I'd Gladly Pay You Tuesday for a Hamburger Today

There will be much hand wringing on the left today now that the Senate is expected to ratify a bill reforming personal bankruptcy. It is a valid criticism to say that the measure, in essence, turns the federal government from a protector of debtors to a collector for creditors.

But the anguish over the bill is misplaced. The issue of debt in America is enormous and goes to the heart of core issues like standard of living, pension policy and Social Security reform, economic growth, and maybe in the end national sovereignty. Instead of wailing about the bankruptcy bill, we should be taking a long look at the much bigger problem.

A short history of the debt revolution

The United States was built on debt and a dream of tomorrow. Thanks to 18th century indebtedness and usury laws, much of colonial America's labor force was comprised of indentured servants working off debt. The Revolution against the British was financed by borrowings from the French, and the stability of the early republic was partially ensured by the government's willingness to take on debt to pay former members of the continental army. In the dream of tomorrow, growth would inevitably come and debts would easily be paid.

But beginning in the 1980s, the nature of debt in America began to change. Remember the 1970s? It was a dark time of national malaise, gas lines, double-digit interest rates, stagflation, and "Whip Inflation Now" buttons. But in 1978 the Supreme Court, in Marquette National Bank of Minneapolis v. First Omaha Service Corp, took the breaks off American debt, opening the door for states to set their own usury rates regardless of where the borrower resided. What seemed like a footnote of a case opened the floodgates to new nationwide interest rate competition.

According to a fascinating 2003 study by the FDIC, it was the Marquette decision that set in motion the explosive growth of the modern credit card industry, allowing card issuers to set up shop in states with the highest allowable interest rates and then sell credit products nationally to consumers.

But the consumer credit binge didn't truly begin in earnest until the 1990s, when improvements in IT technology allowed banks to better model financial risk and essentially automate the process of setting risk-adjusted interest rates and making consumer loans, including the issuing of credit cards.

In addition, the financing innovation of securitizing debt--bundling receivable assets into pools owned by special purpose entities financed through bond issues--created an environment for issuers that was lower in risk, more predictable in nature, and higher in liquidity.

Finally, tax policy--which creates incentives for consumers to borrow to buy homes--and monetary policy--which has been driven by the principles of low interest rates and expanded money supply--has been tailored to fuel deficit spending.

The predictable result has been a substantial increase in consumer debt. From the fourth quarter of 1980 to the fourth quarter of 2004, the nation's consumer debt service ratio (the ratio of debt payments to disposable personal income) has grown by 25% while total indebtedness has passed the 100% mark.

All this borrowing hasn't been bad, however. Tradition economic models anticipate a decline in consumer spending proportional to a rise in household debt. But since 1980 the economy has grown, inflation has declined, and interest rates have dropped to historic lows raising the overall standard of living. And during the recent recession, consumer spending fueled by borrowing at low interest rates was the only real driver of the economy. Sure we could reduce debt and increase saving by increasing interest rates, but I can't imagine that anyone wants to go back to the days of 14% inflation and 22% mortgage loans.

The principal beneficiaries of the debt revolution have been lending institutions. But the second biggest beneficiaries have been homeowners. While the the debt service ratio for mortgages has grown by 18.5% since Q4 1980, the rate of over all home ownership has skyrocketed. The potential market of buyers, increased by cheap debt, has grown faster than the supply of houses, driving up home values creating a "wealth effect" since real estate is the nation's primary financial asset. ("Households own more than $14 trillion in real estate assets, almost twice the amount they own in mutual funds and directly hold in stocks," Alan Greenspan noted in a speech last year.) And homeowners have leveraged their homes in ways that where never possible before the debt revolution--one-half of all homeowners who refinanced during 2001 and early 2002 took cash out, with an average of $27,000 in equity liquefied, according to the FDIC paper. Many either reinvested that money in their homes through improvements or used that cash to pay down higher rate credit card debt.

The dilemma of tomorrow

But there is a dark side to the debt revolution--the impact it has had on the young, the working class and the poor. In order to keep pace with the growing economy, but without the assets required for home ownership, these often subprime groups have taken on debt at a faster rate than homeowners, particularly credit card debt.

From the 2003 FDIC report:

In 1998, 28 percent of families in the lowest income quintile had at least one bank credit card, up from 17 percent in 1989, while the percentage of households in the second income quintile that carried one or more bank credit cards climbed to 58 percent from 36 percent over the same period. Not surprisingly, increasing access to credit has brought about increased borrowing, a change that is again especially pronounced for families in lower income brackets. The percent of families in the lowest income quintile holding credit card debt doubled from 15 to 30 percent between 1989 and 2001, while households in the highest two income quintiles actually became less likely to carry outstanding balances

The Fed breaks out numbers for renters on one hand and homeowners on the other when it tracks the consumer debt service ratio and the financial obligations ratio (which adds automobile lease payments, rental payments on tenant-occupied property, homeowners insurance, and property tax payments to the debt service ratio).  The renters list, as Greenspan noted, typically consists of younger and poorer folks than the homeowners list. While the financial obligations ratio for homeowners increased 15% since the end of 1980, the FOR for renters increased 33%

It is this poorer group that has been aggressively targeted by the subprime lending market, not just the credit card issuers but also car loan lenders and other lenders with the radio ads promising loan approval no matter how bad your credit. This is the industry that pushed for the new bankruptcy legislation.

With wage and job growth stagnant among this group, it's hard to see how it will grow its way out of its debts. Worse still, with as much as one third of its income needed to fund debt and insurance obligations), this population--like most of the American population--has simply stopped saving. That means whether it is now--as this group struggles with its debt load under new bankruptcy rules--or whether it is tomorrow when this group reaches 62 without retirement savings, the nation as a whole will have to bear the cost of social services to support it. Maybe the new legislation slow the aggressiveness in the subprime lending market, or make cash poor consumers think twice about piling on more debt, but human nature suggests not.

The present bankruptcy legislation, which is no more than a sop to subprime lenders, does nothing to address the structural problem of America's overall debt binge. Spend less, save more is not a popular message.  But by ignoring the core problem--how to better balance consumer debt and overall growth--the nation's lawmakers are just putting off today's problem until tomorrow like a Walmart employee buying groceries on his sixth credit card.

Comments

[Tom W.]

Great post Jason - for some fascinating background on American roots in debt, the big Alexander Hamilton biography by Ron Chrenow is a must-read.

And the Achilles heel of this is the value of the dollar around the world - if it remains a top-tier currency (a must-hold for big governments and banks) then the debt should be safe - if it doesn't - a real threat that Krugman and others have pointed out - then our debt society becomes devalued, our homes plummet in value, and we're paying double for a hamburger today that we won't get tomorrow, a la Argentina.

[Tony Alva]

Very good topic and post Jason.

Consumer debt is no different than dope in my mind. It's harmless fun when you’re doing it on weekends and in small qty’s while you're in college, but can become an addiction and life struggle quickly if not kept in check. I dabbled in both (dope and debt spending), and was lucky enough not to have gotten buried too deep in either before getting my shit together.

I have little sympathy for lending institutions who are handing out car/home loans and credit cards to those who can't afford to make payments and it pisses me off to no end that taxpayers have to bear any of the burden whatsoever for those who get in too deep by their own compulsion (I'm not talking about situations that involve catastrophic health crisis or death of a spouse).

My wife worked for a nat'l homebuilder for many years. We bought and built our first home with them (still live in it) and the process was quite an eye opener for me. With our good credit rating and very modest combined income our builder approved us for an incredible loan amount for our first home. I can tell you that there was NO WAY we could have afforded to make payments on a mortgage for the full amount they were offering us. I’m not sure if I could afford it now for that matter. We settled on a little over half of what we qualified for and built a 3 BR, 2 1/2 bath and are better for it, but Cathy would come home day after day spinning stories of these homeowners throwing all common sense out the window and building these huge houses that they simply didn't need nor could afford only to go into foreclosure before the builder could even sell the loan. Watched it happen to a few of my own neighbors as their homes were completed (my wife had all the inside scoopage).

Car loans with 72 and 84 month terms, for what? So newly minted college grads making $25K a year can ride to work in a BMW and eat ramen noodles for dinner? Credit cards with huge limits so these same kids can eat their ramen noodles in front of giant plasma screen TV's? Believe me, I love all the gadgetry and toys money can buy and have a great deal of the stuff, but it came incrementally through the course of my life, not all at once. Again, I was fortunate enough to see where my debt spending was getting out of hand and had a chance to rein it in before it got out of control with simple common sense and discipline.

How would I fix it? Simple, stop bailing out any and all institutions who lend money to those on the bubble and get back to more sensible and sane risk assessments when it comes to evaluating loan and credit card applications. It's that simple. Individual discipline will fall in line as a natural byproduct of this approach.

BTW Speaking of debt spending and bad karma… That Focusrite mic preamp I bought without my wife’s knowledge blew up on me during my first recording session using it. I was aghast. Fortunately, my trusty studio gear repair place was able to rescue it for $150 (blown IC on the input side). Boy was I sweating that out. Her: “What’s this $1,500 to PayPal all about?! Me: “Oh, that’s the mic preamp that I got to use for all of 15 minutes before it blew up, but for that 15 minutes I had the best vocal sound I’ve ever put down on tape.” The whole incident almost had me believing a Tom Watson/Jason Chervokas GOP/conservative like conspiracy was at work :-)

[chervokas]

Tony, great note.

The nation needs to think a lot more in a systematic way about debt, growth and the working population, especially as a generation begins to age out with low savings and high debts.

It's like steroids in baseball, the owners wanted a bulging, hugely successful game so they didn't mind if the players were quietly juiced....we pumped up the money supply, eased credit (both consumer and corporate), and explosively grew the economy, more or less over a 20 year period. But although maybe you can sometimes grow your way out of debt, you can't count on it, as many an LBO investor will tell you.

It's a lousy way to manage a nation.

BTW, I find any Paypal charge under $300 is bound to be discovered around my house. One day we should get your focusrite mic pre together w/ my vintage RCA 77-DX ribbon mic. I think they'd have a good time.

[bruce b.]

Jason deserves credit for citing Wimpy, who along with Popeye, Bluto, and Olive Oyl, formed the nexus of one of the greatest schools of political and economic thought of the 20th Century.