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It is difficult to quantify the notion of "too much debt" [ClearOnMoney]
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It is difficult to quantify the notion of "too much debt"

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Commentary

It is difficult to quantify the notion of "too much debt"

11 Jun 2011 by Jim Fickett.

There must certainly be some level at which the household sector has too much debt. But it is very hard to tell what that level might be. First, the US debt/income ratio has risen gradually for a long time, and some of that rise is due to changes in norms that are, at least for some people, quite harmless. So the rising trend might well continue. Second, some other countries showed considerably higher debt/income than the US in the boom, yet did not have a worse crisis. So it is difficult to find evidence that even the pre-crisis levels of debt were too high. The problem might be more in who holds the debt.

In a recent post, Household debt is back near the long-term trend line, I made the (somewhat cryptic) statement,

For each of the three curves [of debt as a percentage of disposable personal income], I've connected the first and last points with a dashed line, to show that current debt levels are not too far from the long-term trend.

This seems to imply that continually rising debt is not a problem. In the comments, Colin Wilshire quite reasonably challenged this, writing,

for once I have a problem with your analysis. Adding a “trendline” thru total credit liabilities to Income implies this percentage can continue to rise. Surely at some point excess indebtedness to income will be an alarm to lenders much as with high levels of Sovereign debt to GDP. Isn't it more plausible that after the excesses of 1987 - 2007 that total debt to income will fall back to some more sustainable level of non rising trend?

It is true, of course, that debt as a fraction of income cannot keep rising forever, and I should have done a better job of explaining where I was coming from. I'll attempt that now.

Some part of the long-term rise in debt/DPI is an artifact. Credit cards have replaced cash and checks to a large extent for many people. And a large fraction of all cardholders pay off their balance every month. For those people, the credit card balance that the Fed counts in consumer credit will soon be paid off, and is really just a substitute for cash – it does not indicate any real increase in indebtedness. Admittedly, this is a relatively small part of the picture.

More importantly, whereas my parents' generation was anxious to pay off the mortgage and own the house free and clear, many people today are quite content to pay the mortgage off as slowly as possible, or even to keep refinancing and never pay it down much at all. Here is a recent graph from Calculated Risk showing the average percent equity of households over time:

How much of a problem is high mortgage debt? It depends. Some people bought much more house than they can afford, or didn't set aside any savings to cover the mortgage when out of a job, and in those cases mortgage debt can be a big problem. But what of people who bought a modest house and are only paying the bank about what they would pay in rent? Those people have much more debt than the corresponding renter, but the strain on their budget is no worse. And if they are prudent and have some savings for emergencies, the risk of default may be quite low. So some part (and I have no idea how to estimate what part) of the rise in mortgage debt is more a change in cultural mores than an increase in risky behavior.

There must, indeed, be such a thing as too much debt. But it very hard to know what that level might be. In the run-up to the crisis, the household sector in the Netherlands increased its debt to 185% of disposable income, compared to 130% in the US.

Yet the Netherlands did not have a worse crisis than the US. Consumption only declined slightly more than in the US and, according to the OECD, “The increase in unemployment was surprisingly limited”.

So overall,

  • Yes, there is such a thing as too much debt, but I don't think anyone can tell what that level may be
  • Part of the long-term increase in debt is due to changing norms, and may not be particularly risky; it depends on who holds the debt
  • I would not necessarily expect debt to ever come back to the levels of previous generations
  • While I personally would be more comfortable to see debt levels come down significantly further, I still take some comfort from seeing debt levels come back to the long-term trend line