Postcards from Old Europe – In debt we trust

The FOMC’s recent change in the wording of their statement has clearly shown that the times of E-Z financing are coming to an end. The recent past has seen the Fed engineer a near-rational bubble in asset prices which has served to push household wealth up past the levels of the stock market bubble. Cheap credit has supported household spending at a time in which incomes have been growing at a snail’s pace.

A quick series of (substantial) interest rate hikes could therefore lead to a substantial slowdown in consumption and thereby negatively impact future GDP growth. Consumer credit delinquency rates are already at near record highs while ever more home buyers finance their homes with no money down and use adjustable rate mortgages to squeeze out a larger loan. The reasoning behind this behavior is nicely stated in this NY Times article. Excerpt:

“I’m too young to be scared,” he said last week, betting that both the value of the house and his income will keep rising. If the bet fails, he said, it will not be the end of the world, adding: “There is a difference between being poor and being broke. Being broke is more of a temporary condition. Donald Trump has been broke a couple of times.”


Mr. Thompson, who completed the purchase of his townhouse near Denver on Friday, said he would have qualified to borrow $330,000 if he had taken out a traditional fixed-rate mortgage. He qualified for a loan up to $550,000 by taking an adjustable-rate mortgage that will be constant for the first five years and that requires only interest payments.

What I like most about this statement is that the person cited is supposed to be a “management consultant”. I’m sure that an optimist like him is much in demand!

This kind of mindset has kept consumers spending all through the recent economic weakness and has also served to boost consumer credit to a level of over $2 trillion. Total household debt is at a level of around 90% of GDP and the average American now spends almost 20% of their disposable income servicing debt. This is in sharp contrast to Euroland where household debt stands at around 60% of GDP.

The picture looks a little different if you look at household debt as a percentage of disposable income. Some European countries – such as Germany or the Netherlands – have a household debt to disposable income ratio which is higher than the US ratio. The Euro-average is around 30% below the US level though.

Another thing to keep in mind is the evolution of the savings rate. While the US savings rate is at a rock bottom 2% the Euro-average stands at around 13%! Europeans have reacted to sluggish economic growth and high unemployment by retrenching and saving more. In sharp contrast US consumers have decided to take a different course and spend more – even if it means taking on more debt.

The US consumer’s decision has been vindicated by the behavior of asset prices. Up until the popping of the bubble the stock market did the job of saving for the individual. Rising house prices took up much of the slack after the bubble burst. This asset price inflation with corresponding price disinflation has made many households feel wealthy and consume more.

The only problem is that asset prices are just numbers in a ledger until you liquidate the asset. You need real money to consume and pay down debt. The worst scenario would entail your debt-service costs rising faster than your income – this leads to a sharp curtailing of other expenses to reduce the onerous costs of debt. This scenario isn’t that far-fetched. Anyone with an adjustable rate mortgage or sizeable credit card debt should think long and hard about what could happen.

If the Fed really takes the bunch bowl away by raising – say – by 150bp over the next 12 months people with adjustable credit terms will find that E-Z financing can quickly turn into E-Z bankruptcy. While the press tells us that consumers are getting more bang for their (debt service) buck

[…]thanks in part to lower interest rates, monthly debt payments consume a smaller share of monthly income today than in late 2001.

we shouldn’t forget that this doesn’t mean that people are actually saving money. Consumers have simply adjusted the amount of principal upwards!

To sum it up: while Eurozone consumers are saving more and spending less, US consumers are borrowing more and spending more. The US private sector has kept the economy afloat over past years – albeit at the cost of rising exposure to the vagaries of the financial markets. Households have turned into mini-banks who have to manage their assets and liabilities in such a fashion that they remain solvent. Let us hope that they’re up to the task!

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