NCPA - National Center for Policy Analysis

DEMOCRATIZATION OF DEBT

August 23, 2006

No society can forever raise its borrowing faster than its income -- which is what we've been doing.  Sooner or later debt burdens become oppressive.  One reason for thinking we've passed that point is that the last spasm of credit expansion was partially artificial, says columnist Robert Samuelson.

To soften the 2001 recession -- to offset the collapsed stock market and tech bubbles -- the Federal Reserve embarked on an audacious policy of easy credit.  From December 2001 to November 2004, it held its key short-term interest rate under 2 percent.

A real estate bonanza ensued:

  • From 2000 to 2005, housing starts rose by a third.
  • Sales of new and existing homes increased by almost 40 percent.
  • In hot metropolitan markets, prices more than doubled over five years (San Diego, up 109 percent; Washington, D.C., up 113 percent).
  • Nationally, the increase was 57 percent.
  • The frenzy depended heavily on mortgages with low interest rates; in 2005 about half of new home loans had variable interest rates (often with low introductory teaser rates) or required only interest payments.

What the Fed giveth, the Fed taketh away:

  • Since June 2004 it has raised short-term interest rates from 1 percent to 5.25 percent.
  • Whether the Fed achieves the vaunted "soft landing" -- an economic slowdown that reduces inflation without causing a recession -- hinges heavily on how the credit boom of the past few years unwinds.
  • If it ends violently, with a crash in home prices and housing construction, a recession could follow.

This turn of the credit cycle could signal the end of the decades-long rise of personal debt in relation to income.  For years, the democratization of debt stimulated the economy. What happens without that prop?  For better or worse, we may soon learn, says Samuelson.

Source: Robert J. Samuelson, "Unwinding the Credit Boom," Washington Post, August 23, 2006.

For text (subscription required):

http://www.washingtonpost.com/wp-dyn/content/article/2006/08/22/AR2006082200976.html

 

Browse more articles on Economic Issues