As Fed Expands Credit, Consumers Drown in Debt

If you weren't bored to tears or taking a nap during the first few lessons of Economics 101, perhaps you remember the instructor droning on about the role of the Federal Reserve (search). You may even recall how that role was summed up in the mysterious phrase, "Controlling the money supply."

While that phrase offers a kernel of truth, there is a greater truth about the central bank that your econ professor probably did not discuss -- that in terms of volume, the Fed's bigger task is to help expand credit.

And for decades, the Fed has indeed expanded credit to staggering levels. Web sites of the various Fed branch banks document the expansion, which dates from 1949, in the form of "money stock measures" -- the deposits that become assets that financial institutions use to make loans.

This immense but overlooked enterprise is a book-length story, yet its most amazing chapter may be the past three years: 2001-2003 has arguably been the most active and aggressive attempt to expand credit in the Federal Reserve's history.

Let's consider how the attempt has "succeeded."

If you begin with individual households -- revolving home equity loans, for example -- the amount of debt has more than doubled in those years. It rose from $128.3 billion in January 2001 to an all-time record $269.9 billion as of Nov. 5, 2003, according to the Fed's own data.

Meanwhile, household savings has fallen to barely 3 percent of disposable income (search), dismal by historical standards. What's more, consumer debt (search) as a percent personal disposable income reached record levels in 2001-2003.

I know what you're thinking: If they don't have any savings, and their debt eats up more of their income, and home equity loans are mushrooming ... could it be that Mr. & Mrs. Homeowner are cashing out their equity to go on buying sprees?

One answer appeared more than a year ago in public remarks from someone who has pretty reliable numbers, and who (so I've read) spends much of his time studying those numbers.

"According to survey data, roughly half of equity extractions are allocated to the combination of personal consumption expenditures and outlays on home modernization ... the extraction of equity from homes has been a significant support to consumption during a period when other asset prices were declining sharply. Were it not for this phenomenon, economic activity would have been notably weaker in the wake of the decline in the value of household financial assets."

So that IS what's up with the $270 billion in mortgage refinancings. Mr. & Mrs. Homeowner ARE cashing out big-time equity. (Funny how debt is called "cashing out," isn't it?) In turn they become Mr. & Mrs. Consumer; add a new room to the house; then fill the new room full of new stuff from the mall.

This is all for the good, mind you, at least according to the person who offered the remark above -- "powerful stabilizing force" were his words. Refinancing is good; cashing out is better; new stuff from the mall is better still. And as you may have figured out from the prose style, the gentleman who said it was Mr. Alan Greenspan in testimony to Congress.

Home equity loans (search) are not the only type of household debt, of course. In fact, consumer debt now comes in so many flavors that the Fed recently had to devise new ways to keep track of it all. The good news is that these new measures are "more accurate and comprehensive." The bad news is, consumer debt levels are even greater than the old measures indicated.

How bad is the bad news? For comparison's sake, consider the recession in the early 1990s. During that time households reduced their debt levels as a percentage of disposable income. They began to take on more debt only as the economy turned up. Yet when the economy turned down again in 2000-2001, household debt as a percentage of disposable income kept increasing, and has hardly come down at all.

According to (using Fed data), household debt as a percentage of annual disposable income rose to and remains in record-high territory during 2001-2003. This is unprecedented in the 30-plus years the Fed has gauged consumer debt levels. "Credit expansion" indeed.

Now consider an entirely different category of debt, which the Fed calls "commercial and industrial loans." Here the debt has been progressively shrinking. It reached a record $1.1 trillion in January 2001, and from there has steadily fallen to five-year low of $885 billion.

Just like consumer debt, commercial and industrial loans must be repaid. Yet the difference is that commercial debt typically produces growth and income, via new equipment, facilities, hiring, etc.

So: During the most aggressive credit expansion campaign in its history, the Federal Reserve's strategy has encouraged millions of households to convert their assets into burdensome liabilities. And this debt produces no income -- only the burden of repayments. Yet the Fed's actions have not helped increase overall businesses borrowing, which would create economic growth.

These facts show that the Fed's attempt to expand credit has increased "bad" debt, even as "good" debt shrinks. This is what the media has overlooked in the thousands of "Fed rate cut" stories of the past three years. The policy of credit expansion is, at best, a very blunt tool. It can and does produce unforeseen and dangerously uneven outcomes -- as in consumers borrowing more than the Fed expected and businesses borrowing not enough.

Can a sustained "recovery" proceed in the face of these facts, especially in an economy that depends so greatly on "consumer spending"? In a word, "No." There is a limit to the refinancings, the cashing out, the number of new SUVs packed with stuff from the mall. Households are literally in debt beyond their means, even as the business sector is literally less and less willing to borrow cheap money.

This adds up to an economic future that is very different from the sort of reporting you've read in the financial media lately.

No individual can prevent the train wreck, but you don't have to be aboard. Get out of debt. Sell assets that are overpriced -- certainly stocks that are overvalued, overpriced real estate if doing so makes sense. Bank the profits, and then get advice from folks who know how to weather a crisis.

Robert Folsom is a financial writer and editor for Elliott Wave International, a financial analysis company. He has covered politics, popular culture, economics and the financial markets for 16 years, and today writes EWI's popular Market Watch column. Robert earned his degree in political science from Columbia University in 1985.

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