Revolvers (Updated)

Jame Surowiecki in this week’s New Yorker‘s Financial Page:

…credit-card companies have created a strange business, in which there’s a fine line between good and bad customers. Their best customers aren’t those who dutifully pay off their balance every month; instead, they’re the ones who charge a lot and pay only a little every month, carrying a sizable balance and racking up interest charges and late fees. These are the “revolvers,” and the credit-card business feeds on them. Credit-card companies don’t necessarily want revolvers to pay off their debts; if they did, there’d be no interest or fees to collect. They want their loans to be, in the words of a banking regulator, “a perpetual earning asset.” [link]

Looks like the credit card companies are really cracking down – or are they cracking up? Perhaps it’s symptomatic of the times. Most business function “normally” in good, or at the very least, decent economic times. Right now though, all bets are off. Not surprisingly, the credit card business is analogous to the housing credit market:

This is the paradox of deleveraging: it’s good for borrowers to reduce their debt, and good for lenders to be more rigorous in their standards, but when everyone deleverages at once it does real damage. It’s like a drug addict whose dealer cuts him off: it’s good to stop using, but withdrawal is painful. [link]

The solution, of course, is to keep fewer credit cards, and Surowiecki does say that in the long-run, having fewer credit cards is a good thing. In the short-run though, reducing credit cards reduces spending:

…studies suggest that people really do spend more when they can pay with a credit card, and that big credit lines further encourage extravagance…[but] the high price of credit-card debt meant that billions of dollars in interest and late fees went to credit-card companies instead of to more productive uses. [link]

Too much credit is bad. Too little credit is bad. So optimality seems to be the right way to go. But what is optimal? Certainly not the level of of household debt as a percent of GDP, which was at around 96% in the third quarter of 2008, down from 97% in Q2. While it is not the amount of revolving credit – what the above article was about – it’s still shocking, nevertheless.

householdsectordebt_q308

Data source: Economagic.com

Update: A 2004 paper in the Bank for International Settlements Quarterly Review by Guy Debelle discusses the increase in household debt. Note that it was not just the US that saw this drastic rise in the 80s and 90s. Here’s an abstract and link. I will be discussing this some more at the beginning of class today.

Lower interest rates and an easing of liquidity constraints have led to a substantial rise in household debt over the past two decades. The greater indebtedness has made the household sector more sensitive to changes in interest rates, income and asset prices. This enhanced sensitivity is higher where more households have variable instead of fixed rate mortgages. [link]

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2 comments for “Revolvers (Updated)

  1. Jennifer Stanton
    March 12, 2009 at 10:07 am

    I had to go to check your source because that appeared utterly unbelievable to me. I see that in 2000, it was only 67% of GDP. At the end of 2007 it was 98%. I cannot, of now, comprehend how that happened. But I can ask some questions.

    Where does household debt fit into GDP? It’s consumption of a final good and service in past that has not been paid, so is accumulating interest. The interest will go to the credit card companies but I’m not sure how to categorize the initial debt. Can we say it is consumption even though it hasn’t been paid? I feel like it’s a market failure because the final good has been consumed but the business has not received it’s revenue!! Or has it? I don’t use a credit card so not exactly sure how paying with credit works….

  2. Arnav
    March 12, 2009 at 10:58 am

    I think it was a combination of easy access to liquidity that allowed households to borrow more post-2002,3 (remember the low Fed Funds rate, at the time?). And it’s not just credit cards – mortgages make up the largest chunk.

    Debt does not fit into GDP – only the service fees and interest payments do.

    And I am not sure, but if this number includes business loans for households wanting to start their own business then that would also make it larger.

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