As the end of the year approaches, many people are writing the standard "year that was" and "biggest story of the year" columns. I am throwing my proverbial two cents into the ring with this story. What was the big economic story of 2005? For me, it is a tie between the continued growth of consumer debt and the lack of savings.
The US debt binge continues
First, the Flow of Fund report provides the best information on consumer debt. However, the most recent FOF report only covers the first three quarters of 2005. Considering American consumer's love affair with debt during the present expansion, I feel safe is saying I doubt this trend will show a major decline in the 4th quarter of 2005.
Consumer debt increased 9.1%, 11.1% and 11.6% for the first three quarters of 2005, respectively. Total respective consumer borrowing for the first three quarters was 929 billion, 1.158 trillion and 1.235 trillion. Total respective consumer debt outstanding for the first three quarters of 2005 was 10.4 trillion, 10.6 trillion and 11 trillion.
The Federal Reserve also tracks consumers Debt Service Ratio and Financial Obligations Ratio:
The household debt service ratio (DSR) is an estimate of the ratio of debt payments to disposable personal income. Debt payments consist of the estimated required payments on outstanding mortgage and consumer debt.
The financial obligations ratio (FOR) adds automobile lease payments, rental payments on tenant-occupied property, homeowners' insurance, and property tax payments to the debt service ratio.
Both of these numbers stood at record highs in the third quarter of 2005.
There are several arguments made against the alarm some economists have with these numbers.
1.) Consumers are acting rationally given that interest rates are at historic lows. In other words, drop interest rates to incredibly low levels and consumers will borrow like there is no tomorrow. This in fact is a good thing.
First, I will be the first to admit the incentive to borrow is directly related to the actual price of money; I am partially a strict monetarist. However, I would add this caveat: is the sheer amount of debt financially and economically healthy? The answer to this is no. At some point, people have to pay debt back to the lender. While monthly payments are low because interest rates are low, the consumer must still payback the entire loan.
At some point, consumers will continue to act rationally and realize that while their monthly payments are low, their amount of debt is increasing at record rates. As a result, they will choose to pay down debt instead of borrowing and spending more. Considering that consumer spending represents 70% of GDP growth, this event will slow US economic growth.
Let use some very simply numbers to illustrate this point. Family X has increased their total debt from $100,000 to $200,000 of the last 5 years. Low interest rates have limited an upward increase in the actual amount of their respective monthly payments. However, at some point they will look at their total debt increase from $100,000 and $200,000 and start to "act rationally" by paying more of their income to pay down a larger percentage of the debt. When enough people do this at the macro-level, overall consumer spending will slow, lowering GDP growth.
2.) The financial obligation ratios have been inching up for a number of years. The recent record highs are part of a long-term trend and are therefore nothing to worry about.
The problem here is simple: the US consumer is more and more prone to use debt to finance his lifestyle. Instead of increasing equity (actual ownership) in "stuff", the US consumer is more prone to "buy now and pay later." As I mentioned above, at some point the consumer will realize he doesn't actually own a larger percentage of his assets, and will start to "act rationally" by paying down his debt.
The Savings Crisis
For an economist, savings is the amount of money left over after all monthly expenses. For the last 7 months of 2005, this number has been negative. From the FOF report, for the first three quarters this number was 47 billion, -21 billion and -132 billion, respectively.
Some have argued the US method of calculating savings is far too low for several reasons. First, many people have monthly deductions from their paycheck for their retirement. These contributions would be classified as expenses from the above economist's definition of savings. However, the actual contributions to various retirement plans are still abysmally low. Since 1995, defined pension plan contributions have been negative. For the years 2000-2005, net acquisition of financial assets by defined contribution plans (401K's) have respectively been (in billions) 9.7 billion, 16.3, 17.3, 24.2 and 18.5. On a national level, these amount to less than 1% of GDP. IRAs have seen the biggest increase in assets for 2000-2005. However, the largest percentage of GDP contribution occurred in 2000, when the IRA contributions as a percentage of GDP were 2.4%.
Some people on the right argue that home equity is in fact savings. The problem with this argument is home equity loans must be paid back to the lender. This violates a basic idea of savings, which is essentially "money put away for a rainy day."
In short, US consumers are spending everything they make and not putting any money away for tomorrow.
Conclusion
Record debt and no savings is a recipe for economic problems. High debt levels increase the likelihood of bankruptcy for consumers, which hinders the financial progress for years. No savings means a consumer has less actual ability to weather a financial downturn.
Problems have not started in a large way from this situation. There is a possibility they won't. However, the recipe for problems already exists.