An interesting article here from the Federal Reserve. Well worth a read - especially given all the turmoil that has been happening with mortgage prices and stocks over the last few months. Key excerpts from the conclusion of the article follow:
” The debt of U.S. households has risen very substantially relative to income, especially in the past five years or so. This increase mainly reflects the efforts of households to smooth consumption over time in response to shifting perceptions about future income, wealth, and interest rates, along with the effects of financial innovation that has reduced constraints on the ability of households to realize desired consumption patterns.
The information we looked at did not suggest that households have become more impatient–that they are more inclined to bring a given amount of future consumption forward. Nor did we unearth strong evidence of reduced risk aversion or perceived risk as a motive for borrowing and spending more now instead of saving. To be sure, aggregate income flows have become less volatile as part of the “Great Moderation,” but individual households appear to face, if anything, the potential for greater swings in earnings due to the churning associated with technological change and globalization.
Demographics have probably contributed to greater indebtedness, through both the greater concentration now of baby boomers in the part of the lifecycle where debt use is highest and the increases in educational attainment, likely a proxy for higher lifetime earnings as well as more-sophisticated use of financial instruments. Declines in longer-term interest rates and increases in expected incomes may have also boosted debt to some extent. With regard to the latter, the step-up in productivity growth in the mid-1990s in the United States should have raised calculations of lifetime incomes. But median real incomes have not grown very rapidly in recent years, and survey responses suggest that households have not been very optimistic about their earnings in the immediate future over the past several years, when the growth in debt has been especially strong.
The most important factors behind the rise in debt and the associated decline in saving out of current income have probably been the combination of increasing house prices and financial innovation. We noted a number of channels by which higher house prices can lead to higher debt. And causality probably runs to some extent in the other direction as well, especially in light of financial innovation that has reduced the cost and increased the availability of housing finance. Innovation has opened up greater opportunities for households to enter the housing market and for homeowners to liquefy their housing wealth, thereby helping them smooth consumption of all goods and services. One implication of this analysis is that a portion of the rise in debt relative to income probably reflects a shift in the level of spending that is not likely to be repeated unless house prices continue to increase as quickly as in the past and financial innovation continues to erode cost and availability constraints at a rapid pace.
With regard to the implications of greater household indebtedness, it seems unlikely that households have deliberately put themselves in a position in which they see their consumption as more vulnerable to unexpected economic developments, especially given that risk aversion and risk perceptions among households are probably largely unchanged. Although higher debt service obligations relative to income would appear to leave households more open to unexpected changes in income and interest rates, many macroeconomic shocks involve the demand for goods and services and tend to lead to offsetting movements in income and interest rates. Moreover, the increase in access to credit and levels of assets over time should give households, on average, a greater ability to smooth through any shocks.
That said, there are a number of reasons to be cautious about concluding that rising debt levels have not increased macroeconomic vulnerabilities. For one, household spending is probably more sensitive to unexpected asset-price movements than previously. A higher wealth-to-income ratio naturally amplifies the effects of a given percentage change in asset prices on spending. Further, financial innovation has facilitated households’ ability to allow current consumption to be influenced by expected future asset values. When those expectations are revised, easier access to credit could well induce consumption to react more quickly and strongly than previously. In addition, to the extent that households were counting on borrowing against a rising collateral value to allow them to smooth future spending, an unexpected leveling out or decline in that value could have a more marked effect on consumption by, in effect, raising the cost or reducing the availability of credit.
Another caution involves the distribution of credit and, in particular, a tendency for some households to become very highly indebted relative to income and wealth. The spending of those households is likely to be constrained by negative income or asset-price shocks as well as by households’ capacity to service their loans. Although these households represent a relatively small share of the population, in some circumstances such developments could have effects large enough to show through to the macroeconomy.”