US household debt hit a record $16.15 trillion in the second quarter of 2022. Mortgage debt accounts for 75% of the total; College debt another 10%. The rest is mostly auto and credit card debt.
Rising household debt over the past two years is a concern and will become a bigger problem if interest rates continue to rise. More worrying, however, are the consequences. Excessive debt can force people to reduce spending, which will slow economic growth and lead to a recession.
$16 trillion is a big number. But what really matters is the debt relative to what people have to pay back. College debt of more than $100,000 is no big deal for doctors and lawyers who earn many times that amount every year. The situation is very different for teachers who only earn half of what they owe.
From that perspective, things have gotten better lately. Household debt to disposable income fell from 150% in 2009 to 130% in 2016, where it has remained ever since; and household finances improved during the coronavirus pandemic. Consumer debt payments (excluding mortgages) as a percentage of disposable income fell from 13% in 2007 to 8.4% in early 2021. Arrears (debt payments more than 90 days overdue) fell from 3% pre-Covid to below 2% in 2020 and 2021. Covid (which kept people home and reduced spending), low interest rates, and generous government benefits during the pandemic (stimulus checks, child tax credits, and a moratorium on college debt repayments) all contributed.
Also, debt isn’t always bad. Mortgages allow households to buy a home and gain equity as they pay it off. With borrowed money, people can go to college and buy cars. Debt also allows people to get through tough times — a layoff, gig workers getting fewer gigs and non-gig workers getting fewer hours, or any disaster that precludes employment for some time. However, high debts make life stressful and difficult. People worry about evictions, utility shutdowns, putting food on the table and saving for retirement.
Household debt also boosts the economy and creates jobs. But that too is a double-edged sword. Even a small spending cut due to the high level of debt will have negative macroeconomic consequences. Inventories will pile up, companies will cut production and workers will be laid off. Service sector workers receive less income and their appearances or hours are reduced.
Since the 1980s, the main driver of the reduction in consumer spending has been the larger share of total income going to the rich, who save large parts of their income. This leaves less for households struggling to maintain their standard of living. Because low- and middle-income households typically spend almost all of their income, these households have accumulated or become indebted.
But households can only handle a limited amount of debt. While the actual breaking point is uncertain, once that limit is reached, economic outcomes can be catastrophic.
In 2008, the Great Recession began when homeowners couldn’t pay their mortgages. Lehman Brothers collapsed and many other financial institutions were on the brink of bankruptcy. The government bailed out the financial institutions that had caused the problem, but then did little to help households burdened with mortgages they couldn’t possibly pay back. This is one of the reasons why the economic recovery was so weak and it took almost a decade for household income (adjusted for inflation) to reach pre-2008 levels.
A similar problem led to the stock market crash and Great Depression in October 1929. During the Roaring 20s, people bought stocks with borrowed money. When stock prices fell somewhat, calls for margin were raised. Lacking sufficient savings to pay off stockbroker loans, people had to sell stocks to get cash to pay off their loans. This pushed stock prices further down, leading to more margin calls and eventually a market crash. What was happening on Wall Street soon affected Main Street as everyone became reluctant to spend.
While household debt is not yet near a tipping point, four forces will drive the debt-to-income ratio sharply in the coming months.
First, the Federal Reserve has been raising interest rates since the beginning of this year. They plan to continue doing so at least through the end of 2022 (see “The Fed’s Battle with Inflation: A pyrorhic Victory? Or Will the Federal Government Join the Fight?” in the July/August 2022 Washington Spectator). This will raise interest rates on credit cards, college debt, and car loans. We’ve already seen one effect of this – the ratio of consumer debt payments to disposable income rose to 9.5% in the second quarter of this year (from a record low of 8.4% last year).
Second, the majority of household debt comes from housing. House prices increased by 4.5% annually from 1992 to 2019. As of 2020, they have increased by more than 10% per year, resulting in a nearly 40% increase in property prices between 2019 and now. Homes are less affordable today than they have been since June 1989. As the Fed continues to raise interest rates, home prices will begin to fall, leaving some homeowners under water. Similar to the Great Recession, many will default on their mortgages and lose their homes.
Third, President Biden recently announced that the college debt moratorium would end in 2023. This moratorium is one of the main reasons that household debt has been less of a problem during the Covid pandemic. Proceeds not used to pay off college debt were used to pay off other debts, keeping people from going into further debt. When college loan repayments resume in January, many households will struggle to pay their bills and also repay their debts.
Finally, government benefits helped US households during the coronavirus pandemic. These benefits have ended. Families struggling to make ends meet must now rely on high-interest loans (credit cards, payday loans, and auto title loans) to survive.
The good news is that financially troubled households can be helped. First of all, the Fed can stop raising rates before they push the economy over the edge.
A more difficult solution is meaningful bankruptcy reform that allows people to pay off their college debts instead of being squeezed during their working lives and then taking whatever they still owe off their Social Security checks.
Before the Bankruptcy Reform Act of 2005, it was easy and cheap for people to reduce their debt through bankruptcy. This is no longer the case. Now people have to take two credit counseling courses before they can reduce their debt. Many studies have found that these classes are worthless. They don’t change behavior, but they are costly to people who are already deprived of their financial resources. Additionally, delaying bankruptcy protection leads to abuse by creditors and possible loss of home and car.
For many people, bankruptcy is the only way to escape the crushing debt that comes with losing a job, huge medical bills, divorce, and other unforeseen events. The bankruptcy code change is required. To that end, Elizabeth Warren (D-MA) introduced a new bankruptcy bill in the Senate in 2020. It is stuck in committee because it lacks the votes to end a Republican filibuster.
A more liberal bankruptcy law would help, but it doesn’t solve the root problem. People who rack up large debts and then pay them off in bankruptcy court about every six years embody Einstein’s joke about insanity — “keeping doing the same thing and expecting different results.” The root cause of the household debt problem – greater inequality – needs to be addressed. As noted above, if more income goes to the top 1%, everyone else will have to fill the gap by spending more or borrowing more. Failing this, economic growth slows and household debt becomes more of a problem – not because of more debt, but because of less income to pay back that debt. That’s why higher taxes for corporations and the wealthy, and more generous spending programs (such as reviving eligible child tax credits and increasing Social Security and Medicare benefits) are needed. It’s for the good of the economy and the nation.
If no action is taken, household debt will continue to rise. And it threatens to rise to the point where it breaks the backs of American households and the US economy.
Steven Pressman is part-time Professor of Economics at the New School for Social Research, Professor Emeritus of Economics and Finance at Monmouth University, and author of fifty great economists, 3rd edition (Routledge, 2013).