10/27/2008

Fed Policy and Credit Bubbles

By David Bourn and Martin Gremm

The US relies heavily on consumer spending to prop up the economy in times of economic contractions. The Federal Reserve Board spurs consumption by adjusting short-term interest rates, which encourages Americans to buy consumer goods on credit.Historically, consumer debt levels have risen faster in lower interest rate environments.

Each time the Fed lowers interest rates to smooth out the economic cycle, the amount of outstanding consumer debt increases, but it shows no signs of decreasing when the economy is strong. Consumer debt has been increasing since the Great Depression. This trend cannot continue indefinitely. At some point it will become impossible for consumers to make the interest payments, let alone repay their debts and we may be dangerously close to that point.

Figure 1 below shows the Debt Service Ratio (estimate of debt payments divided by disposable income) over the past several decades.Currently consumers spend over 14% of their disposable income to service $2.6 trillion of unsecured consumer debt.

Debt Service Ratio

The Fed's reliance on consumer deficit spending to smooth out the economic cycle has long-term consequences that this country will eventually have to face.

In the best case scenario, the Federal Reserve Board will lose its ability to boost short-term economic growth as lenders become unwilling to extend further credit to consumers or high levels of debt payments pressure borrowers to stop taking on more debt.

The worst case scenario is that a rise in interest rates or outstanding consumer debt, or a decrease in the median family income could push the Debt Service Ratio into unmanageable territory. The result would be a marked increase in consumer debt defaults. The total amount of unsecured consumer debt is considerably larger than the total amount of subprime mortgage debt. This suggests that widespread defaults on consumer debt would be more severe than the mortgage crisis, because there is no collateral, such as a house, that lenders can seize to recover some of their losses.

The government’s economic policies are not primarily responsible for the run up in consumer debt. Consumers who are willing to live beyond their means by funding discretionary spending through the use of credit are a necessary ingredient.

What can we do now that our happy, overextended boat is sinking in the sea of consumer debt? For the individual the answer is fundamentally easy: Live within your means! Do your part to decrease consumer indebtedness, even if the fiscal policies of the government encourage us to take on exorbitant levels of debt. The ultimate decision and the overall future direction of the American economy lies in the hands of the American people.

For policy makers, the answer is more complicated. They need to balance the short-term benefit of smoothing the economic cycle with the long-term consequences of increasing the level of consumer debt. For the last two decades the emphasis has been on smoothing the cycle, but it needs to shift to gently deflating the credit bubble before it pops on its own. The tech bust and the mortgage crisis are recent examples where policy makers stepped in only after the crisis had started and it was too late to do anything but pick up the pieces.

Unfortunately it is very unlikely that politicians or the Fed will take steps to defuse this looming credit crisis until events force their hands. At that point the ‘solutions’ will probably consist of various bailout packages, which mainly work by transferring unmanageable debt from individuals to the government. This is another short term fix that amounts to refinancing the problem, instead of solving it.