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Americans Resort to Plastic Safety Nets

Americans are starting to borrow once again, they're doing so at an unexpectedly high level, but it's for all the wrong reasons

Victor Nava and Anthony Randazzo
July 20, 2012

Americans are starting to borrow once again, they're doing so at an unexpectedly high level, but it's for all the wrong reasons.

A recent Federal Reserve report revealed that outstanding consumer credit rose by 8 percent in May, nearly double the previous month's growth rate. The increase amounted to a $17.1 billion jump in consumer credit usage. On its face, this may sound encouraging, since more borrowing may translate into more investment, more consumption, and ultimately more economic growth. However, this surprising increase in credit usage was fueled by an 11 percent rise in credit card and other revolving credit forms, while the growth of non-revolving lines of credit actually fell from 9.6 to 6.5 percent.

To understand why this matters, here's a little background:

There are two significant forms of consumer credit measured by the Fed, revolving credit and non-revolving credit. Revolving credit is credit that automatically renews as debts are paid off; credit cards the perfect example. The more revolving lines of credit that are being used, the more households are adding to their debt levels (unless, of course, they pay off their credit cards in full every month).

Non-revolving credit, by contrast, requires monthly payments and does not allow repaid funds to be drawn down again from the credit limit. This category of credit includes things like business improvement loans and student loans. These also add debt to household balance sheets, but it is debt that is required be paid down in a structured process - unlike credit card balances, which can just see interest piled up over time. More to the point, non-revolving credit is often put to productive use, spurring investment rather than just spending.

(Technically speaking mortgages, which at best are very low yielding investments, and home equity loans are also forms of non-revolving credit, but the Fed does not include these forms of credit in their survey.)

Easy access to credit was one of the driving forces behind American economic growth from 1982 to 2007. During that period, the annualized growth rate of revolving credit never went negative. It is no coincidence that in 1984, when non-revolving credit outstanding increased by 15.8 percent from the previous year (the biggest jump since 1978) the nation also saw a 7 percent increase in GDP (again, the largest increase since 1978).

The increase in credit during this period certainly fueled a bubble, and the debt it produced has weighed heavily on the economy since that bubble burst. But the availability of credit was not necessarily the root cause of the crisis, or the subsequent recession. It simply interacted with many other factors - like housing policies and other regulations that distorted the allocation of capital, and ignorant, reckless behavior in the financial sector - to create a perfect storm and lead us to economic collapse.

Yet debt is not inherently bad, and easy credit does not necessarily mean unbearable debt—if it is well managed.

Unfortunately, household debt levels shot up unsustainably during the bubble years, largely because the generally accepted measure of whether taking on more debt was a good idea was simply the cost of servicing that debt (i.e. could you get a low, fixed interest rate and a monthly payment that fit your current budget?) rather than aggregate debt levels. Once the economy cooled and interest rates climbed in 2007, household debt service payments as a percentage of disposable income quickly rose to over 14 percent. Homeowners began to default.

What made this problem worse was that while fixed private investment and non-revolving credit outstanding grew at an average annual rate of 4.5 percent and 6.4 percent respectively during the bubble years, revolving credit outstanding (such as credit card debt) grew at an astonishing 11.5 percent. All those credit card bills that financed consumption began to pile up alongside mortgage payments, freezing household purchases as the recession took hold.

At least with a student loan, individuals are getting a degree they can leverage for employment and increased income. With credit card debt they are simply piling up interest payments that suck money away from more productive uses.

In order for businesses to start growing again they need customers, but most households won't be buying at the levels they were during the boom years until they've paid down debts. For example, outstanding mortgage debt levels have declined by close to $1 trillion since their high point in 2008, but still need to fall by another $6 trillion or so to reach pre-bubble levels. And household debt is slowly but surely starting to climb again. The fourth quarter of 2011 saw the first rise in household debt in three and a half years—a disturbing trend.

This added debt is coming from increased levels of borrowing on revolving lines of credit. Households are struggling to pay their bills, leading credit card usage specifically to jump 11 percent in May. Essentially, households are taking on more debts with high servicing costs - not low rate home and business loans.

This spike in the use of credit cards happened to coincide with a disappointing jobs report, in which the headline unemployment rate remained unchanged at 8.2 percent and the broader "U-6" measure of unemployment came in at 14.9 percent. At the same time, rising prices for basic household goods like food and utilities have increased pressure on household balance sheets. According to the latest Bureau of Labor Statistics data, food prices are up 2.6 percent over the last 12 months. The price of electricity is expected to rise by 2.4 percent from this time last year, despite falling natural gas prices (natural gas, which provides nearly one-third of our nation's energy, is 43 percent cheaper than it was this time last year).

These negative numbers help explain July's Thomson Reuters/University of Michigan consumer confidence index, which shows confidence dropping to its lowest level of the year. Throw in the fact that, according to Fed data, wages grew at an annualized rate of just 1.3 percent in May—the slowest rate of wage growth since the Fed started keeping track in 1964—and increased credit card usage begins to make a lot of sense.

So while the Federal Reserve's recent consumer credit report may appear to paint a rosy picture of Americans who are spending money, taking out bank loans at a growing rate, and generally feeling better about the economy, closer inspection suggests a stagnant economy that is failing to create jobs, and Americans resorting to their "plastic safety nets" just to get by.

Victor Nava (victor.nava@reason.org) is a research assistant and Anthony Randazzo (anthony.randazzo@reason.org) director of economic research at Reason Foundation. 

Update: Anthony Randazzo on RT discussing how the consumer report interacts with recent food price concerns (while also being unable to say the phrase "make ends meet").


Victor Nava is Research Assistant

Anthony Randazzo is Director of Economic Research


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