Sunday, April 15, 2012

Rising Consumer Debt May be Dangerous for the Economy—but Getting Out from Under is neither Easy nor Fair

It is clear that the rise of household debt--combined with weak consumer protection and financial literacy--contributed to the global financial crisis of 2007-09 and the Great Recession that followed. But the question is whether improved consumer protection and financial literacy can help to address the crisis, once it has landed upon us. That is a far more difficult question to answer.

In its chapter on household debt released this week, the World Economic Outlook of the International Monetary Fund highlights the risks to an economy when household debt rises very quickly—and then housing prices fall. It is with alarm that the IMF report explains how the leverage of the consumer sector rose rapidly. In just five years, household debt in the advanced economies rose by 39 percentage points as the level of debt increased to an average of 139 percent of annual income. Similar levels were seen in the former transition economies of Hungary, Estonia, Latvia and Lithuania.

All countries were hit hard by falling housing prices. By 2011, in the U.S. real housing prices had fallen 23 percent from the peak, 29 percent in Iceland and 41 percent in Ireland. The result has been a drastic decline in spending by households and economic stagnation.

The problem is not primarily the fall in housing prices, argues the World Economic Outlook. It is the combination of a fall of housing prices and very high levels of leverage among households. The report estimates that the difference in four-fold. Consumer spending fell by only 0.4 percent in the low-debt economies that had falling housing prices. However in the parts of the world with both high household debt and declining asset prices, consumption by households declined 4.3 percent over five years.

The report continues to explain how all this happened. Looking at housing crises in the U.S. in the 1930s and today, Colombia in 1999, the Scandinavian countries in the early 1990s and Hungary and Iceland today, the report cites two common characteristics seen just prior to the collapse of the economies: (1) financial innovation and (2) declining lending standards.

Looking at the U.S., in the 1920s, it was the introduction of installment financing of consumer durable goods that brought financial innovation (and looser credit). In particular, General Motors Acceptance Corporation provided consumer financing for automobiles, allowing consumers to pay for cars over time rather up-front with cash. The result was a huge expansion in the credit available to households. A similar form of financial innovation developed in the 2000s. Consumer credit grew by leaps and bounds as “private-label securitization” permitted residential mortgages to be bundled together and sold in the global capital markets, all without a government guarantee. At the same time, standards for extending credit fell with the creation of mortgages described as interest-only, "negative amortization" and the all-time favorite, NINJNA loans referring to mortgages with the borrower had no income, no job and no assets (or at least, none that could be documented.)

By 1925, housing prices had peaked and started to fall. Asset prices were further undermined in October 1929, when the stock market crashed. Some eight decades later, in 2005, housing prices again hit a peak. The bankruptcy of the investment bank, Lehman Brothers, followed in September 2008 and caused the global capital markets to collapse.

In both cases, as asset prices fell, the household sector began to shed debt, or “deleverage” as it is called in the vernacular. The national and global economies slowed down.

The World Economic Outlook estimates that in the U.S. another three million homes will be subject to foreclosure—in addition to the 2.4 million properties that were still in that deep hole at the end of 2011. The report further estimates that for every one million foreclosed homes, between 0.3 and 0.4 percent of national output is lost. If only there were a way to avoid the three million foreclosures, then U.S. gross domestic product would be another 0.9 to 1.2 percent higher. With such large amounts at stake, the report looks at what could be done.

The report suggests four possible solutions. First, monetary policy should be expanded as much as possible so that interest rates are very low. This makes most sense where mortgages are provided at adjustable interest rates. However most variable rate mortgages have already been converted to fixed rate loans. Furthermore the problem is one of a “zero lower bound on interest rates” as economists describe it. Borrowing rates cannot go below zero percent before an Alice-in-Wonderland situation arrives and borrowers are paid to borrow money.

Second, the social safety net should be strengthened. This generally means that unemployment benefits should be extended so that homeowners have some income with which to make their monthly payments. Again the report points to a difficulty—if the government has already taken on so much debt that it cannot (or should not) borrow more. This is the problem for advanced economies worldwide.

Third, the banks should be bailed out. More precisely, the government should buy all distressed debt held by the banks, as was done in the U.S. with the Troubled Asset Relief Program (TARP). However there may be some political limitations on such bailouts. In September 2008, I recall sitting in an outdoor café in Washington discussing financial consumer protection policy with one of my colleagues. It was a Friday and office workers were wearing business casual dress. One had a t-shirt with a bold question. “Where is my bailout?” it read, expressing the view of many Americans that households should be given assistance, not the banks.

Fourth, homeowners should also be bailed out by restructuring their residential mortgage debt. It is only in the fourth and last solution that consumer protection and financial literacy play any role at all.

It is this last area—restructuring of mortgage debt—that is gaining attention at the global level. The chief of the International Monetary Fund, Christine Lagarde, is now recommending that—for the sake of the world economy—the U.S. and European governments should restructure mortgage debt of their heavily indebted borrowers. The World Economic Outline provides some justification for this approach. The report argues that for every $1 spent by the government in reducing mortgage debt of financially strapped homeowners, the U.S. economy will grow by $1.30. A similar program for the European Union would raise output by $1.10.

However what the report does not say is that the real question is one of fairness and equity. Should all taxpayers be obliged to bail out the reckless homeowners who would have kept all their earnings, had their bets paid off? Is that fair?

Instead the report provides technical details on two programs that seem to have worked--Iceland after 2008 and the U.S. in the 1930s. The two approaches are very different, even though that had the same objective in mind.

In Iceland, the government revised four different areas to prepare a comprehensive (and effective) solution. First, the laws were changed. The legislation on bankruptcy was amended to allow consolidation of secured and unsecured debt and permit short discharge periods. In addition, the law on mitigation of residential mortgage payments was changed to permit the write-down of secured debt to the amount of the appraisal and conversion of the remaining obligations to unsecured debt. Both revisions allowed the courts to take effective decisions on restructuring personal debt. Second, out-of-court mechanisms were put in place. Third (and most interestingly), a system of debtor ombudsmen were established to supervise negotiations of household debts. Fourth, the banks were encouraged to write down their loans to households.

The U.S. solution from the 1930s was very different. A new government agency was established, the Home Owners’ Loan Corporation. HOLC issued government bonds, which the agency exchanged with the banks for distressed mortgages. Once the mortgages were in the hands of the HOLC, its agents renegotiated the mortgages, one by one, often with debt counseling and even training on family budgeting. It is not clear if the accompanying “financial education” was helpful but it was clearly a resource-intense activity.

According to the World Economic Outlook, the final cost of the HOLC program was just 5.4 percent of GDP even though it rescued one in every five residential mortgages.

Thus the World Economic Outlook provides some useful ideas on ways in which consumer protection and financial literacy might help countries avoid the heavy burden of foreclosures of residential mortgages. Taking ideas from the experience of Iceland, a debtor’s ombudsman might be a useful way of encouraging (and supervising) restructuring of household debts one-by-one with the banks. From the U.S. experience emerge suggestions on effective financial education, at least to provide debt counseling and assistance in preparing family budgets.

However the larger story remains. To avoid the risk of a major slowdown in consumer spending, it would be best to discourage the household sector from taking on too much debt. Safe and Fair Finance Blog proposes a combination of clear consumer disclosure (to make sure that consumers have understandable information about their debts) plus a healthy dose of financial education (to help consumers understand the risks of high leverage).

But then, there is still that pesky question of how to establish basic fairness in a program to restructure household debt. For that, the World Economic Outlook has no suggestions.

Safe and Fair Finance Blog argues that if the system is not fair, it will not be accepted by taxpayers who must pay the costs of the restructuring. It will become yet another argument how capitalism in the 2010s is stacked against those who are honest and play by the rules.
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