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Debt and Debt Maintenance: Why American Households Are Not in Big Trouble

Gary North
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Sept. 15, 2011

There is no more fundamental law of economics than this one: When the price of something falls, more of it is demanded.

This is illustrated by a demand curve. The demand curve slopes downward and to the right. The higher the price, the less is demanded. The lower the price, the more is demanded.


Are you with me so far? Good. Let's continue.

The price of obtaining a loan is set by the rate of interest. The higher the rate of interest for any period of time, the higher the price of the loan. As the rate of interest falls, more debt is demanded, other things remaining equal.

The rate of interest has fallen dramatically over the last 22 years. This is especially true of mortgage loans. You can check this here. Here is the trend for 30-year fixed-rate loans.

The monthly mortgage payment is by far the main component of household debt. So, when the price of leasing the money fell, more Americans borrowed the money and used it to buy nicer housing. This was a rational decision. "More house for the same monthly payment -- what a deal!"

When it ceased to be a deal, housing prices fell. Again, people have been acting rationally. When things get tight, pay off old debt and stop adding more. Or substitute new debt at a lower rate. Cut your monthly payment. This is what Americans did.

Americans are not irrational. They can add up a column of figures. They do make monthly budgets. They do estimate how much money they require to get through one month. Then they make sure they don't run out of money during the month.

To think that people do not do this is to imagine that they are fools. They are not fools. They are rational calculating decision-makers. They do not do self-destructive things unless they are addicted.

They are not addicted to debt. They are rational users of debt. They achieve their goals by using debt.

The Federal Reserve provides data going back to 1980 on what households pay out each month for the money they have borrowed. The data indicate rational behavior. People do not keep borrowing when they exceed a specific percentage of debt repayment in relation to disposable income. For home owners, the top rate is about 19%. In contrast, when this rate reaches 15%, they increase their debt burden. In the third quarter of 2007, the rate peaked.


According to the National Bureau of Economic Research, the recession began in December: the last month of the fourth quarter.

The public adjusts to the economy. The public seemed to know what the non-Austrian economists did not know in the fourth quarter of 2007: a recession was imminent. It was time to cut back on debt in order to reduce the monthly debt repayment burden. The public took defensive action before corporations did.

Now let's look at a graph of the left-hand figures.

Yet there are columnists out there who think the public is trapped, that people in general have been caught by external events they have no control over. The numbers do not support this theory.

The American public is rational. They do not need to be given instructions by experts who supposedly know more than the poor, stupid households about personal debt as a tool of human action. The public as a whole has far better judgment than the columnists. The public surely has better judgment than Congress, which really is increasing debt maniacally.

The people with really poor judgment are creditors, who will get stiffed by the government or the Federal Reserve at some point. These are the top 20% of the nation in terms of income and wealth. They have faith in the full faith and credit of the United States government. Silly people.

Why have people increased their total debt? Because it has paid them to do so, given their lack of concern about retirement. They are confident that they will be able to retire in comfort. They do not look at the long term. They trust the U.S. government: Medicare, Medicaid, and Social Security. So, the savings rate has fallen.

Are they stupid? No. Are they too trusting? Yes. But they are correct to run up the debt. There is no way that they can retire. The only rational use of the money is to start a business, and few people have the incentive or skills to do this. If they saved like maniacs, they could not hope to retire in comfort. Stocks have gone nowhere. Bonds are now futile.

Should they be out of personal debt? Consumer debt places them at risk in an economy supervised by the Federal Reserve System, with its booms and busts, but fixed-rate mortgage debt is a shield against inflation. If voters better understood the Austrian theory of the business cycle, they would eliminate consumer debt, but not mortgage debt.

Has the level household debt risen? Yes.

Has the consumer price index risen? Yes.

Was it smart to load up on mortgage debt and invest in houses? Most of the self-made multi-millionaires I know did it this way. They bet on inflation, and they won. They borrowed millions and let renters pay it off with depreciating money. They still own the houses.

I have recommended this to my subscribers for 35 years. Buy homes from distressed sellers -- houses that produce positive cash flow -- and let renters make you rich.

This is why I do not take seriously all the professional hand-wringing about consumer debt. There is no crisis. Individual decision-makers in the free market are rational. They adjust to changing conditions.

So does Congress -- by increasing the level of debt. Here, hand-wringing is a perfectly rational response to an obvious threat to our wealth. We need lots more hand-wringing here.

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