The Other Debt Crisis

article | August 26, 2011

The country is facing a serious debt crisis that threatens to undermine our economic recovery. No, not that one. American households are carrying around $11.4 trillion of debt. This amounts to around 90 percent of GDP. This is twice the amount of household debt held during the last major recession in 1982. On a macro level, this is bad because people with a lot of debt don't spend money. Demand for goods and services is what keeps the economy going (and people employed), but households need economic conditions to improve so that they can deleverage, and the economy needs households to deleverage so that they can spend. It's a stalemate that predicts long-term sluggishness. CBO, for instance, projects that unemployment will remain above 8 percent until 2014.

There are suggestions for dealing with this stalemate by moving the levers on either side of the debt equation: the value of the debt and the ability of the household to pay the debt. Since most of the debt being carried by families is in their home ($9.21 trillion of it), one way to reduce the value of the debt would be to allow homeowners to refinance their mortgages to the low rates that are now available. This could increase the capacity of  homeowners to spend by around $85 billion a year. As an alternative, the government could compensate for low aggregate demand through an infusion of resources, or stimulus, to prop up demand until it becomes self sustaining, also know as the "fake it 'till you make it" model. Some would argue that at times of historically low interest rates, government borrowing in exchange for a functioning economy would be the bargain of the century. 

These would offer short-term fixes, but in the long-run, we need to restructure the way that families finance their investments or even basic needs through a more robust set of savings policies to serve as an alternative to debt. Savings can be applied to a range of purchases, and by having those resources on the front end, it can prevent making costly sacrifices on the back end. In a 2008 survey of middle- and low-income households, thirty-seven percent reported using their credit cards to cover basic living expenses, such as rent or utilities, and were likely to be carrying a balance over $5,000 more than households who charged discretionary purchases. For families already unable to pay for their basic needs, debt may bridge a short gap between what they have and what they need, but can compromise their ability to pay for it in the future, and, consequently, make taking on more debt necessary, which could account for their higher balances. In this way, even debt acquired for short term purposes displaces other, more productive uses of resources that allow families to move forward in their lives.

Shifting the balance from debt to savings could also increase access to investments that enhance one's ability to move up the economic ladder, like a college education. A postsecondary degree still represents one of the most consistent predictors of upward economic mobility for low-income individuals. Only 16 percent of Americans born in the bottom income quintile who earn a college degree stay at the bottom, compared to 45 percent of those without a college degree.

Despite the increasing importance of higher education, students in the lowest income quartile are graduating at the lowest rate in 30 years. A driving factor of the decline in college completion among low-income students is the precipitous rise in cost. From 1982-2008, tuition and housing costs rose 439 percent, compared to just a 147 percent increase in median family income. This increase is costly for all families, but for low-income households it can be prohibitive. For low-income families, the cost at a 4 year college minus all types of grant aid can constitute almost half of their annual income. As a result, many students rely on loans to bridge this gap. This reality is demonstrated in the striking increase of student debt, 25 percent over the last 10 years, in the face of declines in other forms of consumer debt. Not only is this form of debt becoming more prominent, it's also harder to pay off. Student loans are the only component of consumer debt where delinquencies are increasing. Low-income students are acutely challenged to repay loans given the rate and amount they borrow compared to other students. In 2008, 87 percent of Pell Grant recipients had student loans and were carrying an average of almost $25,000 in debt. Nationally, these averages were 67 percent and just over $23,000, respectively. These costs can create substantial financial challenges for after graduation and reinforce the perception among many low-income students that college either isn't accessible or worth it. 

Policies like the ASPIRE Act, which would endow every child at birth with an account in her name and seed that account with an initial deposit, would create an infrastructure for universal and life-longs saving that could begin to reorient the way that investments are financed away from debt. The Saver's Bonus would similarly target the low income households in the most need of help saving and provide them with an account to support saving for everyday purposes up through retirement. Most importantly, it would help them start saving, which is often the hardest part. Policies like these could help make families, and the economy, more resilient in hard times and better positioned to pursue a prosperous future.