Will Household Deleveraging End Anytime Soon?
The Federal Reserve Board recently released its comprehensive overview of financial flows and balance sheets in the U.S. economy for the third quarter of 2014.1 As the figure below shows, the ratio of household net worth to disposable personal income has changed little since late 2013 and remains slightly below the levels of 2005-07. Meanwhile, the ratio of total household liabilities to disposable personal income declined during the third quarter, continuing a trend of household deleveraging that has continued almost unabated since the onset of the recession in December 2007. When will this run of deleveraging come to an end?
Given the almost continuous increase in the ratio of household liabilities to income observed between the early 1950s and 2008, as shown in the figure below, one might conclude that this ratio will resume its upward march at some point. Because disposable personal income can react sharply to changes in tax policies, which were significant during the recession and its aftermath, the figure below also displays the ratio of household liabilities to gross domestic product, which is not affected as much by tax changes. This ratio has declined in 19 of the last 21 quarters, including the third quarter.
Another reason one might expect an end to deleveraging is that some measures of consumer confidence have improved in recent quarters.2 The three periods of significant cumulative decline in the household liabilities-to-income ratio since World War II—1965-75, 1979-84 and 2008-14—were all characterized by economic and financial turmoil and uncertainty:
- Inflation rates increased sharply during the 1965-75 period, and two recessions occurred.
- The 1979-84 period also included two recessions, as well as a burst of double-digit inflation rates, followed by a rapid disinflation.
- The most recent period of household deleveraging included a housing crash, a financial crisis and the Great Recession.
As in these earlier periods, the passage of time and normalization of economic conditions might lead to the resumption of an upward movement in the liabilities-to-income ratio. On the other hand, there are reasons to believe the ratio of liabilities to income will not increase forever:
- First, households generally do not have access to large and profitable arbitrage opportunities, which would encourage them to borrow large amounts of money and invest the proceeds in a way that generates a risk-free profit. In fact, a typical household’s cost of borrowing may exceed the average returns on its investments, including housing.
- Second, the average interest rate that households pay to borrow is of the same order of magnitude as the growth rate of their incomes. Households cannot borrow large amounts and expect their incomes to outgrow the accumulating interest burden on the debt.
The consequence of these conditions is that, in general, the larger the ratio of a household’s liabilities to its income, the larger the share of its income required to service its debt. A household’s need to eat and purchase other goods and services puts a limit on how much debt it can take on. Thus, household debt growth cannot outstrip income growth forever, and the ratio of household liabilities to income cannot rise forever.
Therefore, despite the large cumulative increase in the ratio of households’ liabilities to their incomes in the decades before 2008, there is no compelling reason why that ratio must increase further, nor is there any reason why the current episode of deleveraging must end any time soon. Indeed, if the run-up in household debt prior to the financial crisis was excessive in any sense, deleveraging could continue for years or even decades to come. In sum, there is no way to know if—and no strong reason to believe that—household deleveraging is over.
Notes and References
1 Financial Accounts of the United States. See www.federalreserve.gov/releases/z1/Current/z1r-1.pdf.
2 For example, the Conference Board’s measure of consumer confidence increased from 72.0 in November 2013 to 88.7 in November 2014, while the University of Michigan’s Consumer Sentiment index increased from 75.1 to 88.8 during the same period.
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