Spotlight on Financial Services

Too Much Consumer Credit?

Neither a borrower nor a lender be. Although this admonition was more common a century ago, Americans still seem to have misgivings about debt. Don't cut taxes; pay off the federal debt. Credit cards make it too easy to get into debt. Perhaps we are heading towards a recession because consumers have so much debt that they are reducing their spending. The misgivings about consumer credit are long standing. A few years ago, Durkin and Jonasson, two economists with the Federal Reserve System, surveyed news articles on consumer credit beginning in 1950 and concluded that about 80 percent of the articles were negative in tone.

Dean M. Maki, also an economist with the Federal Reserve, has released an excellent research paper that addresses several basic questions. He presented an earlier version of the paper at a conference celebrating the 25th Anniversary of the Credit Research Center at Georgetown University. We summarize his main themes below, updating his data where appropriate. This summary is divided into three parts:

What has been the overall trend in household borrowing?
How should we measure consumers' debt burden?
What do these measures suggest concerning the outlook for the U.S. economy?

Trends in household borrowing

The Federal Reserve Board's Flow of Funds Accounts show that at the end of 2000 consumers owed a total of about $6.9 trillion, of which $5.2 trillion was in nonfarm home mortgage debt and $1.6 trillion in various forms of consumer credit. While both forms of consumer debt have been rising over the past decade, mortgage debt has contributed more to the total growth. From the end of 1996 to the end of 2000, consumer credit rose by 29.5 percent, while nonfarm mortgage debt climbed by 40.0 percent.

Measuring debt burden

The amount of consumer debt outstanding is impressive, but it should not be depressing if consumers can meet the required monthly payments. A useful measure of debt burden is provided by the Federal Reserve in its quarterly reports on consumers' debt service burden—expressed as the percentage of monthly after-tax income that is devoted to required monthly payments on mortgages and installment debt. At the end of the fourth quarter of 2000 debt payments amounted to 14.29 percent of disposable income, the highest level since the fourth quarter of 1986, when it reached 14.38 percent.

Implications for the future

Maki analyzes the growth in consumer and mortgage credit and the changes in consumers' debt burden in relation to subsequent delinquencies on their debts and to their expenditures for goods and services. With respect to the first point, the debt service burden is a statistically significant predictor of current delinquencies. The analysis "suggests that the measure is a useful harbinger of household distress." It also seems to predict changes in personal bankruptcies.

While the debt service burden helps to predict consumer bankruptcies, bankruptcies are not a very good predictor of total consumer spending. First, bankruptcies afflict only a very small portion of the population. Second, under current law, consumers can file bankruptcy and still spend their future income without worrying about payments on their past debts. However, Maki finds that a "high debt growth tends to be associated with high future growth in spending." He suggests that the growth in spending results from optimism about the future, with optimism also increasing consumers' willingness to add to their debts. Also, lenders may be more optimistic and, therefore, more willing to lend to consumers.

Maki concludes: "Strong growth in consumer credit tends to be associated with positive future growth in consumption. Little empirical support exists for the idea that household debt service burden or other credit quality variables are negatively related to future consumption in the short term."

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