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Monday, June 19, 2006

Consumer Debt

These writers from Fred Alger Management argue that the current level of consumer debt is not a problem:

Alive and well under a mountain of debt, by Zachary Karabelland and Dan Chung, Commentary, Financial Times: Remember the scene in Monty Python and the Holy Grail where two men push a wheelbarrow through a plague-afflicted village shouting: “Bring out your dead”? A family heaves a body on to the pile, whereupon it lifts his head and says: “But I’m not dead yet!” One man whacks him with a cudgel and says: “Now you are.” That is the perfect metaphor for the American consumer on the one hand and strategists, commentators and economists on the other. They keep trying to bury the consumer under a mountain of debt, even though he is alive and kicking.

There is an understandable cultural prejudice against debt. For most of history, the risks outweighed the costs. If you calculated wrongly, you did not just go bankrupt: you lost your business, home and possessions. ... Low interest rates, securitisation and bankruptcy law have changed the nature of debt.

Our prejudice against debt no longer makes sense. In March, Federal Reserve chairman Ben Bernanke said as much when he suggested that the substitution of mortgage debt for credit card and automobile debt had been a rational decision by consumers to shift leverage into lower-rate obligations. But his assessment is at odds with attitudes on Main Street and Wall Street, especially in light of global agitation over inflation and excess liquidity.

There is no denying that the absolute amount of consumer debt is higher than ever. ...  a total of $11,500bn. Big numbers, yes, and big numbers are easily turned into a harbinger of crisis. But take the financial net worth of US households (which excludes the value of homes): $26,500bn, an all-time high. With home value included, that rises to $52,000bn – more than four-and-a-half times household debt. ...

Even with the Fed tightening, the absolute level of rates is low by historical standards, so low that for all the refinancing and home-equity extraction we have seen, we can still see more. The average mortgage rate for a 15-year loan is around 6 per cent. In 2000, it was 7.72 per cent. Even though conventional wisdom says that consumers are tapped out, they can continue to use their homes as piggy banks. Even if rates go up another 50 basis points, it is likely that consumers will extract hundreds of billions of dollars in cash-out refinancing this year.

Furthermore, the amount that households must spend to service their debts is manageable. That should be the central concern: not how much debt, but whether it is affordable. In 2001, households spent 12.9 per cent of income to service their debts; by the end of 2005, that had risen to nearly 14 per cent. Again, the key issue is rates: if rates are at or near a peak, debt-financed spending can continue. If not, we will face a credit crunch, especially since average incomes are barely rising.

Anyone who defends current [debt] levels risks being labelled as blind not only to structural imbalances but to the struggles faced by families who are taking on debt to meet basic obligations such as homes, medical costs and education. We are not making a judgment about the wisdom of individual consumers, about the struggles they face or about an American culture that overemphasises consumption and encourages excessive spending. We are making a structural argument that the economy can sustain far higher levels of consumer debt than in the past. Even if more individuals face a credit squeeze, the system overall is in no jeopardy.

In addition, many consumers may be using debt more wisely than commentators give them credit for. The increasing array of financial instruments means that people can take on more debt when they are young and their career outlooks are improving. ...

Stripped of its stigma, debt is a neutral tool. Used prudently, it generates economic activity; taken on foolishly, it is a recipe for problems. The question is: what is the tipping point? Prudence, say the sceptics, dictates cutting back now. But is that prudence, or fear? ...

In a world of low rates and less structural risk, the definition of moderation – and risk – must change. The fear debt arouses once protected people from stupid decisions, but today it impedes a rational assessment of costs and benefits. ...

Recent evidence indicates:

"On average, debt burdens appear to be at manageable levels, and delinquency rates on consumer loans and home mortgages have been low," Mr. Bernanke said...

While consumers are managing their finances fairly well so far, I am not as willing as the authors to declare household debt a worry free zone, particularly in the event of a sudden downturn in the economy.

    Posted by on Monday, June 19, 2006 at 02:05 PM in Economics, Saving | Permalink  TrackBack (1)  Comments (55)

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