Bankruptcy

Consumer Spending

By Elizabeth Warren

As the country contemplates a recession, economists are wringing their hands over a slow-down in consumer buying.  About two-thirds of the economy is driven by consumer purchasing.  Without that engine, economists fear that the economy will be in serious trouble.

But I haven't read much about the role that debt will play in slowing down consumer spending--recession or no recession.  The staggering debt burden that American families are carrying should have everyone worried.  The math is easy:  Every dollar that goes to paying interest is a dollar that is not used to buy socks or movie tickets or double lattes. 

The debt service ratio estimates the proportion of after-tax income that families spend on mortgages and consumer debt.  That ratio rocked around 10-11% for the early 1980s, then it began to climb. Since the second half of 2005, despite record low interest rates, the ratio has remained above 14%.  That's about a 30% increase in the amount of income consumed by debt payments alone.

The reason debt service has grown isn't hard to figure out.  From 1990 to 2004 alone, Americans shifted from owing about 86.2% of a year's disposable income to owing 105.1% of their disposable income.  We don't have the numbers yet, but no one thinks the debt load shrank from 2004 to 2007. 

An increase of three percentage points in the debt service ratio may not sound like much, but that's an additional $3 taken out of every $100 of after-tax income just to make interest payments.  It has the same effect as taking a 3% pay cut.

The rise in the debt service ratio is remarkable for another reason.  From 1980 until 2007, the proportion of two-earner families increased dramatically.  Inflation adjusted wages for a fully employed male did not rise, but a second income pushed up median family earning throughout this period.  As families earned a second income, we might have expected that the proportion of total income that went to debt service would fall.  Instead, the debt burden ratio rose even faster, consuming a larger share of the couple's combined larger income. 

Consumers may or may not cut back on spending because they are glum about the future.  But at some point, psychology doesn't matter and hard economics take over.  Families face a relentless drain on their incomes, spending more every month on interest payments.  Sooner or later, more interest means fewer lattes--and more worried economists.

Full post as published by Credit Slips on January 15, 2008 (boomark / email).