Debt, Delinquencies, and Consumer Spending Jonathan Mccarthy

February 1997 Volume 3 Number 3 Debt, Delinquencies, and Consumer Spending Jonathan McCarthy The sharp rise in household debt and delinquency rates over the last year has led to speculation that consumers will soon revert to more cautious spending behavior. Yet an analysis of the past relationship between household liabilities and expenditures provides little support for this view. Analysts forecasting the course of the U.S. economy reflecting the fact that mounting delinquencies prompt pay close attention to consumer spending. Because per- lenders to tighten consumer credit. sonal consumption expenditures make up about two- thirds of the country’s gross domestic product, factors Interpreting Household Debt and Expenditures that could influence consumer spending can have sig- One can construct two very different hypotheses to nificant effects on the economy’s health. Among these explain the increased indebtedness of U.S. households factors, the sharp increase of household indebtedness and its effect on spending. The first hypothesis— and the rising share of income going to payments on which underlies current concerns about a retrench- credit cards, auto loans, mortgages, and other house- ment in spending—suggests that households have hold loans have recently caused some concern. Could taken on too much debt in recent years, placing them- rising debt burdens precipitate a significant cutback in selves in a precarious financial position. Over time, spending as apprehensive consumers take steps to sta- these households will recognize that their indebted- bilize their finances? ness has made them more susceptible to financial distress in the event of a serious illness, job loss, or other To determine whether such concerns are justified, misfortune. As a result, they will seek to reduce their this article investigates the historical relationship vulnerability by paying down debt and decreasing between household sector debt and consumer spend- their expenditures. ing.1 The article analyzes correlations between debt and spending in U.S. aggregate data for the past three According to an alternative hypothesis, however, decades and presents some statistical tests of this rela- households have willingly assumed greater debt in tionship. Overall, the evidence suggests that a rise in recent years because they expect their incomes to rise. household debt is less likely to be a portent of reduced They spend more in anticipation of increased earnings consumer spending than a sign of increased optimism and they finance their higher spending through debt. about income prospects. The article also examines Even if their incomes begin to fall, households may whether high delinquency rates—another striking continue to increase their debt to maintain their spend- development in household finances in the last year— ing—albeit at a reduced level—on the assumption that are associated with lower consumer spending. The data the income decline will be short lived. Only if the do show a historical link between these two variables, decline proves to be long lasting will households cut but the relationship appears to be an indirect one, expenditures further and begin to pay down their debt. CURRENT ISSUES IN ECONOMICS AND FINANCE To appreciate the difference between these two which account is most consistent with the historical hypotheses, consider how they account for consumer relationship between debt and spending. behavior in the early 1990s. The first hypothesis would hold that consumer spending fell during the 1990-91 How Debt and Expenditures Are Related: 1962–96 recession and could recover only sluggishly because First, what do the data reveal about the magnitude of households were reacting against their accumulation of the current household debt burden? Debt levels rela- excess debt in the late 1980s. The second hypothesis tive to income have reached record highs recently, would hold that consumer spending and debt fell because surpassing their earlier peak in the late 1980s.2 the 1990-91 recession and the subsequent slow recovery Nevertheless, interest rates are lower now than they lowered household expectations of future income. were in this earlier period, effectively reducing the current debt burden relative to that experienced by house- Because both hypotheses offer plausible interpreta- holds in the 1980s. A measure that adjusts for the tions of consumer behavior, we turn to actual data on effects of interest rate changes is the ratio of debt ser- household liabilities and expenditures to determine vice payments to disposable income estimated by the staff of the Federal Reserve Board of Governors. This ratio consists of scheduled payments on mortgages, Chart 1 credit cards, auto loans, and other household loans as a Debt Service Payments Ratio percentage of income. By this measure, the current Percent debt burden falls below its peak in the late 1980s, but 18 it has been rising rapidly since 1994 and has now reached 17 percent, a relatively high level (Chart 1). 17 Thus, even when interest rate effects are factored in, the debt burden may be large enough to validate the concerns of those who believe that it will lead to a cut- 16 back in consumer spending. An initial analysis of the aggregate data3 from the 15 early 1960s through the first quarter of 1996, however, provides contrary evidence. If it is true that consumers respond to high levels of debt by reducing their liabili- 14 197173 75 77 79 81 83 85 87 89 91 93 95 ties and hence their consumption, then we would expect debt to slow before or at the same time as spending Source: Board of Governors of the Federal Reserve System. slowed. The trends depicted in Chart 2 show instead Notes: The debt service payments ratio refers to scheduled payments on that spending slows before debt slows, most obviously mortgages, credit cards, auto loans, and other household loans as a percentage 4 of disposable personal income. Shading denotes recession periods. in the years since 1974. This pattern is consistent with Chart 2 Debt Trails Consumption Year-over-year percentage change Year-over-year percentage change 10 18 Personal consumption Debt expenditures 8 Scale 16 Scale 6 14 4 12 2 10 0 8 -2 6 -4 4 1962 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 Sources: Board of Governors of the Federal Reserve System, Flow of Funds Accounts; U.S. Bureau of Economic Analysis, National Income and Product Accounts. Notes: Debt is total household financial liabilities. Shading denotes recession periods. FRBNY 2 our second hypothesis, which predicts that households quent periods. In the estimated model, however, spend- will begin to reduce spending when income falls, but ing on durables appears to rise following an unexpected will decrease debt only when the income decline proves debt increase.7 Now consider the effect of an unex- to be long lasting. pected increase in spending on debt (Chart 3, right panel). Such an increase could be construed as a sign of A more rigorous test of the two hypotheses utilizes a optimism about future income. If this optimism leads statistical model relating expenditures and the financial households to spend more and to take on more debt— status of households. Each equation in the model pre- our second hypothesis—then an unexpected spending sented here relates one of four variables—assets, debt, increase in one period should cause debt to rise in sub- spending on nondurables and services, and spending on sequent periods. This is precisely the pattern observed 5 durables—to past values of all four variables. in the model. Overall, the model simulations suggest that there is little reason to expect that current debt burdens will trigger a decline in consumer spending. Overall, the model simulations suggest Nevertheless, while this analysis does not support that there is little reason to expect the more alarmist view of debt, it does not necessarily that current debt burdens will trigger preclude the “common sense” notion that higher house- a decline in consumer spending. hold debt burdens will cause households to reduce their spending. First, debt may amplify the effects on spending of more fundamental economic forces such as mon- etary policy rather than drive consumer spending in its Consumer spending is divided into durables and non- own right. If so, the sequence in which debt and spend- durables because the financial condition of households ing changes occur may provide little information about is likely to affect spending for big-ticket durable goods the direction of causation between these two variables.8 such as automobiles and furniture more dramatically Second, debt burdens may have to reach some threshold than spending for nondurables. The model is simulated before they have a negative effect on spending. Finally, to identify how a one-period unexpected increase in one common measures of the household sector’s debt bur- variable affects all the variables of the model over time.6 den, such as the ratio of debt service payments to income reported in Chart 1, may not provide accurate Consider first the effect of an unexpected increase in information about the extent of household financial debt on spending (Chart 3, left panel). If high debt bur- distress if the “average” household is not typical of dens move households to reduce their expenditures as households constrained by their financial condition. one way of strengthening their balance sheets—our first hypothesis—then an unexpected debt increase in This last possibility opens up another issue for one period should cause spending to decline in subse- investigation: namely, whether a relationship exists Chart 3 Simulations of Durables Expenditures and Debt Percent Percent 1.5 1.5 Response of Expenditures to Debt Increase Response of Debt to Expenditure Increase 1.0 1.0 0.5 0.5 0 0 -0.5 -0.5 0 2 4 6 8 10 12 14 16 18 20 0 2 4 6 8 10 12 14 16 18 20 Quarters after debt increase Quarters after expenditure increase Source: Author’s calculations.

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