About the Author: mason jw is a professor of economics at John Jay College, City University of New York, and a fellow of the Roosevelt Institute.
Almost everyone, it seems, now do you agree that higher interest rates mean economic pain. This pain is generally seen in terms of lost jobs and closed businesses. Those costs are very real. But there is another cost of rate hikes that is less discussed: their effect on balance sheets.
Economists tend to frame the effects of interest rates in terms of incentives for new loans. As with (almost) anything else, if loans cost more, people will accept them less. But interest rates don’t just matter for new borrowers, they also affect people who have borrowed in the past. As debt rolls over, the current higher or lower rates are passed through to the costs of servicing the existing debt. The effect of changes in interest rates on existing debt loads can dwarf their effect on new loans, especially when debt is already high.
Let us step back for a moment from the current debates. One of the central macroeconomic stories of the last few decades is the rise in household debt. In 1984, it was just over 60% of disposable income, a proportion that had hardly changed since 1960. But over the next quarter century, the debt-to-income ratio would double, reaching 130%. This rise in household indebtedness was the background to the global financial crisis of 2007-2008, turning household indebtedness into a political issue live for the first time in modern American history.
Household debt peaked in 2008; since then it has fallen almost as fast as it rose. On the eve of the pandemic, the total debt-to-income ratio of households was 92%, still high by historical standards but much lower than a decade earlier.
These dramatic changes are often explained in terms of household behavior. For some on the political right, the increase in debt in the period 1984-2008 was the result of misguided government programs that encouraged excessive indebtedness and perhaps also a symptom of cultural changes that undermined responsible financial management. On the political left, it was more likely to be seen as the result of financial deregulation that encouraged irresponsible lending, along with income inequality that pushed those further down the income ladder to spend beyond their means.
Perhaps the only thing these two parties would agree on is that a higher debt burden is the result of more borrowing.
But as the economist Arjun Jayadev and I have shown in a Serie of documents, This is not necessarily so. During much of the period of rising debt, households borrowed less on average than during the 1960s and 1970s. No more. So what changed? In the previous period, low interest rates and faster nominal income growth meant that a higher level of debt-financed spending was consistent with stable debt-to-income ratios.
We found that the rise in debt ratios between 1984 and 2008 was not primarily a story of people taking on more debt. Rather, it was a change in macroeconomic conditions that meant that the same level of borrowing that had been sustainable in an era of high growth and low interest was unsustainable in the higher interest environment that followed sharp rate increases under the Federal Reserve Chairman Paul. Volcker. With higher rates, a level of spending on houses, cars, education and other debt-financed assets that would have previously been consistent with a constant debt-to-income ratio now led to a rising one.
(Yes, there would later be a big increase in lending during the real estate boom of the 2000s. But that’s not the whole story, or even most of it.)
Similarly, the fall in debt after 2008 reflects in part a sharp reduction in indebtedness in the wake of the crisis, but only in part. Defaults, which led to the cancellation of around 10% of household debt between 2008 and 2012, also played a role. More important were the low interest rates of these years. Thanks to low rates, the overall debt burden continued to fall even as households started borrowing again.
In effect, low rates mean that the same fraction of income devoted to debt service leads to a larger drop in principal, a dynamic any homeowner can understand.
The nearby figure illustrates the relative contributions of low rates and debt reduction to the decline in debt ratios after 2008. The thick black line is the actual path of the aggregate household debt-to-income ratio. The red line shows the path it would have taken if households had not reduced their debt after 2008, but instead continued to take on the same amount of new debt (as part of their income) as they did on average over the previous 25 years. years of mounting debt. The blue line shows what would have happened to the debt ratio if households had borrowed as much as they actually did, but faced the average effective interest rate for that previous period.
As you can see, both Fewer loans and lower rates were needed to reduce household debt. If one of the two remains constant at its previous level, household debt today would approach 150% of disposable income. Note also that households were mainly paying down debt during the crisis itself and its immediate aftermath; that’s where the red and black lines diverge sharply. Since 2014, as household spending picked up again, only thanks to low interest rates has the debt burden continued to fall.
(Yes, most household debt is in the form of fixed-rate mortgages. But over time, as families move houses or refinance, the effective interest rate on their debt tends to follow the rate set by the Federal Reserve).
Rebuilding family finances is an important but rarely recognized benefit of the decade of ultra-low rates after 2007. It is one of the main reasons the US economy weathered the pandemic with relatively little damage, and why is growing so resilient today.
And that brings us back to the present. If low rates eased the debt burden on American families, will they push them back onto an unsustainable path?
The danger is certainly real. While most of the discussion about rate hikes focuses on their effects on new loans, their effects on existing debt burdens are arguably more important. The 1980s, often seen as a success story in controlling inflation, are a cautionary tale in this regard. Although household indebtedness fell in the 1980s, the debt burden continued to rise. The developing world, where external borrowing had soared in response to the oil crisis,it was much worse.
Yes, with higher rates people will borrow less. But they are unlikely to borrow enough less to offset the increased debt load they already have. Major credit-financed assets—homes, cars, and college degrees—are deeply ingrained in American life and cannot be easily dispensed with. It’s a safe bet that a prolonged period of high rates will result in families carrying more debt, not less.
That said, there are reasons for optimism. Interest rates remain low by historical standards. The improvement in household finances during the decade after 2008 was reinforced for the substantial income support programs in aid packages approved by Congress in response to the pandemic; this will not be reversed quickly. Continued strong job growth means rising household income, which mechanically pushes down the debt-to-income ratio.
The cancellation of student debt is also timely in this regard. Despite the fears of some, debt forgiveness will not boost current demand—no interest has been paid on this debt since March 2020, so the immediate effect on spending will be minimal. But forgiveness will improve household balance sheets, offsetting some of the effect of interest rate hikes and encouraging spending later, when the economy may be struggling with too little demand rather than (possibly) too much.
Reducing the debt burden is also one of the few positive aspects of inflation. It is often assumed that if people’s incomes rise at the same rate as the prices of the things they buy, they will not be better off. But strictly speaking, this is not true: the income is used to pay off debt and also to buy things. Even if real incomes stagnate or fall, the increase in nominal income reduces the existing debt burden. That is No an argument that high inflation is a good thing. But even bad things can have both benefits and costs.
Will we remember this moment as the beginning of a new era of financial instability, as families, businesses and governments find themselves unable to keep up with the rising costs of servicing their debt? Or will the Fed be able to declare victory before too much damage has been done? At this point, it’s hard to say.
Either way, we should focus less on how monetary policy affects incentives and more on how it affects the existing structure of assets and liabilities. The Fed’s ability to steer real variables like GDP and employment in real time has, I think, has been greatly exaggerated. Its long-term influence over the financial system is an entirely different story.
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