Will household debt derail the US economy?
US household debt hit a record $16.15 trillion in the second quarter of 2022. Mortgage debt accounts for 75% of the total; university debt by an additional 10%. The rest is mostly motor vehicle and credit card debt.
Growing household debt over the past two years is worrisome and will become a bigger problem as interest rates continue to rise. What is more worrying, however, are its consequences. Excessive debt can force people to cut spending, which will slow economic growth and lead to a recession.
$16 trillion is a big number. But what really matters is the debt versus what people have to pay back. College debt over $100,000 isn’t a big deal for doctors and lawyers who earn many times that amount each year. The situation is very different for teachers who earn half of what they owe.
From this point of view, things have improved lately. Household debt relative to disposable income fell from 150% in 2009 to 130% in 2016, where it has remained since; and household finances have improved during the coronavirus pandemic. Consumer debt payments (which exclude mortgages) relative to disposable income have fallen from 13% in 2007 to 8.4% at the start of 2021. Delinquencies (debt payments more than 90 days past due ) fell from 3% before covid to less than 2% in 2020 and 2021. Covid (which kept people home and reduced spending), low interest rates and generous government benefits during the pandemic ( stimulus checks, a child tax credit and a moratorium on college debt repayment) have helped achieve this.
Plus, debt isn’t always bad. Mortgages allow households to buy a home and gain equity when they pay it down. Borrowed money allows people to go to college and buy cars. Debt also allows people to survive hard times – a layoff, construction workers getting fewer gigs and non-gig workers getting fewer hours, or any disaster excluding employment for a while. . However, high debt levels make life stressful and difficult. People fear being evicted, shutting down utilities, putting food on the table and saving for retirement.
Household debt also stimulates the economy and creates jobs. But that too is a double-edged sword. Even a small reduction in spending due to high debt levels will have negative macroeconomic consequences. Inventories will pile up, companies will cut production and lay off workers. Service sector workers will receive less income and have their gigs or hours reduced.
The main force that has reduced consumer spending since the 1980s has been the greater share of total income going to the wealthy, who save a large portion of their income. That leaves less for households struggling to maintain their standard of living. Since low- and middle-income households typically spend almost all of their income, these households either got into debt or got more into debt.
But households can only manage a certain amount of debt. If the actual breaking point is uncertain, the economic results can be catastrophic once this limit is reached.
In 2008, the Great Recession started when homeowners couldn’t pay their mortgages. Lehman Brothers went bankrupt and many other financial institutions were on the verge of bankruptcy. The government bailed out the financial institutions that created the problem, but then did little to help households struggling with mortgages they couldn’t pay. This is one of the reasons why the economic recovery was so weak and it took almost a decade before household income (adjusted for inflation) reached its pre-2008 level.
A similar problem led to the stock market crash of October 1929 and the Great Depression. During the Roaring Twenties, people bought stocks with borrowed money. Once stock prices fell a bit, margin calls died out. Not having enough savings to repay loans from stockbrokers, people had to sell stocks to get cash to repay their loans. This drove stock prices further down, generating more margin calls and, ultimately, a stock market crash. What happened on Wall Street quickly affected Main Street as everyone became reluctant to spend money.
While household debt levels have yet to approach a tipping point, four forces will sharply raise debt-to-income ratios in the months ahead.
First, the Federal Reserve has raised interest rates since the beginning of this year. They plan to continue doing so until at least the end of 2022 (see “The Fed’s Battle Against Inflation: A Pyrrhic Victory? Or will the federal government join the fight? » in the Washington Spectator July/August 2022). This will raise rates on credit cards, college debt and auto loans. We’ve already seen a consequence of this: the ratio of consumer debt repayments to disposable income rose to 9.5% in the second quarter of this year (from its all-time high of 8.4% last year).
Second, the majority of household debt comes from housing. House prices have increased by 4.5% per year from 1992 to 2019. From 2020, they have increased by more than 10% per year, leading to an increase of almost 40% in house prices between 2019 and today today. Homes are less affordable today than they have been since June 1989. As the Fed continues to raise interest rates, house prices will start to fall, putting some homeowners under water . Similar to the Great Recession, many will not be able to pay off their mortgages and will lose their homes.
Third, President Biden recently announced that the college debt moratorium will end in 2023. This moratorium is one of the main reasons why household debt has been less of a problem during the covid pandemic. Earnings not used to pay off student debt went to pay off other debts and kept people from taking on more debt. When college loan repayments resume in January, many households will struggle to pay their bills and service their debt.
Finally, government benefits have helped American households during the coronavirus pandemic. These benefits have ended. Families struggling to make ends meet now have to rely on high-interest borrowing (credit cards, payday loans and auto title loans) to survive.
The good news is that households in financial difficulty can be helped. For starters, the Fed can stop raising interest rates before they push the economy over the edge.
A more difficult solution is meaningful bankruptcy reform, including allowing people to pay off college debt, rather than being squeezed through their working lives and then having everything they still owe taken away from them. their social security checks.
Before the Bankruptcy Reform Act of 2005, it was easy and inexpensive for people to reduce their debt by filing for bankruptcy. This is no longer the case. Now people have to take two courses in credit counseling before they see their debt reduced. Many studies have found these courses to be worthless. They do not change behavior, but they are costly for people who are already exhausted from their financial resources. Additionally, delaying bankruptcy protection leads to abuse by creditors and the possible loss of one’s home and car.
For many people, bankruptcy is the only option to escape crippling debt that stems from job loss, huge medical bills, divorce, and other unforeseen events. Changing the bankruptcy code is necessary. To that end, Elizabeth Warren (D-MA) introduced a new bankruptcy bill in the Senate in 2020. It remains stalled in committee for lack of votes to end a Republican filibuster.
A more liberal bankruptcy law would help, but it does not solve the underlying problem. People who rack up big debts and then wipe them out in bankruptcy court every half dozen years or so epitomize Einstein’s quip about insanity – it’s “doing the same thing over and over and expect different results. We need to address the root cause of the household debt problem – greater inequality. As noted above, when more income goes to the top 1%, everyone else has to pick up the slack by either spending more or taking on more debt. If that doesn’t happen, economic growth slows and household debt levels become more of a problem, not because of more debt, but because they have less income to pay off that debt. That’s why higher taxes on corporations and the wealthy and more generous spending programs (for example, reviving the refundable child tax credit and increasing Social Security and Medicare benefits ) are necessary. This is for the good of the economy and the nation.
Unless action is taken, household debt will continue to rise. And it will threaten to rise to the point of breaking the back of American households and the American economy.
Steven Pressman is a part-time Professor of Economics at the New School for Social Research, Emeritus Professor of Economics and Finance at Monmouth University, and author of Fifty great economists, 3rd edition (Routledge, 2013).