Are US Households Done Deleveraging?

This Tuesday, I’ll be  at Joseph Stiglitz’s event at Columbia University on finance and inequality, presenting my work with Arjun Jayadev on household debt. You can find the latest version of our paper here.

In preparation, I’ve been updating the numbers and the results are interesting. As folks at the Fed have noted, the post-2007 period of household deleveraging seems to have reached its end. Here’s what the household debt picture looks like, in the accounting framework that Arjun and I prefer.

The units are percent of adjusted household income. (We can ignore the adjustments here.) The heavy black line shows the year-over-year change in household debt-income ratios. The bars then disaggregate that change into new borrowing by households — the primary deficit — and the respective contributions of interest payments, inflation, income growth, and defaults. A negative bar indicates a factor that reduces leverage; in most years, this includes both (real) income and inflation, since by raising the denominator they reduce the debt-income ratio. A positive bar indicates a factor that increases leverage; this includes interest payments (which are always positive), and the primary deficit in years in which households are on net receiving funds from credit markets.

Here’s what we are seeing:

In 2006 and 2007, debt-income ratios rose by about 3 percent each year; this is well below the six-point annual increases earlier in the 2000s, but still substantial. In 2008, the first year of the recession, the household debt-income ratio rises by another 3 points, despite the fact that households are now paying down debt, with repayments exceeding new borrowing by nearly 8 percent of household income. This is an astonishing rate of net repayment, the greatest since at least 1931. But despite this desperate effort to deleveraging, household debt-income ratios actually rose in 2008, thanks to the sharp fall in income and to near-zero inflation — in most years, the rise in prices automatically erodes the debt-income ratio. The combination of negative net borrowing and a rising debt burden is eerily reminiscent of the early Depression — it’s a clear sign of how, absent Big Government, the US at the start of the last recession was on track for a reprise of the Depression.

Interest payments make a stable positive contribution to the debt-incoem ratio throughout this period. Debt-service payments do fall somewhat, from around 7 percent of household income in 2006 to around 5 percent in 2013. But compared with other variables important to debt dynamics, debt-service payments are quite stable in the short-term. (Over longer periods, changes in effective interest rates are a ] bigger deal.) It’s worth noting in particular that the dramatic reduction in the federal funds rate in 2007-2008 had a negligible effect on the average interest rate paid by households.

In 2009-2012, the household debt-income ratio does fall, by around 5 points per year. But note that household surpluses (i.e. negative deficits) are no larger in these years than in 2008; the difference is that we see resumed positive growth of inflation and, a bit later, real incomes, raising the denominator of the debt-income ratio. This is what failed to happen in the 1930s. Equally important, there is a sharp rise in the share of debt written off by default, exceeding 3 percent in each year, compared with a writeoff rate below one percent in all pre-recession years. Note that the checked bar and the white bar are of similar magnitudes: In other words, repayment and default contributed about equally to the reduction of household debt. If deleveraging was an important requirement for renewed economic growth then it’s a good thing that it’s still possible to discharge our debts through bankruptcy. Otherwise, there would have been essentially no reduction in debt-income ratios between 2007 and 2012. [*]

This much is in the paper. But in 2013 the story changes a bit. The household debt-income ratio rises again, for the first time since 2008. And the household balance movers into deficit, for the first time since 2007 — for the first time in six years, households are receiving more funds from the credit markets than they are paying back to them. These events are linked. While the central point of our paper is that changes in leverage cannot be reduced to changes in borrowing, for the US households in 2013, it is in fact increased borrowing that drove the rise in debt-income ratios. Inflation and income growth were basically constant between 2012 and 2013. The 5-point acceleration in the growth of the household debt-income ratio is explained by a 4.5 point rise in new borrowing by households (plus a 1.5 point fall in defaults, offset by a 1-point acceleration in real income growth).

So what do we make of this? Well, first, boringly perhaps but importantly, it’s important to acknowledge that sometimes the familiar story is the correct story. If households owe more today than a year ago, it’s because they borrowed more over the past year. It’s profoundly misleading to suppose this is always the case. But in this case it is the case. Secondly, I think this vindicates the conclusion of our paper, that sustained deleveraging is impossible in the absence of substantially higher inflation, higher defaults, or lower interest rates. These are not likely to be seen without deliberate, imaginative policy to increase inflation, directly reduce the interest rates facing households, and/or write off much more of household debt than will happen through the existing bankruptcy process. Otherwise, in today’s low-inflation environment, as soon as the acute crisis period ends leverage is likely to resume its rise. Which seems to be what we are seeing.

[*] More precisely: By our calculations, defaults reduced the aggregate household debt-income ratio by 20 points over 2008-2012, out of a total reduction of 21.5 points.

Deleveraging by Default

The new Household Credit and Debt Report came out last week from the New York Fed. Fun!

The stuff about student debt got the scary headlines, and with reason — especially once you notice that the 17 percent delinquency rate on student debt, bad enough, understates the problem, since that figure includes debt on which no payment is due:

when we remove the estimated 44 percent of all borrowers for whom no payment is due or the payment is too small to offset the accrued interest, the delinquency rate rises to over 30 percent.

Student debt is not really my beat, though, so I want to call attention to something which has gotten less attention: how much household “deleveraging” is really about defaults, rather than reduced borrowing.

The Credit and Debt Report is based on the New York Fed’s Consumer Credit Panel, with the underlying data from the credit bureau Equifax. It’s unique, as far as I know, in its comprehensive coverage of the various flows that make up changes in household liabilities. The Flow of Funds, by contrast, sees household debt only from the creditors’ side, and doesn’t directly observe flows, only changes in stocks of debt. So with this data we can see much more clearly what’s actually driving the fall in household debt-to-income ratios. [1] And here’s what we find:

The heavy lines are the year-end ratios of mortgage and total household debt, respectively, to disposable personal income. The dotted lines are the path these ratios would have followed if defaults were held fixed at their pre 2007 levels. So we see that total household debt peaked at 119 percent of income at the end of 2007, and has since fallen to 100 percent, a substantial decline. But when we break out the various factors accounting for changes in debt — new borrowing, repayment, and default — we find that the fall is entirely the result of higher defaults. If households had continued defaulting on debt at the same rate after 2007 as before, household debt would not have fallen at all. (It is true that since 2009, there has been some deleveraging even net of defaults, but even over those two years two-thirds of the fall in debt-income ratios is due to elevated default rates.) Mortgage debt follows the same pattern: If default rates had continued at their 2003-2006 level, mortgage debt would have been greater, relative to income, at the end of 2011 than at the end of 2007.

It’s interesting to compare the debt writeoffs reported by households with the writeoffs reported by commercial banks. The biggest difference between the two series is that banks report their net losses, i.e. after recoveries. But both show the same dramatic rise in the Great Recession.

As we can see, the two series move more or less together. It’s noteworthy, though, that before the crisis the amount of debt discharged by default was consistently about five times greater than banks’ default losses; after 2007, this ratio dropped to more like like two to one. This represents some mix of lower recovery rates — underwater homes are worth less than their mortgages — and a worse default performance among mortgages owned by entities other than commercial banks.

So why does all this matter? Well, the obvious reason is that we want to get the story of the recent past right. The usual debate about falling debt is how much it’s due to banks’ unwillingness to lend, and how much to households’ unwillingness to borrow. If it’s really due largely to higher default rates, our stories of the financial crisis and its aftermath should reflect that. But they seldom do. Richard Koo, just to pick one example at random, treats changes in household liabilities as simply a measure of household borrowing.

A couple other reasons to care. For one, the role of defaults is further evidence against the idea that demand is being constrained by a lack of access to credit. 

More broadly, it’s evident that the relationship between defaults and changes in income is nonlinear. Over a normal business cycle, household defaults are stable and fairly low. (This is not true of business and especially commercial real-estate defaults.) It takes an exceptionally deep fall in income to produce a noticeable rise in household defaults. The macroeconomic significance of this is that defaults, like Koo-style deleveraging, weaken the link between current income and current expenditure; in both cases, a higher share of changes in income show up as changes in the flow of payments to creditors, rather than changes in spending on currently produced goods and services. This dampening of the income-expenditure link helps put a floor under demand fluctuations, as discussed in the previous post (provided that defaults don’t limit other units’ access to credit — this is an important difference  between the recent crisis and 1929-1933.) But by the same token it also weakens demand dynamics in the recovery; if a major margin on which households adjust to changes in incomes is changes in payments to creditors, rising incomes will do less to raise demand for current output.

The central importance of defaults in the deleveraging process to date also is a reminder of the importance of the terms on which debt can be discharged. Laws and norms that make default relatively easy can evidently serve as an escape valve that helps prevent the debt deflation process from taking hold.

Looking forward, this is further evidence of how difficult it is to reduce leverage just through lower expenditure. It’s noteworthy here that since 2007, the household sector has had large primary surpluses (i.e. new borrowing is less than interest payments), but in the current environment of slow growth, relatively high real interest rates, and low inflation, this has not been sufficient on its own to produce any fall in leverage. So if lower debt-income ratios are a precondition for sustained growth, more systematic debt writedowns may be necessary. From the conclusion of Arjun’s and my paper:

A recent IMF staff report (Gottschalk et al., 2010) notes that for public sector debt, defaults are most likely to lead a long-term improvement in the fiscal position (and have generally occurred historically) in countries with small primary deficits, or primary surpluses. In such cases unsustainable debt growth is driven by the interaction of high effective interest rates with a large existing debt stock; a one-time reduction in the debt stock can change an unsustainable path to a sustainable one, even if the interest rates on new borrowing rise as a result. A similar logic might apply to private sector debt. If so, some form of systematic debt forgiveness may be the logical, and eventually unavoidable, solution to the problem of excessive household leverage.

Finally, the importance of defaults over the past five years is a reminder that a crisis is precisely a situation when inconsistent expectations cannot be ignored. By definition, in a crisis not all contractual commitments can be fulfilled, and it’s always ultimately a political question which are honored and which are not.

[1] The published report doesn’t include writeoffs, only the fraction of debt that is currently delinquent. To get annual household debt writeoffs, we have to combine the report with the numbers reported by the New York Fed in its Liberty Street blog.