Private debt and the Economy

Politics around public debt are distracting us from the fact that our economy is strangled by household debt.  Consumer spending drives 70% of the US economy.  That spending is crippled in over-indebted households.

Much of the consumer spending in the last decade was with borrowed money.  The economy grew because consumer borrowing grew.  Unsustainably high growth in consumer borrowing drove a massive increase in household debt from $4.6T  in 1999 to $12.5T in early 2008.  It is now dropping, slowly, so far only to $11.5T. 

More important even than the amount of household debt is its ratio to disposable income.  The ratio was steady at 64% from 1965 to 1984.  It began climbing steadily from 1985, reaching 97% in 2000 and peaked at 133% in 2007.  

Consumer spending is crowded out by paying interest on that debt and repaying it to cut future interest costs.  Household debt has dropped only to 118% of disposable income so far.  That is almost twice the steady-state from 1965 to 1984.  It will continue to be a great burden on the economy.

Three quarters of household debt (74%) is mortgage debt.  Mortgages were traditionally viewed as the cornerstone of a middle-income household’s asset-building.  That changed when home equity loans were introduced in the early 1980s.  One’s house could then become a source of disposable income.  In 2006, 9% ($800B) of total household disposable income came from equity loans.  

It is impossible now for most households to finance today’s consumption by borrowing against the equity in their house.  They likely no longer have any equity because house prices collapsed.  Others lost their job and could not get a loan even if they had any equity.

What to do?  We could bail out householders on a much larger scale by cutting interest rates on existing mortgages and the amount owed.  Banks holding the mortgages could be compensated by issuing more public debt.  Bankruptcy of individuals would then be averted in the same way it was for too-big-to-fail banks.  Consumers relieved of debt would in theory return to spending just as big banks returned to profitability.

The main reasons not to bail out mortgage-holders are it would further increase public debt and it would create “moral hazard”, i.e., encourage individuals to borrow more than they could repay expecting “the government” to bail them out.   The reason to consider it is that there seems no other way in the near term to revive our consumer-driven economy.   

My opinion is we should allow the creative destruction of household debt to unfold “naturally” (we should have done that with the big banks), protect our citizens from being made destitute as that happens (yes, that means more public debt), and invest all our creativity (and public investment when essential) to make our society successful in the evolving global economy.

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