy I don’t think that we can begin to address that issue until the financial sector becomes functional again.

          2. Deflation and deleveraging are two words for the same thing.

    2. Their kids probably do have a more responsible view.

      That’s whey the boomers will use the government to steal that money from those younger than they, and “redistribute” it to the boomers. The mechanism is already in place, and if we don’t change anything, this will happen by itself.

  7. But easy access to credit creates prosperity! Remember the big run-up in housing prices from 2000 to 2007, and how rising home equity allowed so many Americans to experience the dream of home ownership, and then tap that rising equity to buy new cars and clothes and take vacations? Think of how many realtors and car dealers and department stores and hotels and restaurants profited from that spending spree, and all the sales taxes they paid! Everyone was doing much better back then!

    1. My meta narrative is that the run up in consumer debt papered over the economy destroying regulations that began under pappy Bush and have accumulated without pause for the last twenty four years.

      1. Well, yeah. Not just your meta narrative. I’ve thought exactly that since I really started paying attention to this stuff, in the late ’90s.

  8. It seems to be a mistake to think only of the curtailment of spending by debtors and not think also about the spending patterns of creditors. Every dollar that a debtor pays goes to someone who also consumes or saves his income.

    This doesn’t seem true for government debt, in that the people responsible for paying off the debt, the taxpayers, are forced into that position. “We owe it to ourselves” seems true for private debt but not for government debt.

    I am happy to be corrected.

    1. I’d be happy to correct you if I knew WTF you are saying.

    2. My attempt at answering my question:

      My sense is that the problem of debt overhang arises because of the difference between stocks and flows. Although the debt-holder can spend the interest that the debtor pays her, the debt-holder cannot spend the principal at the present time.

      So the effect of debt on spending is asymmetric. Bond buyers are reluctant to buy securities from high-debt businesses because a larger share of the businesses’ profits will go to pay off existing debt-holders. But no corresponding mechanism induces existing debt-holders to invest more of their own resources.

      I’m writing this because the problem of debt overhang isn’t actually addressed in this article, so I am trying to piece it together for myself. I’d be happy to learn more about debt overhang from any commenter (barring Aresen, who seems only interested in insults).

      1. Debt is nothing more than shifting demand from the future to the present. The debt overhang is the accumulated destruction of demand.

        It cannot be avoided. The only question is who pays the piper – the borrower, by paying the loan off, the creditor, by default on the loan, or some combination of the creditor and everyone, by inflation/currency debasement.

  9. It seems to be a mistake to think only of the curtailment of spending by debtors and not think also about the spending patterns of creditors. Every dollar that a debtor pays goes to someone who also consumes or saves his income.

    This is a common misconception.

    With fractional reserve banking, lending creates new money and repaying the loan destroys the new money.

    And the current system is even worse because there is no real money anchor on the fractional reserve side of the equation.

    1. It’s true that the quantity of money varies with the ratio between currency and deposits, which is another way of making your point. But the problem as I understand it is not a monetary one so much as a financial one. The reason why debt might be a problem is not that the money supply contracts but rather that spending falls. That may cause problems but it is a different issue.

  10. But the problem as I understand it is not a monetary one so much as a financial one.

    The two phenomena are tightly related, but different.

    In a FRB system when outstanding loan repayment exceeds new loan origination the quantity of money declines because the the principle repayments are a net loss to the economy. The money so spent vanishes, it is no longer avaible to the debtor nor is it transferred to the creditor, as would be the case with a private party loan.

    1. The principal repayments are not a net loss to the economy, they are a contraction of the money supply. These are not the same thing.

      1. They are a loss in purchasing power for the borrower and when credit is contracting overall the aggregate is a net loss in purchasing power and classic bad-deflation.

        Which as it works its way through the economy causes businesses to close and consumers to retrench. Causing lower employment, lower utilization rates and less trade. All of which are negative to the economy.

        In a perfect world all prices would simultaneously reset based on increases or decreases in the quantity of money. But we are very far from that ideal and changes in the money supply do cause real dislocation.

  11. Good article, with one minor quibble.
    You say:
    “The biggest challenges of debt come when loans are taken out irresponsibly…”
    Yes, that is true, but the sentence should have this addition “…and when they are approved irresponsibly.”
    Giving lending institutions a pass on irresponsible loans is missing at least half of the problem.
    I remember when I bought my first house the rule of thumb was one weeks salary equal to your one month’s mortgage payment. If you did not fall somewhere in that range (or close, maybe 30% rather than 25%), you would not only be creating hardship for yourself, but the bank would probably reject you anyway.
    Individuals may have lost that level of responsibility, but so did banks.

  12. Oh come on, do I have to be the first one?

    If you’ve been successful piling up debt, you didn’t get there on your own. You didn’t get there on your own. I’m always struck by people who think, well, it must be because I was really good at getting credit cards and buying stuff I couldn’t afford. There are a lot of out there with credit cards who buy things they can’t really afford. It must be because I went shopping more often everybody else. Let me tell you something?there are a whole bunch of people who shop a lot out there.

    If you were able to fill out an application for credit, use a computer to buy stuff online, or drive an expensive car, somebody along the line gave you some help. There was a great teacher somewhere in your life. Somebody helped to create this unbelievable American system that we have that allowed you to get credit cards and assume debt. Somebody invested in roads and bridges that are used to drive those new cars on, deliver credit cards, and ship mail order merchandise. If you’ve got a pile of debt?you didn’t spend that. Somebody else made that happen. The Internet didn’t get invented on its own. Government research created the Internet so that all the companies could make money off the Internet.

  13. Entrepreneurs with ideas often don’t have the capital to launch their business, and organizations with capital often don’t have the ideas to grow that money on their own. The beauty of finance is that we have developed tools to connect these two groups so that the entrepreneurs and capital investors have mutual benefit.

  14. Informative post. Most of Americans would like to consider about debt option when they wants to have money for filling their bills and payments. It’s true fact that private debt is crippling the financial economy.

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