Academic journal article Economic Commentary (Cleveland)

Is Household Debt Inhibiting the Recovery?

Academic journal article Economic Commentary (Cleveland)

Is Household Debt Inhibiting the Recovery?

Article excerpt

When the profits of trade happen to be greater than ordinary, ovetrading becomes a general error both among great and small dealers. They do not always send more money abroad than usual, but they buy upon credit both at home and abroad an unusual quantity of goods....The demand comes before the returns, and they have nothing at hand with which they can either purchase money or give solid security for borrowing. Adam Smith, Wealth of Nations, 1776.

Forecasting short-run economic activity is a tenuous business. Though all economic contractions and expansions have certain well-defined characteristics, history never completely replicates itself. Thus, the particulars of past economic downturns are distinct, and the task of forecasters is something of an art--that of identifying the relevant caveat in the current economic outlook.

One particular of the most recent recession and the current period of sluggish economic activity--a particular in most forecasters' bag of caveats--is the level of household debt. By the end of 1990, the ratio of household debt outstanding to disposable income was at a historically high 99 percent. The corresponding ratio of household debt to assets stood at a similarly unprecedented 19 percent.

Many observers believe that such household debt burdens will, at the very least, constrain consumer spending and inhibit the economy's recovery from recession. This concern was succinctly expressed in a May 1991 Wall Street Journal editorial: "What's different about this recession--what is retarding or blocking these normal financial responses to recession--is the abnormally heavy burden of...household debt."(1)

Implicit in this argument is the presumption that the borrowing behavior of the 1980s has significantly weakened the viability of consumer financial positions. Two fundamental concerns are at the core of this presumed weakness. First is the issue of consumers' ability to service debt in the short run, which is generally viewed as being inversely related to household debt-to-income ratios. Second is the issue of consumers' solvency, or their ability to pay off debts in the long run. A household is solvent as long as its assets are greater in value than its liabilities. The probability of insolvency is therefore generally viewed to be inversely related to a household's debt-to-asset ratio.

But how relevant are observations such as "the ratio of household debt to income is 99 percent" or "the ratio of household debt to assets is 19 percent" when evaluating patterns in business activity? Although rarely discussed in popular debates, a complete analysis of the influence of consumer debt on economic activity requires a distinction between the level of debt-to-asset and debt-to-income ratios and changes in the level of these ratios. Stated alternatively, assessing the role of debt in business-cycle fluctuations requires distinguishing between the effects of trend behavior in household debt and the cyclical behavior of such debt.

Existing theoretical and empirical research does implicate household debt as a factor in propagating (if not in fact causing) downturns in economic activity. Yet, no convincing case has been made, and we believe none exists, for the claim that the current household debt situation and its effects on overall economic activity are in any way extraordinary by historical standards.

In this Economic Commentary, we examine trends in household debt burdens in their historical context. We propose that the much-maligned growth in debt-to-asset and debt-to-income ratios that characterized the 1980s appears to be a return to a long-term trend that, for whatever reason, was interrupted in the 1970s. In fact, these debt measures have been increasing since the turn of the century. If the severity and length of recessions are truly correlated to the level of household leverage, then past recessions should have exhibited increasing amplitude and duration over time. …

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