Winner of the New Statesman SPERI Prize in Political Economy 2016

Monday 11 January 2016

Personal debt

A simple point, not very deep or constructive

This earlier post, which has been followed by pieces in the financial press saying similar things, was meant as an antidote to alarmist popular commentary that you can find all over the shop (except the financial press). It was not meant to imply that there are not serious issues to consider in a more thoughtful way around personal debt. (For more discussion on some of these articles, see here.)

There is a view, that some economists hold, that in aggregate we are highly unlikely to ever get a situation where there is too much personal debt, because on average people will not take out more debt than they can afford to pay back. That does not mean that personal debt is always at its optimal desired level, because there are various reasons why people may be unable to borrow as much as they should be able too. [1] But it means aggregate personal debt is either at or below its optimal desired level. There is no reason why an economy can have too much personal debt. (Banks can have too much leverage, but that is different.)

As I said, that is a view that some economists hold. It is not my view, for various reasons, some better than others. First, calculating how much debt you can afford to take out is very very difficult, and as a result there is no reason why on occasion people in aggregate might not be systematically too optimistic. This is obvious to non-economists, but for economists I would say: Friedman’s Billiard player analogy does not hold here because in life we only get to play one game. To put it another way, although I believe rational expectations are the best starting point for analysis, that does not mean we should never look at the possibility of departures from it. Second there may be deep reasons why the young may on average be over optimistic. A third possible reason explored by some is that a widening distribution of income may encourage people to take out too much debt because they aspire to keep up with others. A fourth, which may be a combination of the above, is that debt can be systematically missold, as we discovered in the subprime crisis in the US.

For these reasons I think it is interesting to ask how much personal debt there should be in the economy if people were totally rational and their borrowing was unconstrained, and compare that to how much debt there actually is. Macroeconomic theory tells us this is a tricky calculation to do. Many people will be in debt for what we might call ‘life cycle reasons’: they are students with a loan, or the young(er) household with a mortgage. In other cases people may be borrowing because times are bad (they have become unemployed), but they expect/hope they will get better. So to do the calculation we need a lot of information about the distribution of income over time. (I do not know of any study that tries to do this, so if you do please let me know.)

But at present it is even more complicated than that. This was brought home to me when I saw a chart showing a tight correlation between household debt and car purchases, but I’m afraid I cannot find it again so instead I’ll have to fall back on something more personal. I’m lucky enough to be able to afford to buy a new car when I need it using cash. Yet when I bought my current car, the dealer insisted I took out a zero percent loan with the manufacturer. Although nominal interest rates on the liquid assets I hold are very low they are still not negative, so why turn down an interest free loan?

So I am in debt, because in effect the car manufacturer wanted to lend me money for free. I suspect they saw it as another way of making their car more attractive, and if I was a microeconomist I would probably have fun speculating why they preferred that to just cutting the price. But the point was it made me part of the ‘personal debt time bomb’! I didn’t fall into either of the categories I outlined above, but I was in debt because of the competition strategy of car manufacturers.

This is another reason why aggregate personal debt may be above the level that an economist might think of as reasonable, but the reason for it is utterly benign. It is a danger to no one, as those taking out the debt have the liquid assets to pay off that debt immediately. I’m afraid my conclusion is that any good answer to the question 'is there too much personal debt' is bound to be very complicated.

[1] These credit constraints may change over time, as the financial sector evolves, as I have discussed elsewhere. This means that rising debt income ratios may tell us that credit is getting easier because people are becoming less (unnecessarily) credit constrained, rather than because they are borrowing too much.    


  1. Interesting that today Mises had an article on the US car debt bubble suggesting that it might be about to pop. In today's world we have interesting problems with peer pressure, the need to show and the onslaught of very clever marketing. Hyperinflation could be a fix, what worries me is that people might actually vote for it.

  2. "... the car manufacturer wanted to lend me money for free".

    But they didn't, did they. They're capitalists. So it's pretty obvious that the reason that they offer this is that it's more profitable for them to do so. I have no idea of the details, but I suspect that the reason they can do this is because your straightforward purchase has been financialised - so in some way additional profits can be made by off-shoring or tax evasion - most likely at the expense of the UK tax authorities. Maybe somebody else can provide the details.

    I have great respect for you, but I'm surprised if you didn't know about this kind of thing. And then why you would go along with it. The dealer might insist, but I doubt that they would have turned down cash. It might cost you a little more money (the interest on the cash presumably) but why would you go along with this farago? Except for the same reasons that people still buy from Amazon.

    1. Oh dear. You have no idea why the manufacturer was offering interest free credit, but you expect me to make myself worse off because the reason must be to do with a tax dodge.

  3. Now this discussion is very interesting to me. I wonder at the focus on aggregate debt levels though. All four listed reasons concern too much debt among particular subgroups; young people, poor people, gullible people. So why care about aggregate debt levels at all? Surely a far more profitable line of inquiry would be to focus on debt levels within these groups.

    Mian and Sufi who wrote House of Debt make a compelling case that poor households were very much the focal point of the debt problems of the recent great recession in the US. Aggregate debt is presumably correlated with debt levels in the risky subgroups but it seems like a sloppy method for measuring the latter.

    Or have I missed something?

    1. For what it is worth, I think you are absolutely correct.

  4. Isn't the question of "too much debt" not just about what is rational for the individual, but also about whether high overall debt levels carry an externality in that they potentially increase the sensitivity of private expenditure to shocks?

  5. My extended family is a good example of both situations.
    My parents have a car "on credit" for similar reasons to you.
    I'm carrying some credit card debt, rolled over to "0% offers" that I believe I can repay when the time comes out of expected income - but as part of a small business, the income is definitely not guaranteed - and indeed at some level it is dependent (amongst other things) on Osborne not breaking the economy again.

  6. " I’m afraid my conclusion is that any good answer to the question 'is there too much personal debt' is bound to be very complicated."

    Yes , we need to do more studies on this. Maybe we'll have the answer in another decade or so.

    Meanwhile let's crank open the credit spigots again. The 1% are itching for another round of asset-stripping !


  7. I really believe that all economists could learn about economics of the real world if they have a stint as a loan officer, tax preparer for a year and then follow it with foreclosure officer position.

    I was a loan officer and tax preparer where i got an important experience that helped me greatly with understanding financial economics.
    It is not a level of personal debt, it is all about changes. It is about fluid not static matter on personal debt. Did wage fall or rate rise with subprime, health or mariage issue that caused extra expenses not forseen. Conditions of borrowers at the time of taking the debt on can change, and that makes the problem of too much personal debt.

    USA used to have the solution for such cases where unforseen change of borrowers can solve the problem of debt without alienating the property that was colateralized.
    As banks creates credit they have to erase it as debt is payed off. When debtor becomes unable to keep with payments a bankrupcy judge can allow banks to erase the debt without destroying the money. Banks does not have to strugle with selling the reposesed property while getting rid of liability and owner keeps the property. Banks allready lost the income from interest when borrowers stoped paying, there is no loss there either way. Both sides do better in this process and that is proverbial free lunch often mentioned in economics but never specified, allowing borrower to start over and not punishing borrowers kids for failings of a parent.

    Free lunch is personal and corporate bankruptcy when conditions force it.

  8. If you think private debt isn't a huge problem, then you struggle with the dynamics.

    The problem is when the flow becomes insufficient and then the whole thing quickly collapses like a house of cards.

    I've no idea whether the the government's policies will affect things before 2020. The dynamics are too complex and they haven't yet managed to make anything of note stick.

    Like last time they seem to be spending a lot of time talking about doing something without actually doing very much.

  9. I will also note, that the EU Referendum is coming up and the Chancellor probably wants a climate of pessimism and fear, with risks overestimated.

  10. rates of changes in the supply , and the demand, for economic resources in the economy are surely affected by the aggregate of the outstanding debt of the participates in the economy are they not.

  11. The car salesman was on a commission from the finance company

  12. That information about compulsory zero interest loans for car purchasers is interesting. There has to be some sort of cross subsidisation going on there. SW-L hasn't figured it out, and nor have I.

  13. There are a couple of other factors to consider which might make you worry a little more about the debt build up:

    1) Liquidity risks from the fixed nature of debt repayments. Highly indebted households are more vulnerable to unanticipated changes in circumstances: a holiday can be postponed but the credit card or mortgage still needs to be paid.

    2) We should consider not just the level of debt but also its rate of increase. The household savings ratio has fallen steadily since 2010 and is now at an historic low. When this trend reverses it will reduce demand and growth.

  14. The financier takes an excellent quality asset (your debt) in exchange for a sharply depreciating asset (a new car) and seller possibly books profit and? Motability is an interesting business model BTW.

  15. Yet another good blog: Doesn't dramatic increase in pension participation from automatic enrolment also suggest rational expectations is a poor description of longer-term financial management?
    PS Doesn't Friedman's billiard player ignore many evolutionary reasons why humans may become innately good at spatial tasks?

  16. I would take issue with "utterly benign ... danger to no one". There is a *reason* (besides simple pricing model) that makers force dealers to "insist", and that is "long(er) term financial relationship". People solvent today may not be tomorrow (some probability, even for you), and then they've got you. Also, even supposed "zero-interest loans" are assets for the holder, right? Because there is always the possibility over time of changing the terms, either by the original holder, or by a servicer, or by a buyer of the loan.

  17. Recent car purchase internet search revealed lower price with dealer finance than straightforward full cash purchase!

  18. Doesn't bankruptcy law guarantee over indebtedness? Moral Hazard, I can always walk away if my fortune declines because of a bear market. Also, if monetary authorities assure that rates will be low for almost ever, shouldn't I borrow to the hilt like a real estate investor to maximize my net worth? I mean, if I can't trust Greenspan and Bernanke, then who?

  19. Zero-interest finance is not free. We pay for it through providing personal data that has a market value. This is the model that has made billionaires out of 'free' aps.

  20. During the housing bubble, it appeared to me from the inside that the mechanism for ordinary people taking on too much debt was their reliance on agents. Because the calculation is too difficult for most, they rely on expert representations that the proposed deal is do-able. Then they commit. Meanwhile for someone who could do the math, and many did, it was clear the deal was equivalent to a transfer of net worth from the borrower to the lender.

    It seemed that if we retain any pretense toward "efficient markets" we SHOULD be able to rely on the advice of agents in situations like this. Regulation should solve this problem, and equity suggests unwinding the deals to the benefit of the borrowers was desirable.

    But anyway, this is how it appeared people ended up with to much debt, by bad agency.

  21. There is something missing from all this - asset prices. People think they can afford the debt - not because they can pay it back from income, but because they have an asset they could sell to pay off the asset. But the inherent price of some assets (especially urban land) is difficult to calculate and subject (especially at low rates of discount - i.e. nominal interest rates) to wild swings. Or do bubbles never happen?

  22. Zero-interest loans: Check the fine print. I was offered the chance to finance some care repairs with a 0% APR loan. I thought, sure, why not, until it came time to sign the papers, and there was a mandatory fee for an "insurance policy" on the debt that amounted to an 8% rate of interest. What exactly do they think interest is, if not an insurance policy for default?

    Anyway, exercise caution and when modeling the economics, keep in mind that, as with the no-free-lunch argument, businesses are a lot better at making costs opaque than eliminating them.


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