A Note on Consumer Debt

As our government continues its journey toward the debt-crisis iceberg, the private sector is actually seeing a bit of debt relief.* This is good, because it eases the burden on taxpayers who are going to have to fork over gobs of money to government in the near-to-distant future. Not only will taxes go up to fund our never-ending government, but we are also going to see higher costs in the form of:

  • Higher interest rates when our over-indebted government’s credit rating tanks, or
  • Massive inflation when our over-indebted government’s credit rating tanks and it decides to fill the deficit gap with ripe new greenbacks from the Federal Reserve.

Whether through taxes, interest rates or inflation, one way or the other we are going to have to pay the bills for our welfare state.

Good thing, then, that America’s households in general are less indebted now than they were in the recent past. Figure 1 reports the Debt Service Ratio (DSR), which is the cost of household debt as share of disposable household income. That ratio fell dramatically after the Great Recession and has remained low since then.

The DSR is compared to an interesting ratio that is not talked about that much, namely revolving consumer credit as share of total household debt. More on that in a second; first, behold Figure 1:

Figure 1

Source: Federal Reserve

The revolving-credit part, which is pretty cool, consists of credit cards and comparable consumer credit that you can use, pay off and use again. It differs in that respect from installment credit, which we know primarily as mortgages and car loans. It was invented as a consumer product in the 1960s and became a relevant credit product during the ’70s.

Its share of total household credit topped out at 40 percent in the late 1990s. The reason was not primarily that people became more responsible with their indebtedness, but that the non-revolving kind has continued to increase at steady pace. Looking at five-year periods,

  • In 1970-75 households increased their volume of non-revolving debt by 49.3 percent. Revolving credit – which again was new at the time – increased by 243.4 percent.
  • In 1975-80 the two expanded at, respectively, 60.7 percent and 307.4 percent.
  • In 1980-85 non-revolving credit continued its steady expansion, growing at 43.5 percent; revolving credit increased at 91.9 percent.

The disparity continued through the 1990s; the period 2000-05 was the first five-year episode since the 1960s when non-revolving – installment – loans outpaced revolving credit (50.7 vs. 30.2 percent). Since then, the traditional mortgage-and-car type of credit has grown faster than credit cards.

It is actually good for the U.S. economy that households have returned to more traditional debt. Installment loans are tied to households building equity; even a car loan is a form of equity-building, as the car gets paid off over time. That said, there is one aspect of consumer debt that is not apparent in the numbers we have looked at so far. Figure 2 reports the long-term trend in consumer debt as share of personal income. It has never been higher than in recent years:

Figure 2

Sources of raw data:
Federal Reserve (Debt); Bureau of Economic Analysis (Income)

The combination of Figures 1 and 2 gives us a clue as to what will happen to our economy when (not if) our beloved federal government strikes that iceberg. The cost of consumer debt – the Debt Service Ratio – has gone down while consumer debt itself has risen only because interest rates have gone down and installment payment periods have been extended (especially on car loans). Higher interest rates will, in a heartbeat, inflict major damage on the cost of household debt; if the debt-to-income ratio had been half of what it is today, the shock-absorb margins in household income would obviously have been bigger. That is not the case now; the only advice to give American consumers is to free up as much room as ever possible in their finances.

If we don’t get an interest-rate shock we will get an inflation shock. That, in turn, is akin to a pay cut: inflation erodes your disposable income by increasing overall cost of living; debt and debt-service payments remain unchanged, which in reality means that the cost of debt goes up.

For now, things look good. The outlook on the future depends entirely on which way government borrowing will go. If we get Biden in the White House and crazy new stimulus money courtesy of a spendoholic left, or if a renewed Trump administration listens to Steve Moore and suspends all federal income taxes for a year, does not really matter in the end. Both scenarios mean massive money printing, with predictable consequences once we reach the hyperinflation trigger point.

*) If you are one of those nerds out there, please do not respond “Ricardian Equivalence – duh!” unless you have anything more to say about this than the usual accounting-identity talking point. Your cooperation is most highly appreciated.