Yesterday, the Federal Reserve reported that the amount of outstanding consumer credit fell by $3.5 billion in October. As shown in the graph below (from http://www.calculatedriskblog.com/), declining consumer credit is a very unusual occurrence, particularly on a year-over-year basis.
However in this downturn, consumer credit has been down in 12 of the last 13 months, and is now 3.6% lower than a year ago. The previous record year-over-year decline was back in 1991 at 1.9%.
These numbers are not adjusted for inflation, so comparing the current declines, or even the rate of increase during the early years of this century to the rates in the 1970’s and 1980’s is a bit misleading. Consumers are trying to repair their balance sheets, and one of the best ways to do that is not take on more debt (and pay down the debt that you do have).
That is counterbalanced by people who are being forced to take on new debt due to unemployment or reduced earnings due to reduced hours. OK, perhaps “forced” is too strong a word, but if people see the reduced income as temporary (i.e. they will get a new job soon), then using debt to smooth out your current income to more nearly match your permanent income level is a rational thing to do. After all, we all probably have commitments for ongoing spending that we could cut if we absolutely had to, but could be costly to do in the short term if we were going to start them up again shortly.
A classic example among the more well-heeled set would be a country club membership. You pay a big initiation fee, so resigning your membership just because your current income is down for a few months would not be an economically rational thing to do. But if you knew your income would be lower forever, well then perhaps you would learn to play on public courses.
College tuitions would be a similar case. You don’t make your kid drop out of the private school they are going to and transfer to an in-state public school right away, but if you knew your income were not coming back you might consider it.
Consumer credit comes in two basic flavors — revolving and non-revolving. (Real estate-related debt like mortgages are not included in this report.) Revolving debt is basically credit card debt, and non-revolving debt is for things like car loans. Revolving debt has fallen by much more than non-revolving over the last year or so.
Since the peak at the end of the third quarter of 2008, revolving debt has declined by 8.9% to $888.1 billion from 975.2 billion. On the other hand, non-revolving debt is down by just 0.5% to $1,594.8 billion over the same time period. In October, credit card debt fell by 0.77%, or at an annualized rate of 8.9%. Non-revolving debt on the other hand increased by 0.22% or an annualized rate of 2.7%. Auto loans are one of the big parts of non-revolving credit, and the pick up in auto sales has probably contributed to the increase in non-revolving credit.
Part of the reason for the difference is that the big credit-card issuers like American Express (AXP) and Capital One (COF) have been actively trying to cut their exposure to potential losses on bad debt by reducing credit limits and raising the minimum monthly payment.
Over the long term, that is a good thing for consumers, since consistently paying just the minimum on your credit card balances is a good way to sell yourself into debt slavery. However, it is probably painful for many right now. Those that have the ability to do so should pay off their balances as quickly as possible. Since credit card debt is not tax deductable, the money you save in interest costs avoided is the equivalent of earning a tax free return.
It is also risk-free. I know of no other tax and risk free investment that is yielding anything close to the 18% or more that many people pay on their card balances. Buying any stock or bond (outside your 401-k or IRA) while you have an outstanding credit card balance is, in a word, STUPID.
It should be noted that the decline in credit was well below the $9.3 billion decline that was expected, and the decline in September was revised to a decline of $8.8 billion from the original estimate of a $14.8 billion decline. Over the long term, given the state of the consumer balance sheet, a decline in consumer credit is a good thing.
Oh the other hand, credit is a vital part of consumer spending — less credit, less spending. Thus, as it declines it slows the economy in the short term. It is, in effect, similar to an increase the savings rate in that regard (taking out a loan is a form of negative savings). In the long term, it is imperative that the savings rate go up, but in the short-term it hurts.
Read the full analyst report on “AXP”
Read the full analyst report on “COF”
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