Household Debt


karen dynan, the U.S. Treasury’s chief economist from 2014 to 2017, teaches at Harvard.

Illustrations by Anthony Freda

Published April 27, 2018


One reason the Great Recession was, alas, great was the quantity of household debt accumulated in the lead-up to the financial crisis. This debt helped fueled a massive housing bubble, the collapse of which wiped out trillions of dollars of household wealth, put millions of borrowers into default and triggered an economy-crippling credit crunch. Hence, over the past decade, the question of how to help households better manage their use of debt has been front and center in the effort to shield the economy from another leverage-fueled implosion.

Economists (and bankers) have long celebrated the opportunities, created by the democratization of lending, that permit Americans to live in their own homes, invest in higher education and “smooth” consumption of big-ticket items like cars and backyard pools. Policymakers were always aware there was a downside in allowing households to expose themselves to added financial risk. But the crisis brought home the possibility of collateral damage — the potential for household debt to wreak havoc in the broader economy. Much, then, is at stake in figuring out how to protect Americans from losing their footing on the debt mountain without limiting their freedom to climb it. Complicating the challenge, the economic environment facing households is changing all the time, bringing with it alterations in the way that households use debt as well as their vulnerability to the risks of debt.

To be sure, the consumer economy doesn’t seem to be heading lemming-like back toward the precipice. Household “deleveraging,” together with some important policy changes that made the financial system less vulnerable to shocks, mean that we are in a much safer place than we were in the mid- 2000s. But memories are short, and financial actors have a way of rediscovering what the Nobel Laureate Robert Shiller dubbed “irrational exuberance.”

Two Sides of the Credit Coin

The ability to borrow can help people move up the economic ladder by investing in education and new businesses. The expansion of credit card lending in the 1980s and 1990s, along with the greater ease with which households could access home equity through lines of credit and cash-out refinancing, meant that more households could avoid big cuts in their spending in the face of temporary income disruptions. Meanwhile, there is evidence that easier access to mortgages has allowed younger households to skip the “starter home” stage and purchase dwellings more in line with their expected future incomes, simultaneously raising their living standards and saving them thousands in brokerage fees in a second round.

But, of course, the opportunities provided by easy access to credit also pose dangers. Bad luck (say, extended unemployment or medical catastrophe) or unrealistic expectations of future income can bankrupt indebted households that might otherwise have weathered the storm. And less-severe financial hiccups can still generate large costs in the form of impaired credit or the loss of a car or a home (and all the equity built up along the way).

The 2008 crisis also illustrated how the collective impact of a million household missteps can affect the whole financial system. When housing prices started to fall, rising delinquencies made it more difficult for new borrowers to enter the market and for existing borrowers to refinance or extract equity. That put additional upward pressure on delinquencies, which cascaded through financial institutions tied to each other through intricate webs of interconnecting liabilities. The rest, as they say, is history.

Could it happen again? Maybe. The more interesting question is why household debt remains a weak link.

Stagnant Incomes

You’ve heard about this before, but not neessarily in the context of financial instability. The figure below shows 1979-2013 growth in two measures of inflation-adjusted income for the average household. Pre-tax income was up 11 percent — a paltry gain when spread over three and a half decades — while income adjusted for both taxes and transfer was up a still-not-impressive 33 percent compared to the gains of the affluent.

The 33 percent works out to an average of just 0.8 percent growth per year. By comparison, GDP per capita grew at an average annual rate of 1.6 percent, while the top fifth of households enjoyed average annual gains of 1.9 percent and the top 1 percent saw average gains of 3.2 percent — four times the rate of our average American household.

In theory, if middle-income households could manage well enough in 1979, they could manage on one-third more income in 2013. In fact, there are good reasons to believe that the tepid growth led more households to spend more than they could afford. For one thing, when the gaps in household income widen, those trailing are tempted to borrow to keep up with the Joneses. For another, households with low income growth may be unrealistic when it comes to their likely future income growth — particularly when they know the economy as a whole is growing much faster. So, they may take on debt with the expectation that it will be easier to pay off than it actually will be. Then, too, there is the contribution of debt enablers: constituents’ disappointment with stagnant incomes may lead politicians to favor easy credit policies that allow households to spend above their means.

Weak Financial Buffers

Related trends arguably compound the likelihood that household debt will prove toxic. Middle-income households have had alarmingly little success in building wealth over the past few decades. As the figure below shows, not only did households in the middle fifth have fewer financial assets in 2016 than they did prior to the 2007-08 financial crisis, they also lost ground compared to the late 1990s!

The most plausible explanation is that relatively weak income growth makes it hard to save for the same reasons it predisposes households to take on more debt. Whatever the reason, though, thinner financial cushions mean that unanticipated setbacks are more likely to make it impossible to make required payments on mortgages, auto loans, credit card debt and the like. 

Work Insecurity

Another trend compounding the risk posed by household debt is that earnings — at least for some people — are less predictable, in part because what economists call “alternative work arrangements” are on the rise. Altogether, the share of the workforce comprising independent contract workers, “on call” workers, temporary help agency workers and workers provided by contract firms increased from around 10 percent in 1995 to about 16 percent in 2015.

Some of these arrangements — like working for Uber or TaskRabbit — have the advantage of allowing workers to set their own hours and to supplement income from other sources. But only about 0.5 percent of the workforce is employed through an online intermediary. Many other arrangements, like working as an independent contractor to provide outsourced janitorial services, are associated with less predictable hours than traditional work.

For households with limited cash on hand, the spread of work with unpredictable hours increases the need for short-term credit — such as so-called payday loans. These loans are expensive, particularly for those with weak credit histories, which makes them tougher to pay off. Moreover, alternative work arrangements generally provide fewer benefits, which could also increase the risk of households overextending themselves. For example, while workers are now guaranteed access to health insurance through the Affordable Care Act, some don’t buy it because their budgets are already strained, leaving them vulnerable to unexpected medical expenses that require debt to finance.

The Rise of Low-Quality Higher Education

Although much has been made of the upsurge in student debt in recent years, most college grads still enjoy a high return on the money they paid. The truly problematic exceptions are concentrated in students who borrow to attend colleges with poor records in terms of future labor market outcomes.

Thinner financial cushions mean that unanticipated setbacks are more likely to make it impossible to make required payments on mortgages, auto loans, credit card debt and the like.

A key contributing factor has been the rapid growth in for-profit higher education. Recent research by Adam Looney and Constantine Yannelis highlights trends in federal student debt at the 25 schools (private nonprofit, public and for-profit) in which students owe the most. In 2000, students in these most-indebted private-nonprofit and public institutions owed $31 billion, while those in the for-profit sector owed just $2 billion. Fourteen years later, debt linked to the mostindebted nonprofit and public schools had risen to $59 billion – a substantial increase. But it pales beside the whopping $108 billion of debt accumulated by students at for-profits that made the top-25 list.

When it comes to repaying student debt in a timely fashion, the problems are not exclusively at for-profit colleges. But Looney and Yannelis find that students at for-profits are less likely to graduate and subsequently suffer higher unemployment rates and lower incomes than their counterparts at other types of schools. Hence there’s no doubt that the ballooning debt created by attending forprofit schools is adding to the risks of household debt default

Cauterizing the Wound

As noted earlier, we not only need to be concerned about the risks of household debt to the economic security of individual households, we need to worry about risks to the broader economy. Here, too, there are trends that bode ill. In particular, there are reasons to believe that it has become more difficult for policymakers to mitigate the macroeconomic fallout from a debt crisis.

The need to avoid another household debt crisis is heightened not only by our declining ability to effectively respond to recessions, but also by developments that mean the longer-term costs of defaults may prove more consequential than in the past.

First, nominal interest rates are historically very low. In part, that is the consequence of aggressive measures to ease credit in the aftermath of the 2008 meltdown. But rates are also low because of a decades-long downward trend in inflation as well as rapid aging of the global population and other factors that have generated a global glut of savings. Rates are now rising a bit as monetary policy returns to familiar territory, but most economists agree that the new normal will be much lower than it was a decade or two ago.

This trend translates into less room for the Fed to cut rates in the next downturn. The Fed pared benchmark rates by more than five percentage points in each of the past three recessions. But, as of early 2018, the median projection of the Federal Open Market Committee (the group that makes Fed policy decisions) called for the rate to remain at less than 3 percent over the longer run. While central banks have developed other tools, such as large-scale asset purchases, for easing credit when policy rates are near zero, some experts are concerned that these alternative tools won’t be up to the task of providing adequate stimulus in a low-rate environment.

A second development limiting the capacity of policymakers to mitigate the fallout from a debt crisis is the high and rising level of government debt. Debt rose during the financial crisis and, under current law, is projected to rise faster than GDP in coming years because of population aging, tax cuts, and ongoing increases in the cost of governmentsubsidized health care.

The sizable fiscal policy response to the last crisis — close to $1.5 trillion in stimulus when all was said and done — significantly reduced the length and severity of the economic downturn. The next time around, already high levels of government debt would likely diminish the appetite of policymakers to deploy fiscal support of this magnitude, in part because of the greater risk that longterm interest rates would move up sharply in response to a large fiscal expansion.

Household Debt Carries a Bigger Wallop

The need to avoid another household debt crisis is heightened not only by our declining ability to effectively respond to recessions, but also by developments that suggest the longer-term costs of defaults will prove more consequential than in the past.

One such development is the dimming prospect for productivity growth, which — while volatile from quarter to quarter — has been trending down. A long post-World-War- II period of brisk growth (averaging 2.8 percent annually) was followed by a slump (to 1.6 percent annually) from the mid-1970s to the mid-1990s, and then a temporary pickup in the late 1990s (to 3.3 percent) with the information technology boom. But in the past 13 years, productivity growth has averaged a very disappointing 1.3 percent.

One contributing factor is the decline in business dynamism. The rate at which businesses are starting up in the United States is on the wane, as is the rate at which firms are failing. While churn in the market is disruptive for stakeholders, lower churn means slower reallocation of resources to more productive uses — as Schumpeter put it, less “creative destruction.” An inevitable consequence is a decline in the share of firms that are young.

Note the malign feedback between productivity trends and financial crises. The widespread loss of access to credit likely to arise from another household debt crisis would restrict the ability of people to invest in higher education and new businesses — not to mention the ability of existing businesses to invest in equipment and R&D.

Still, it’s not all bad news. There is hope despite the gloom described above.

Americans Have Shed a Lot of Debt

The aggregate household debt-to-income ratio is down from a peak of 125 percent in late 2007 to 96 percent now, matching its level in late 2002 before speculation in housing went into warp drive. Thanks to both a drop in the amounts owed and in interest rates, required debt payments as a share of after-tax income are near their lowest level in the 35-plus years the data have been crunched.

While looking at aggregate measures provides insight into where the household sector as a whole stands, it would be a mistake to focus on these measures alone. One of the lessons of the financial crisis is that we should be watching the most vulnerable groups.

But here, too, the news is generally good. Deleveraging — together with the recovery of home prices in many areas — has led to a drop in the share of mortgage borrowers with negative equity from 30 percent at its peak in 2012 to about 10 percent now. Likewise, the fraction of households with required debt-service payments above 40 percent of their pre-tax income was down to 7 percent in 2016, the lowest level since at least 2004. This progress is also reflected in relatively low levels of financial distress, as reflected in the percentage of household debt that is 90-plus days in arrears. This figure has fallen from around 9 percent in 2010 to close to 3 percent today.

Of course, part of the reason most households are on top of their debts is that jobs are now plentiful and incomes have been rising. All of that could change, though — and will in the next recession. Moreover, there are trends in particular categories of debt that warrant concern even under current conditions.

The rapid growth in student debt has made it a much more important part of families’ financial liabilities. It now accounts for about 10 percent of household debt, triple its share in the early 2000s. According to a Fed study, about 43 percent of households with heads below age 40 have some student debt, with close to one-fifth of this debt owed by families making less than $30,000.

The rapid growth in student debt has made it a much more important part of families’ financial liabilities. It now accounts for about 10 percent of household debt, triple its share in the early 2000s.

As noted earlier, the problem is not aggregate student debt, but the sums owed by former students at low-quality higher-education institutions. The challenges facing this group largely explain why the delinquency rate on student debt (in contrast to other household debt) has barely receded since the upturn in employment.

The social consequences of the run-up in student debt are as yet unclear. Most student lending is done by the government these days, and Washington has programs that reduce monthly payments if a borrower’s income falls below a threshold. Such programs reduce delinquencies and the associated damage to credit records. But rather than forgiving portions of the debt, they just increase the time it takes for borrowers to pay them off, leaving them with balances that could impede access to other credit for a longer period. The modest silver lining to the student debt cloud is that, while defaults incur costs for taxpayers, they do not pose the same sort of spillover risk to the financial system or the macroeconomy as was posed by the excessive mortgage lending in 2008.

By the same token, recent years have seen rapid growth in subprime auto lending, with a parallel rise in delinquencies. The trend raises concerns about the welfare of individual borrowers — for many, the loss of private transportation means the loss of a job.

Prudent Banking

The other piece of good news is that the improvement in household balance sheets has been accompanied by positive changes in bank lending policies. Banks are lending more prudently (with lending perhaps too conservative in some areas, but that is a topic for another day). Changes in required bank capital spurred by changes in U.S. law and the Basel III international regulatory framework mean that banks would be much better able to withstand a wave of defaults on household debt than they were a decade ago. Note, too, that government regulators gained experience in the last meltdown that should help them mitigate the pain of the next. In conducting mortgage-market interventions in the last crisis through the Home Affordable Modification Program and the Home Affordable Refinance Program, the government learned valuable lessons about how to design the programs to reach struggling debtors.

The Road Ahead

Thanks to massive deleveraging, most households are not overextended today, and lenders are better prepared to deal with defaults. But all is not roses. Managing credit risk simply by toughening credit requirements seems like the wrong direction to go, given the role of household debt in increasing economic mobility and smoothing consumption. Rather, we should be considering kinder, gentler ways to make sure households are using and managing debt effectively.

Managing credit risk simply by toughening credit requirements seems like the wrong direction to go. We should be considering kinder, gentler ways to make sure households are using and managing debt effectively.

In this regard, the first step is to clean up the policy detritus from the response to the crisis. The mortgage giants Fannie Mae and Freddie Mac were put under the control of the federal government in September 2008. Although the conservatorship was meant to be temporary, it remains in place today. Comprehensive mortgage finance reform, with a greater role for private capital that provides broad ongoing access to mortgage credit without the incentives for excess risk taking, should be a high priority.

We also need regulations for government student loans that hold colleges accountable for the quality of the services they provide. The best idea around is to build on the so-called “gainful employment” regulations put in place by the Obama administration with measures that require all schools to prove they are delivering high-quality services and use broader metrics of student success.

We should also be looking to the private sector for ways to limit the risks associated with household debt. New mortgage products could better protect households when they fall “under water” with their debt — for example, Janice Eberly and Arvind Krishnamurthy propose fixed-rate mortgages that borrowers can convert to adjustable rates, even for loans in negative equity, so borrowers can more easily enjoy the benefits of lower rates when the Fed responds to a downturn.

By the same token, innovations from the fintech realm show promising potential to improve household debt management through, for example, apps that help households better track their income, assets and liabilities. Finally, big data from financial companies can help researchers better understand the triggers for debt problems and what can be done to provide relief once they occur.

Much of the focus of reforms after the crisis has been on giant financial institutions and the incentives that led them to ever-riskier behavior. But household debt deserves a harder look for multiple reasons. Excessive household leveraging was a necessary if not sufficient component in precipitating the meltdown, and the resulting debt overhang made recovery from the recession more difficult. Last but hardly least, the role of household debt in the crisis testified to the reality that the consequences of rising inequality and lagging standards of living can trickle up, destabilizing the larger economy as well as creating misery for millions.

main topic: Fiscal Policy
related topics: Inequality