Put the brakes on

Policymakers are concerned about the lack of bank lending. Despite their best efforts, the total level of US household debt is falling for the first time since second world war.

While lower debt levels may appear sensible given the recent financial crisis, authorities are concerned that this total decline of debt may actually threaten the economic recovery. This is because by saving more, we are spending less. Lower spending reduces the incomes of others and their ability to save. If everyone saves more, then, the economy may get trapped in an ever-downward spiral of falling spending and incomes. This is what we saw during the 1930s.

Fearing a repeat of the Great Depression, politicians and central banks have taken desperate measures to encourage banks to lend again. Interest rates have been slashed to zero, public funds have been used to recapitalise their balance sheets and moral suasion has been applied. But so far it seems these measures are not working. Politicians may fail in their aim to get banks to lend more. Analysis suggests US household debt as a share of income could fall from 130 per cent last year, to 110 per cent by 2014. The need to keep repaying debt for a sustained period of time could hinder the economy from expanding at an above trend pace, keeping unemployment high. Previous economic recoveries have been vigorous because households have been able to take on more debt, bringing forward consumption from the future.

The belief that everything can return to ‘normal’ and household debt can continue to rise on the same trend path it has taken for previous decades is too optimistic. To understand why, we need to consider the reasons debt has grown so fast in the past and whether those conditions will repeat themselves. In theory, households take on debt to smooth consumption. Borrowing allows households to enjoy the benefits of car and home ownership when they are young in return for paying the money back when they are older. This suggests an important role for demographics. A young population will borrow a lot. But as they age, debt should be repaid.

This fits with the data. Research by the Bank of England suggests most debt is held by households aged 30 to 40. The majority of this is secured on their property. Unsecured debt tends to be held by 20 to 30-year-olds. As households age, the amount of debt tends to fall. Given the population of the US is aging as the baby boomers approach retirement, this suggests debt levels should be falling, not rising.

Home ownership rose artificially following the second world war. The US government made it easy for veterans to get a mortgage as no deposit was required. The Federal Reserve Bank of St Louis argued this helped push up home ownership rates from 40 per cent before the second world war to 64 per cent by 1965. If more people are borrowing to buy a home and fewer people are renting, it stands to reason that debt as a proportion of income should rise.