Monday, July 21, 2008

The American Way of Debt?

(click image for larger view)

I've been meaning to write more about debt for some time now. The New York Times just had a sad article on the impact taking on too much debt has had on a lot of Americans. There are a few observations I'd make:

1) The chart shown above from the article tells very little about the financial shape of the average American. To get a truer picture, you'd want to contrast debt vs. assets, rather than debt vs. savings -- otherwise you are comparing apples to oranges. Also, I'm not sure how they are categorizing savings for this graph, but the savings amount most likely does not include money put into investments which means a 401k, stock investments, principal payments on a home, etc. would not be included in this savings figure. Including these numbers would give a far more realistic snapshot of an average household, but wouldn't be a shocking. This also doesn't account for money invested in education or its likely effects of increased income.

2) Many people who are in over their heads with debt are in this situation because of very poor financial decisions on their part, often using shopping as a way of dealing with emotional stress. (The tipping point often comes when they are confronted with an unexpected financial crisis such as an unplanned health expense and/or unemployment.)

3) Some lenders (credit card companies and home refinancers) do seem to engage in predatory lending that prey upon people with poor self-control.

4) Trying to stop predatory lending by regulation may in fact do more harm than good. (If you were a poor person, would you rather have access to high-interest credit or no credit at all?)

5) There are some truly heart-breaking stories about people who have ruined their financial lives through poor choices. It is hard not to be moved by these.

6) In response to being moved by these stories, it is very dangerous to then turn around and use these stories as the basis of policy-making without fully thinking through the ramifications policy changes might have.

For example, most proposals that seek to address predatory lending essentially boil-down to either:

a) Denying people with poor credit access to any kind of lending (that's what will happen if you mandate maximum interest rates -- lenders will screen people seeking to borrow, not dealing with the highest level risks); and/or

b) Holding lenders responsible for poor decisions by borrowers.

Either approach is bound to make society worse off by restricting both good credit along with the bad.

(Another graphic from the article that looks suspiciously implausible.)

The dilemma is figuring out if some kind of policy should be implemented to address predatory lending and, if so, how to implement it without wreaking havoc on the most well-developed credit markets in the world? I think this is potentially best handled by bankruptcy and tort laws rather than through financial regulation. If there are objectively bad systematic predatory lending practices that intentionally inflicts harm on others, it seems American tort law is sufficiently well-developed to address these wrongs. If lending practices are not objectively bad, then companies shouldn't be punished by unnecessary regulation of financial markets.

Handling personal crisis problems through church programs and other non-profit agencies which can give individualized assistance to people in need of financial help seems far more effective than addressing these problems via impersonal government programs. What is needed in a great many of these cases is help dealing with emotional troubles as much as anything. This requires personal care, time, and attention to help people transition into living more responsible and healthy lifestyles -- something small, private organizations are far better at providing than large government bureaucracies.

One of the downsides of living in a free society is that people sometimes use their freedom to get themselves into trouble. That doesn't mean the freedom of others should be restricted to prevent some people from making poor choices.

Elsewhere, Megan McArdle has some of the best thoughts I've read on debt in America:

If people massively expand their asset base by a house and a couple of cars, not to mention labor-saving appliances like dishwashers and washing machines, 40% of it all debt financed, this is not an obviously worrisome trend. Especially since a lot of that represents a shift from expenses like rent to debt payments, which is not actually a net deterioration in people's finances. Nor is it clear that we should mourn for the days when the repo man could take away your furniture, television, and appliances.

There's another trend buried in there that matters a great deal: the secular decline in interest rates that began in the 1980s when Paul Volcker, then chairman of the Federal Reserve, went postal on inflation. As interest rates fell, debt rose as a percentage of disposable income, but that's because people could afford more debt on the same payment. This does not represent a material adverse change in peoples' circumstances.

I am not trying to be a Pollyanna. Americans need to pay down some debt, and that process will be unpleasant. But they have adequate resources to do so, and the debt they have taken on largely represents an improvement in living standards and a transition to an ownership society that I think is overall a very good thing. More importantly, I find little evidence for Elizabeth Warren's claims about why Americans have all this debt--which is to say that they're being forced into it by heartless capitalism, a lazy government, and rising inequality.

Well said!

I plan to have more up on debt soon. In the meantime, here are some of my previous posts:

1 comment:

thinking said...

Another component is simply increasing the education of people on how to handle money. It's amazing that this is not taught in school from a very early age.

I would also add that in some cases govt regulation is overall a good thing...again, the point is to have a healthy balance.

As we see in the mortgage lending bubble that burst, a lack of regulatory oversight can be a disaster.

Also, it doesn't help when we have a govt that runs up its own huge deficits. When a govt just spend and spends, and doesn't even have the courage to ask people to pay for a war, that's irresponsible.

When we have politicians who talk of tax cuts without also addressing the spending side, that's irresponsible.