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A hint that future household deleveraging may be limited

9 Aug 2011 by Jim Fickett.

A recent academic study, based on a survey of households across eight nations, showed that many households (50% in the US) were unlikely to be able to cope with even a minor financial shock, such as a large auto repair bill. In studying the differences across nations, it was found that a more developed financial system was associated with a lower ability of households to cope with financial shock. This suggests that as long as the banking system is pushing products that tempt households into debt they cannot afford, large-scale voluntary deleveraging is unlikely.

Many economists and other commentators think that a necessary part of the recovery will be for households to further reduce what is widely considered to be excessive debt.

High household debt may be biggest hurdle to US recovery

Across a wide range of measures - employment growth, unemployment levels, bank lending, economic output, income growth, home prices and household expectations for financial well being - the economy's improvement since the recession's end in June 2009 has been the worst, or one of the worst, since the government started tracking these trends after World War II. …

The biggest problem may be household indebtedness. At the peak of the economic boom in the third quarter of 2007, US households collectively had borrowed the equivalent of 127 per cent of their annual incomes to fund purchases of homes, cars and other goods, up from an average of 84 per cent in the 1990s. The money used to pay off that debt means less is now available for new spending. Households had worked their debt-to-income levels down to 112 per cent by the first quarter, in part because banks have written off some debt as uncollectible.

In this article, as in others that I have seen, there is lacking any quantitative argument suggesting an amount by which debt needs to be reduced. Nor is there any serious attempt to estimate what effect debt reduction might have on the economy.

For investors, it is more important to think about what actually will happen than about what some economists think should happen. The two most basic questions are: (1) Do households really have too much debt? (2) Are households likely to voluntarily reduce debt?

There is no magic number for how much debt is too much. Debt is spread very unevenly, and the problems come when those for whom debt service is a large fraction of income have an emergency or lose their income. That is, the question of how much debt is too much comes down to how many households are in a fragile situation, and how many of those receive some kind of financial shock.

On the first point, financial fragility, many news sources reported in May on a study showing that about half of all Americans were unprepared for even a minor financial emergency. Here is the short summary from the Wall Street Journal:

Nearly half of Americans say that they definitely or probably couldn’t come up with $2,000 in 30 days, according to new research, raising concerns about the financial fragility of many households.

… The $2,000 figure “reflects the order of magnitude of the cost of an unanticipated major car repair, a large copayment on a medical expense, legal expenses, or a home repair,” the authors write.

The research paper in question is “Financially Fragile Households: Evidence and Implications”, by Annamaria Lusardi, Daneil Schneider, and Peter Tufano. The WSJ cites NBER, which one must join to obtain the paper, but it is also available without restriction on Daniel Schneider's website.

The first thing that I found striking in the detailed results was very clear evidence that many people are living beyond their means. It is no surprise that among those with income less than $20,000, a majority reported “Certainly not able to cope.” But even among those making $100,000 - $150,000, about a fourth (23.7%) reported that they would probably or certainly not be able to raise $2000 in 30 days. I live in an expensive city, and I understand that, at least in some locations, if you want to own a house and send the kids to college, $100,000 is far from opulent. Nevertheless, if you are in this income bracket and are unable to set aside even $2000, you are living too close to the edge.

One of the ways the survey questions suggested you might raise that $2000 was via a credit card. There are about 600 million credit cards in use in the US; the widespread inability to raise $2000 suggests that many of those cards are maxed out. This fact alone does indeed suggest that a large number of households had, as of 2009, too much debt. So although I remain agnostic on whether the household sector has too much debt, I suspect that many, perhaps even most, households do indeed have too much debt.

The next question is, are households likely to voluntarily reduce debt? Certainly household debt has come down since 2008, but much of this was involuntary – banks writing off losses, foreclosures erasing mortgages, and the end of the home equity ATM. Although most reporters take it for granted that households in general are worried about their “tattered balance sheets”, and are working hard to reduce debt, there is precious little evidence that this is really happening. And in the financial fragility paper there is one interesting bit of evidence that households are, in fact, unlikely to change their ways.

The survey was taken in eight countries, and a good part of the paper was devoted to analyzing differences between the results in different countries. The bit I found most interesting was that, across these eight countries, the ability of households to cope with financial emergencies was negatively correlated with the sophistication of the financial system. I.e. the more clever the banks are, the more consumers get themselves into trouble:

Table 6 shows that perceived capacity to cope with an emergency is lowest in the U.S., U.K., and Germany, all countries in which 50% of households or more would probably or certainly be unable to come-up with the emergency funds. France and Portugal occupy an intermediate position; 46% of respondents in Portugal would certainly or probably be unable to come-up with the funds as would 37% of those in France. The highest levels of coping capacity are found in Canada (28% certainly or probably unable), Netherlands (27.9%), and Italy (20%). In sum, we see substantial cross-national heterogeneity in perceived capacity to cope, with the United States at the upper end in terms of financial fragility. …

The large law and finance literature examines financial development of countries and it might be sensible to predict that citizens of better financially developed countries might show greater abilities to cope with financial shocks. … If anything, the simple correlations with ability to cope are overwhelmingly negative, suggesting a lower ability to cope in more well developed financial markets.

Given that the banks were saved with most of those in the upper echelons unchanged, that regulatory reform failed to address major issues and is currently being gutted in many ways, and that Obama did not think it was worth trying to keep Elizabeth Warren at the Consumer Financial Protection Bureau, it seems unlikely that this aspect of financial “development” in the US will change. Hence I remain doubtful that households will work to voluntarily reduce debt.