US consumers are cutting debt but not by mending their ways through thrift but via the benefit of default.
Recently, the International Monetary Fund (IMF) Managing Director Dominique Strauss-Kahn said that American consumers remained the engine of world growth and the OECD said household debt as a ratio of disposable income, had reached at least 120% of disposable income in UK, Canada, the US and Japan by the time the financial crisis struck in 2008. The UK household debt in 2007 was 176% compared with 70% in Italy, 130% in the US in 2008; 95% in Germany and 93% in France. Ireland isn't included in this category but last year, Goodbody chief economist Dermot O'Leary put Ireland's level at 176% - - one of the highest in the world.
The Federal Reserve reported last week in its flow of funds statement that US household debt contracted at an annual rate of 2½% in the first quarter, the seventh consecutive quarter of decline. Home mortgage debt fell at an annual rate of 3¾%, a significantly faster decline than in the fourth quarter, while consumer credit contracted at an annual rate of 1½%.
The Fed report showed that at the end of March, the average US household’s total mortgage, credit-card and other debt stood at 122% of annual disposable income, meaning it would take a bit more than 14 months to pay it all off if everyone stopped spending money on anything else. That's an improvement compared with the first quarter of 2008, when the debt-to-income ratio stood at 131%. A level of 100% is viewed by economists as reasonable.
The Wall Street Journal in an analysis says the falling debt burden conjures up images of a nation seeking to repent after a decade of profligacy, conscientiously paying down mortgages and credit-card balances. It concedes that this may be true in some cases, but it’s not the norm. In fact, people are making much more progress in shedding their debts by defaulting on mortgages and reneging on credit cards.
The Journal says since household debt hit its peak in early 2008, banks have charged off a total of about $210bn in mortgage and consumer loans, including credit cards. If one assumes that investors suffered at least that much in losses on similar loans that banks packaged and sold as securities (a very conservative assumption), then the total -- that is, the amount of debt consumers shed through defaults - - comes to much more than $400 billion.
However, that’s more than the concurrent decrease in household debts, which amounts to only $372bn, according to the Federal Reserve. That means consumers, on average, aren’t paying down their debts at all. Rather, the defaulters account for the whole decline, while the rest have actually been building up more debt straight through the worst financial crisis and recession in decades.
The Journal says in a sense, people who default on onerous debts - - including the “strategic defaulters” who still have jobs and could pay - - are doing the economy a favour. They’re freeing up cash to spend on other things, which can boost demand and give companies the confidence they need to start hiring again. If everybody just hunkered down and tried to pay their insurmountable debts, America may still be in recession. Defaults are bad for the banks, but taxpayers already covered the cost of the losses through federal bailouts.
The Journal says the bigger question, though, is what America as a society will learn from the experience. The lesson seems to be that the way to get ahead in the world is to take huge risks - - buy a house you can’t afford with no money down, or invest huge amounts of borrowed money in risky loans - - but let somebody else pick up the bill if things go wrong. As the growing US federal debt demonstrates, that’s not a sustainable way to run an economy.
Richard H. Thaler, a professor of economics and behavioral science at the University of Chicago, said in The New York Times last January that a family, which financed the entire purchase of a $600,000 home in 2006 could now find itself still owing most of that mortgage, even though the home is now worth only $300,000. The family could rent a similar home for much less than its monthly mortgage payment, saving thousands of dollars a year and hundreds of thousands over a decade.
Thaler said some homeowners may keep paying because they think it’s immoral to default. This view has been reinforced by government officials like former Treasury Secretary Henry M. Paulson Jr., who while in office said that anyone who walked away from a mortgage would be “simply a speculator -- and one who is not honoring his obligation.” (The irony of a former investment banker denouncing speculation seems to have been lost on him.)
In state such as California and Arizona, where home loan lenders have only recourse to the house, the borrowers pay an extra fee for that facility. So it could be viewed as default insurance.
Prof. Thaler's article from his faculty website: "Underwater, but Will They Leave the Pool?"