In June, US credit card debt reached record levels. The $1.02 trillion in outstanding credit card loans passed the pre-crisis peak set in 2008. Although the US economy is seen to be strengthening in most sectors, some see this as a genuine threat to the stability of the economy, and one which, if realised, would have a disastrous effect on everyone involved.
Excessive credit card borrowing can be a major problem for the macroeconomic performance of the US economy as it results in an artificial, unsustainable level of AD. This is because unless real incomes rise just as fast as credit card debt does, as it has not done in the US in the post-recession years, people at some point will have to stop borrowing and deleverage. Therefore they will have to spend less, as their real incomes do not provide enough to pay back the loans plus the interest on them, as well as sustaining the level of spending that they currently exhibit. This reduction in spending will result in a contraction in AD, and therefore in recession (as long as government spending, net exports, or investment are not seriously increased when this happens).
This is especially relevant to the United States since, at around 70% of GDP, consumption as a percentage of GDP is very high compared to other OECD nations. This means that any reduction in spending will have a pronounced effect upon AD, and due to the accelerator effect, investment will also fall sharply, resulting in recession. Furthermore, the Fed has already raised the Fed funds rate twice this year to 1.25%, meaning that credit card borrowing rates may be about to rise. This would result in less demand for credit card loans, reducing the ability of households to spend (borrowed) money, and lowering the artificially high level of consumer borrowing.
The other scenario that could result from this is that people fail to repay their debts, and hundreds of millions of dollars’ worth of credit card loans are written off. This would result in the bankruptcy of major credit card lending organisations, as well as higher credit card interest rates in the future and the inability of many Americans to borrow easily ever again. This is made more likely by the fact that in the US the people borrowing on credit cards are very unlikely to be the same group of people as those with valuable assets, such as houses, which could be sold if the loan needed to suddenly be repaid. Although the size of the market for credit card borrowing is nowhere near the size of the mortgage market, the writing off of a large proportion of these short-term loans would still have significant negative effects.
However, the vital statistic for assessing whether this will be the case is the default rate on credit card debts. As long as people are able to fund their credit card borrowing practises, then this level of credit card borrowing may not be as big a problem. However, as shown below, default rates, although low by historical standards and far from their peak of 6.77% in Q2 2009, are once again rising. This combination of large sums of outstanding debt and a rising default rate is a dangerous concoction, as it suggests that the above effects could be realised.
For these reasons, credit card debt in the US is an issue that must be tackled and let down slowly in order to avoid a collapse similar to the collapse in the mortgage market in 2007/8. An ideal way to do this would be the continued raising of base rates by the Fed. Although historically credit card rates have only very loosely tracked the base rates, the fact that the interest rates on the outstanding loans will be unaffected by a rise, unlike with variable rate mortgages, means that a rise in the interest rates on credit card loans would only serve to stifle future demand, and not to cause a large proportion of the outstanding debt to be defaulted on. As long as other conditions are right for raising base rates, this remains the best available option.
etonomics.com 