An expansion bought on credit
Financial Times, May 3, 2001

Will the American consumer's willingness to borrow and spend finally be the downfall of the economy? The Organisation for Economic Co-operation and Development, in its Economic Outlook on Thursday, investigates whether overindebtedness in the US is a risk to the global recovery. While there are some worrying signs, US households are not in such bad shape as some measures might suggest.

The US consumer binge was fuelled by debt. Consumer credit grew by nearly 10 per cent last year alone. The percentage of disposable income spent on servicing debt has risen consistently over the past eight years; total household debt is now over 100 per cent of disposable income, from less than 70 per cent in the early 1980s.

However, the rise in debt over the latter part of the past decade was more than matched by an increase in wealth.

The ratio of household liabilities to net wealth fell over the late 1990s, though it has risen recently as a result of equity declines. In short, households are less liquid than they were in the mid-1990s - but are still just as solvent.

In judging the risks to the US economy, then, the issue is not the level of personal debt. It is that this debt makes the US vulnerable to further falls in asset prices, which would cause a sudden deterioration in household balance sheets. Individuals might then start saving to rebuild their assets, and the resulting fall in consumption could threaten recovery.

How real is this threat? Equities have already suffered a major correction. And the housing market - which has a much greater effect than the stock market for the vast majority of Americans - so far looks stable. Despite a steep rise last year, the ratio of house prices to incomes is at a historically low level. Housing market activity in the first quarter of 2001 was robust.

If the labour market continues to deteriorate, though, falling incomes could start to force individuals to realise some of their assets in order to meet their debt repayments. If this were to happen on a large scale, then asset prices could become depressed, worsening the debt picture further and leading to the much-feared consumer retrenchment.

So far, the US is nowhere near the kind of slowdown which would be needed to trigger this vicious circle. Instead, the US Fed's generous interest rate cuts are allowing consumers to carry on their binge.

But here lies a problem. If the US economy's recovery relies on continued consumer spending, and if spending relies on even more borrowing, then indebtedness will continue to rise. Americans can pay their debts now; but if their behavior does not change, then they may not be able to pay in the future.