Unwinding the Credit Boom

By Robert J. Samuelson
Wednesday, August 23, 2006

We are at the end of the credit boom -- certainly the six-year boom and maybe the 60-year boom. Has any society ever created so many ways for people to go into hock? In 2003 Americans had 1.46 billion credit cards, or five per person. Home mortgages total $9 trillion, and some initially don't require borrowers to repay all their annual interest. In 1946 households had 22 cents of debt for each dollar of disposable income. Now they have $1.26. Behind these numbers lies a profound social upheaval: the "democratization" of debt. Everyone gets to borrow. But this process may have reached its limits.

Although Americans are routinely stigmatized as credit junkies, that's unfair. Of course some people overborrow, and some financial institutions lend abusively. Still, the democratization of debt has generally been a good thing. Millions of families can now borrow for college, cars and clothes. The biggest boon has been the expansion of homeownership, up from 44 percent of households in 1940 to 69 percent today. (Three-quarters of household debt consists of mortgages.) At heart, Americans' appetite for credit reflects national optimism. We presume that today's debts can be repaid because tomorrow's incomes will be higher.

The origins of today's credit culture date to the 1920s and the advent of installment lending for cars and appliances (stoves, refrigerators, radios), says economist Martha Olney, author of "Buy Now, Pay Later." Attitudes changed. In the 19th century, "it was thought that only irresponsible families bought on credit," she says. "By the 1920s, it was only foolish families that didn't buy on credit and use it while they were paying for it." In the mid-1920s, 60 to 70 percent of cars were sold on one- to two-year loans.

After World War II credit became part of the mass market. In 1958 Bank of America introduced a credit card that in 1976 was renamed Visa. The combination of aggressive merchandising and government laws prohibiting racial and ethnic discrimination in lending led to a huge expansion of borrowers. One reaction to the anti-discrimination laws was the use of impersonalized, computer-driven credit scores to determine loan eligibility. Now U.S. businesses buy 10 billion FICO scores annually.

Credit is about more than selfishness and impatience. "Once consumers step onto the treadmill of regular monthly payments, it becomes clear that consumer credit is about much more than instant gratification," writes historian Lendol Calder in his book "Financing the American Dream." "It is also about discipline, hard work" -- the attributes necessary to repay the debt and borrow more. Ironically, our optimism feeds our stress.

The trouble is that no society can forever raise its borrowing faster than its income -- which is what we've been doing. Sooner or later debt burdens become oppressive. One reason for thinking we've passed that point is that the last spasm of credit expansion was partially artificial. To soften the 2001 recession -- to offset the collapsed stock market and tech bubbles -- the Federal Reserve embarked on an audacious policy of easy credit. From December 2001 to November 2004, it held its key short-term interest rate under 2 percent.

A real estate bonanza ensued. From 2000 to 2005, housing starts rose by a third. Sales of new and existing homes increased by almost 40 percent. In hot metropolitan markets, prices more than doubled over five years (San Diego, up 109 percent; Washington, up 113 percent). Nationally, the increase was 57 percent. The frenzy depended heavily on mortgages with low interest rates. In 2005 about half of new home loans had variable interest rates (often with low introductory teaser rates) or required only interest payments.

What the Fed giveth, the Fed taketh away. Since June 2004 it has raised short-term interest rates from 1 percent to 5.25 percent. Whether the Fed achieves the vaunted "soft landing" -- an economic slowdown that reduces inflation without causing a recession -- hinges heavily on how the credit boom of the past few years unwinds. If it ends violently, with a crash in home prices and housing construction, a recession could follow. What the Fed wants is a gradual and graceful unwinding.

It's unclear what will happen. Already, housing starts have dropped in five of the past six months. Inventories of unsold new homes have gone from four months' supply a year ago to six months now. Homeowners had taken huge profits by selling their homes or borrowing against higher values; these will probably diminish and depress consumers' purchasing power. Along with high oil prices, these effects are hurting other industries. Last week Ford announced deep production cuts.

This turn of the credit cycle could signal the end of the decades-long rise of personal debt in relation to income. It is not just that debt service -- interest and principal -- is at a historic high, almost 19 percent of disposable income. Credit standards may have been stretched too far. Since 1989 the share of households with debt has risen from two-thirds to three-quarters, reports economist Christian Weller of the Center for American Progress. There are other reasons, too: Much recent debt was contracted at artificially low interest rates, which have risen (or will rise); aging baby boomers will reduce debt by repaying mortgages; and many Americans will replenish their savings.

For years, the democratization of debt stimulated the economy. What happens without that prop? For better or worse, we may soon learn.

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