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Consumer Debt, Not Housing Bubble, May Be Root Of Economic Woes

Too much revolving debt makes recovery more difficult

By Mark Huffman
ConsumerAffairs.com

April 1, 2008

Steven Fazzari, economics professor at Washington University in St. Louis, says rising consumer indebtedness is finally slamming the brakes on the economy.

"For more than two decades we had consumer-led growth, which actually mitigated the recessions of the early 1990s and 2001," Fazzari said. "Part of the reason we had mild recessions was due to consumer strength. But we kept building up debt.

"It was also a period of falling nominal interest rates. This meant that every cycle of low interest rates was another opportunity for people to refinance on better terms and extend their spending further," he said.

In simple terms, consumers are now just tapped out.

According to the latest Federal Reserve Consumer Credit report, total revolving debt by consumers, which consists primarily of credit cards, is at an all-time high of $947.4 billion.

"Americans are in more debt than ever before," said Brad Stroh, co-CEO and co-founder of Bills.com, an online personal finance Web site. "The credit card industry could be the next domino to fall if consumers don't get a handle on their personal finances soon."

Fundamental changes

Fazzari sees fundamental changes in the economy that are reducing the effectiveness of consumer spending as an economic driver.

Part of the problem is the current debt burden. Part of the problem, he says, lies in the fact that its harder and harder to get credit. Even the Federal Reserve Bank's move to lower interest rates doesn't give Fazzari much hope for a turnaround.

"Bernanke deserves credit for creative approaches to containing instability in financial markets," Fazzari says. "But the source of the recession comes from structural problems that need to be changed. Bail-outs may help prevent everything from cascading further, but the Fed does not have the tools to solve these problems.

With property values plummeting nationwide, homeowners no longer have the luxury of tapping into home equity lines of credit. Instead, many have to use high-interest credit cards and other revolving credit for short-term cash.

Time to cut back

This trend also concerns Stroh, who warns that individuals facing economic hardship should be managing and eliminating debt, not adding to it.

"Now is the time for consumers to eliminate unnecessary expenses and then use those funds to pay off their credit card balances," he said. "This will require some sacrifice, but will be worth it in the end."

A credit card industry meltdown would have serious effects on the broader economy and create hardship for banks and consumers alike, according to Stroh. He points out, however, that the worst-case scenarios can be avoided.

"Prudent steps should be taken by consumers to avoid a credit crunch," he said. "Simple things like budgeting and spending plans can make a big difference in averting major economic problems."

Fazzari agrees. There's no magic bullet, he says. The root cause of the current economic slowdown in the U.S. goes back several decades. None of the choices, he says, are pleasant.

"Unfortunately, the cost of letting institutions fail is worse than the cost of bailing them out, but ultimately, the Fed will not be able to stop the downturn in consumer spending. The household sector just has to retrench and repair its balance sheet. In the meantime, the result is a weak economy," he says.

Fazzari notes that the stimulus packages proposed by Congress and the presidential candidates could be useful as well, but even those policies aren't nearly large enough to prevent a deep recession.

"With those proposals, we're talking about something that is a quarter of the size of what's necessary to turn things around."

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