As Economy Thrived Under Greenspan, So Did Debt

The benchmark federal funds rate, the overnight rate on loans between banks, influences many other longer-term rates in the economy, including those on mortgages, car loans and business loans. Low interest rates encourage consumers and businesses to borrow and spend, stimulating economic growth.

The Fed's rate cuts had little effect on corporate America, which had overinvested in equipment, software and factories during the late 1990s boom; businesses retrenched, slashing both payrolls and spending plans, tipping the economy into recession from March through November of 2001.

But low interest rates worked like an intoxicant on consumers, who snapped up new cars and trucks with no-interest loans and seized on low mortgage rates to buy new homes and refinance old home loans. Those sales and refinancings freed up more cash to spend. Households used much of that extra money to pay off credit cards, student loans and other, higher-interest rate debt -- "cleaning up their balance sheets," in economists' terms. They also kept shopping through the recession, the terrorist attacks and the rocky economic recovery that followed.

The tonic worked. Household spending rose in 2001, 2002, and 2004, even as the wealth and income of the typical household fell or remained flat in the same period, according to an analysis by Moody's Economy.com. The recession was one of the mildest on record. The economy has been growing since November 2001 and was strong enough by mid-2004 for the Fed to start raising the benchmark rate.

Fed officials expected then that longer-term rates, such as mortgages, would rise as well, causing consumers to borrow less and save more.

But it didn't work out that way. For several reasons -- low inflation, economic stability and foreign investors pouring their savings into U.S. stocks, bonds and other assets -- long-term interest rates fell for a year after the Fed started raising the benchmark rate and have stayed relatively low.

Mortgage rates also fell, prompting homeowners to refinance repeatedly. Changes in the financial industry made it easier for homeowners to tap their home equity through refinancing. Lenders provided adjustable-rate mortgages that enabled home buyers to pay higher prices while temporarily making low monthly loan payments.

The housing market kept booming. Consumer debt and spending kept climbing.

Living With the Debt

Many households are happy with the results. Homeownership climbed above 69 percent in late 2004, which means millions more people gained a store of wealth that can grow and be available in hard times.

And home values have skyrocketed, pumping up household wealth to a record $51 trillion in the third quarter, according to Fed data.

But household debt rose faster in recent years than wealth or disposable income, reaching an unprecedented 126.1 percent of after-tax income in the third quarter, double its 1980 level.

All this debt isn't straining households so far. Late payments on credit card loans and other forms of consumer debt declined in the third quarter, the American Bankers Association reports. Although delinquency rates probably rose in the last three months of the year because of the delayed effects of the hurricanes, those rates are likely to fall this year because of the strong economy, said ABA chief economist James Chessen. "I think it will be a pretty good year for consumer debt and the ability to pay your loans," he said