Over the past decade, we've seen lower interest rates, a broken housing market, and virtually unlimited options when it comes to personal loans. The end result is that Americans are borrowing money at a record pace; consumer debt is on the rise.
In this article, we're going to discuss the role debt plays in fueling the U.S. economy. To do that, we're first going to talk about concepts such as the money multiplier, and how this economic theory is related to consumer debt. From there, we'll be able to explain both the positive and negative effect this can have in America and on consumers.
In order to know whether or not rising debt is a problem in America, it's important to understand some basic economic rules. For example, when a consumer buys something, the money spent doesn't simply stop at that store.
In fact, experts believe that around 70% of the U.S. gross domestic product (a common measure of economic growth) is derived from consumer spending. This means even relatively small changes in spending habits can have fairly large effects on the health of the economy. Perhaps the best way to understand debt's effect on the economy is explained through an example.
Let's say a consumer decides they want to buy a new car or truck. To buy the truck, the consumer is going to increase their debt load. They're going to borrow money.
When the purchase is finalized, the money doesn't stop there; some of it keeps flowing. The salesperson collects a commission, and the dealership buys another car from the factory. The salesperson now has some extra money to spend. The factory pays its workers to produce more trucks. They purchase parts from their suppliers, who pay their workers to produce those parts...
The salesperson and the factory worker need to pay income taxes, and they may decide to save some money instead of buying another product. But the example has served its purpose. By borrowing money to purchase the truck, the original consumer has transferred wealth to others. That original loan has resulted in a multiplier effect, and the economic boom continues as money changes hands.
The money multiplier concept is often associated with Keynesian economic theory, and has been the rationale for using increased government spending or tax cuts to stimulate the U.S. economy. The example given earlier follows this same theory:
Increased consumer spending is followed by an increase in business revenues. Those revenues result in more jobs which once again result in more spending - and so the cycle continues.
The reason it's important to understand the money multiplier is because the availability of personal loans and consumer debt, can have a large effect on the economy. When the government is trying to jump start a sluggish economy, one of the many tools they can use is to lower interest rates.
Lower rates make borrowing easier for consumers, and that means more money flows into and through the economy. Most consumers are more concerned with the size of their monthly loan payments than how much money they're actually borrowing. Lower interest rates translate into an increase in the ability of consumers to handle a larger debt load, which pumps more money into the system.
This discussion helps to better understand if an increase in debt load is good or bad for consumers or the economy. On the one hand, it helps economic growth. On the other hand, many experts question how much further personal debt can expand without triggering a rise in bankruptcies.
While personal debt has been on the rise, the vast majority of that increase is associated with home mortgages. As consumers borrowed more money to buy bigger homes, mortgages have been used to purchase an appreciating asset. As home values increase, this translates into an increase in consumer wealth.
This is a good combination: rising debt, followed by an increase in wealth. The increase in wealth means a lower chance of default on a loan. After all, homeowners with large mortgages were quickly building significant amounts of equity in their homes. If they got into trouble paying back their loans, they could always pull some of the equity out of their home, or even sell their homes at a profit to pay off the money owed creditors and lenders.
In fact, this was a "healthy" situation until 2007, when the housing market seemed to slow down. This slowdown resulted in a crisis in the sub-prime mortgage market. Borrowers with weaker credit histories, lower household income, and relatively few assets could no longer pay back their outstanding loans. This resulted in a quick rise in foreclosures and bankruptcies; eventually triggering what is known as the Great Recession.
One of the statistics published by the Federal Reserve is the Debt Service Ratio, or DSR. The household DSR is an estimate of monthly debt payments to disposable personal income. Payments included in this ratio consist of the estimated required payments on outstanding mortgage and consumer debt.
The DSR is an indicator of the debt Americans are carrying relative to their disposable income. The higher the ratio, the larger the burden carried by the consumer. In the fourth quarter of 2007, this measure stood at 13.46, which was the highest ratio in the 27 year history of the indicator. This means that for every $100 of disposable income, nearly $14.00 is used just to make the household's mortgage and debt payments. As of the second quarter of 2020, the DSR was 8.69, which is a decrease of 34% from the 2007 high.
For over 25 years, the amount of money borrowed was rising, but much of it was used to buy larger homes. The housing market itself helped support this increase. Home prices were appreciating, and helping to build consumer wealth.
But in late 2007, housing prices started reversing themselves, and interest rates began to rise. Suddenly buying a larger home no longer guaranteed an abundant supply of home equity to support the out-of-control spending habits developed by some consumers. Higher interest rates only added to this problem.
What worries some economists is that consumers can no longer depend on relatively inexpensive home equity loans to satisfy their overzealous purchasing habits. The fear is that consumers will start to depend on more risky, and expensive, sources of money such as credit cards.
This type of debt is unsecured, meaning there isn't an asset (collateral) backing the loan that can be sold to repay the money owed. This type of borrowing can be quickly followed by a rapid rise in bankruptcies. Only time will tell whether or not these "doom and gloom" predictions made by some economists will come true.
About the Author - Risks of Rising Consumer Debt