Household debt: The cost/benefit curve

Thinking about household debt, boost, and drag.

The amount we add to our debt in a given year represents a boost to the economy which arises from the spending of that money.

The total amount  of the debt we carry represents a drag on the economy which results from making the payments on that debt.

The ratio, the addition to household debt relative to the total, is a measure of the benefit arising from taking on more debt.

This graph shows the ratio. The first year shown is 1947:

Graph #1: New Debt relative to Total Debt of Households

Taking on new debt makes the ratio go up. But taking on new debt adds to the total debt we carry, and that makes the ratio go down.

I don't know what the numbers mean, the numbers on the vertical axis. I can describe them as representing "new debt relative to total debt" for households. But I can't put it into more meaningful terms. Still, one can see that the ratio starts out high, when we had little total household debt, and that it ends up low.

I know that since 1980, we pay off about 5 percent of our debt every year. It varies, but roughly 5 percent.

I also know that FRED has data on how much we pay as interest every year.

So I can tweak the graph to show new debt relative to the cost of total debt -- new debt relative to the interest and principal payments we make on our debt. It's just an estimate based on that rough 5% number. But it creates a picture that I want to see:

Graph #2: Additions to Household Debt relative to Household Debt Service Cost (est.)

The shape of this graph is similar to that of the first graph. But the vertical axis numbers now mean something. At the 2.0 level, we buy twice as much on credit as we pay for debt service. At the 1.0 level, the amount we buy on credit is equal to the amount we pay for debt service. Below the 1.0 level, we pay more than we borrow anew. This is all based on that rough 5% number, of course, but maybe it gives you something to think about.

In 1947, when people had relatively little debt, debt service cost was low and we added $2 to our debt for every $1 of debt service we paid. Maybe that's how we get hooked on credit, getting more than we pay for at the start.

I'm thinking that probably each of us has a debt cost/benefit curve like that: It starts out high when we get a job and start using credit. Then the ratio falls as our debt accumulates, and we're lucky if we can stay close to the 1.0 level. Except there's no way that can happen.

These days, though, student loans being what they are, many people are already using credit even before they get a job. Yeah. You know what that's called? "Financial innovation."

So on the graph I notice that the cost/benefit ratio first comes in at the 1.0 level in 1951, and then again in 1954. It drops below the 1.0 level for the first time in 1956, '57, and '58 -- this could be related by cause or by effect (or both) with the "creeping inflation" of those years -- and returns briefly to the 1.0 level in 1959.

I also think I see the effects of inflation on debt -- a higher level of additions to debt, and more spending relative to existing debt -- in the two "humps" of the 1970s. And maybe I see the start of a third hump in the peak of 1985 , when the rate of inflation was down but borrowing was still high relative to the borrowing of the 20 years prior. 

And then a bowl-shaped low following that 1985 peak, the low being evidence of the Savings and Loan crisis. After the S&L crisis, another large hump, this time not explained by inflation but by an act of desperation, a last gasp that ends badly.

Oh, well. Live and learn.

It's not us, by the way. It's policy. The rich people we elect and the central bankers do their best to make things better. I believe that. But their ideas on how to make things better are based on being rich and being bankers. And that doesn't do it for people like me.