Economy Grows on a Shaky Foundation of Debt

Median household income has remained stagnant over the past quarter century, when controlled for inflation. With rising needs like cell phones, computers and cable TV, many U.S. households have had to go into debt to maintain a middle-class standard of living.

This has provided a boost to the overall economy, because consumer spending makes up nearly 70 percent of total spending. As consumer spending goes, so goes the U.S. economy.

But there is a problem with this solution. High debt levels are not sustainable over the long haul. At some point, interest payments on debt become a burden on households, and require that households deleverage, paying down some of their debt. When this occurs, economies usually enter a recession.

Since the start of the Great Recession, U.S. households have sought to deleverage. However, this effort has been mostly unsuccessful. Americans have found it too difficult to shed their debt because of falling incomes.

Debt payments, adjusted for inflation, and debt payments relative to income have fallen since 2007. However, this decline was mainly due to lower interest rates stemming from an aggressive monetary policy, and government programs like the Home Affordable Modification Program, which helps homeowners struggling to pay their mortgages.

The more important metric-- total consumer debt relative to household income-- remains unchanged since 2007. Reduced credit card debt and car debt have been counterbalanced by greater college debt. And mortgage debt remains a serious problem. It has fallen a little bit, relative to household income, since 2007, but remains nearly double the level of 1989.

Moving forward, the big problem is that the Federal Reserve has hinted it will begin raising interest rates later this year. This would increase household debt payments, and make it even harder for them to deleverage. Even worse, more than 1 million HAMP mortgages are starting to reset at higher rates, resulting in higher mortgage payments for these homeowners.

The U.S. economy remains in a fragile state; consumers are still overleveraged. The Federal Reserve must exercise caution and restraint in raising interest rates.

Steven Pressman, an AIER Visiting Research Fellow, recently published a paper on household debt and its economic impact for the June 2015 issue of the Journal of Economic Issues. “Inadequate Household Deleveraging” was co-authored by his Monmouth University colleague, Robert Scott.  Using data from the Federal Reserve’s Survey of Consumer Finances, the paper examines changes in U.S. household debt over the past 25 years.

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