Considering the Consequences of Consumer Credit Contracting

Yesterday the Federal Reserve announced that consumer credit contracted by a much larger than expected $21.5 billion in July, and that the contraction in June was larger than previously thought.

Consumer credit is broken down into two major types: revolving (mostly credit cards) and non-revolving (personal loans, auto loans etc). Real estate-backed debt (aka mortgages) are not included in this report.

The decline in total credit was at a seasonally adjusted annual rate of 10.4%, with revolving credit down at an 8.0% rate and non-revolving at an 11.7% rate. Given the success of the “Cash for Clunkers” program, the decline in non-revolving credit is pretty shocking. It marks a very distinct acceleration to the downside.

In the second quarter, non-revolving credit was contracting at a 4.8% rate and just a 0.2% rate in the first quarter. The decline in credit card debt actually stabilized slightly. It was falling at a 9.7% rate in the second quarter and a 9.6% rate in the first quarter.

Still, this does not augur well for the growth of receivables at American Express (AXP) or Capital One (COF). More of the sales related to Cash for Clunkers actually happened in August than July, so it is very possible that non-revolving credit may tick back up when the August numbers are released.

One of the first things that should be noted is that to have any decline in consumer credit is historically unusual. As the graph below (from illustrates, over the last 40 years, the U.S. has spent far more time with consumer credit growing at more than 15% than it has with consumer credit contracting, at least on a year-over-year basis. While the rate of growth of consumer credit tends to decline sharply during recessions and the immediate aftermath, only twice before has it ever turned negative — right after the mid-1970’s downturn and following the 1990 recession.

The current downturn is far more severe than either of those two episodes. On a year-over-year basis, we are now off 4.8% — the worst reading in 1991 was a 1.9% decline.

Now, to be fair, this is a nominal series, so in real terms the decline was much sharper following the 1974 and 1980 recessions than the chart shows. When credit turned negative in the 1970’s, Jerry Ford and Alan Greenspan were urging everyone to wear their WIN (Whip Inflation Now) buttons, and in 1981, Paul Volker was just starting to break the back of inflation.

Over the long term, the decline in consumer credit is a good thing; it shows that slowly — ever so slowly — Americans are repairing their personal balance sheets. However, in the short run, this is not good news. Paying off debt is, more often than not, the wisest investment you can make. After all, the stock market is not going to offer you risk-free, tax-free returns of 18%, but that is exactly what you get if you pay down a Visa bill with an APR of 18%.

Consumer spending is a function of both people’s incomes and their willingness to take on more debt. When you take out your credit card and hand it to the cashier at Target (TGT), the cashier does not care if you pay off your balance in full every month, or if you are taking on ever escalating levels of debt. She only cares if the machine says the card is not maxed out.

While taking the extra $200 and paying down the balance on your card is a wise investment, it is also $200 that is being spent paying off previous consumption, not adding to current demand. It is $200 that is not spent at Target on new clothes — hurting both Target and apparel companies like Liz Claiborne (LIZ).

Paying down debt is simply another manifestation of the rising savings rate. It is part of the adjustment that the country is making towards a less central role for the consumer. Consumer spending was not always 71% of the economy, nor is it that high a percentage in most other economies.

Over time, I suspect we have to go back to an economy where only about two-thirds is consumer expenditures. That is not a heroic assumption — the U.S. economy was never more than 66% of the economy until the third quarter of 1990. It averaged 64.3% of the economy in the 1980’s.

The huge question is: What will replace it?  This is a question of simple arithmetic. Remember the old formula for what GDP is:  Y= C + I + G + (X-M). Those five components MUST sum to 100%. If C is going to go from 71% to 66%, then some combination of the following has to occur: either I (Investment) or G (Government) has to rise, or we have to reduce M (imports) or increase X (exports).

Our ability to reduce M is in large part tied to the price of oil, or our ability to find alternative domestic sources of energy.  Increasing X would be very nice, but other major economies are not exactly booming (although they do seem to be recovering sort of like we are). However, so far this century, net exports have averaged a -4.7% of the economy, so simply going back to a zero trade deficit could make up almost all the difference.

How much are businesses going to increase I (Investment), when capacity utilization is still near post-war record-lows. Why should they buy a new lathe, when they have 10 of them gathering dust? Also, I is a relatively small part of the economy, averaging 15.8% of the economy so far this century, so adding 5 full percentage points on its own would be a massive increase.

On the other hand, I tends to be very volatile — in recessions it falls like a rock, and is currently running at less than 11% of the overall economy. That leaves G, Government, which is currently a little over 20% of the economy. Like it or not, G is likely to be a bigger part of the economy going forward.

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