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.