Consumer Credit Policy and Savings Rates

Inflation at what the Wall Street Journal this morning called a 44 year low. The consumer price index is -0.1% and the core inflation rate according to the consumer price index is 0.0%.

Mortgage interest rates are low, tracking low ten year Treasury bond rates, in part as a consequence of low inflation rates (expected low future inflation rates lower nominal Treasury bond rates).

Low interest rates are theoretically, a signal to consumers to spend, rather than save. But, of course, that isn't what is happening. Savings rates are high after a prolonged period of near zero and negative savings rates during the boom.

Why aren't savings rates responding as expected to interest rates? What is consumer debt falling instead of rising? Why aren't credit card companies offering more credit, rather than tightening its availability?

Part of the problem with our intuition is that savings, which are measured by the difference between consumer income and consumer spending, misses important "off the books" activity that normal people think of as gains and declines in income. During the real estate boom, lots of people felt like their income was greater than savings rate statistics did because the were experiencing unrealized gains in home values which they borrowed against to spend. The housing bust, in turn, while off the books of savings rate statistics, looked like a huge decline in income to home owners, discouraging them from spending.

But, housing prices aren't necessarily the whole story. Another important policy change has been a great reduction in the amortization periods of consumer loans.

Credit cards companies also, with Federal government encouragement, greatly increased minimum payments as a percentage of the outstanding balance (from 2% to 2.5% before to 4%-5% now), in mid-2009. For example, major credit card issuer Chase increased its minimum payment from 2% to 5% of the outstanding balance last summer. This reduces the amount of consumer debt that can be serviced someone with a constant amount of funds available to make minimum payments by 60%. Almost every major credit card company implemented similar reforms.

Given that a typical credit card interest rate is 1.5% of the outstanding balance per month, the minimum principal payment effectively increased from 0.5% of the outstanding balance per month to 3.5% of the outstanding balance per month, a sevenfold increase for a typical Chase credit card holder.

With the old minimum payment, a $10,000 starting balance, and a minimum monthly payment of $25 in any case, it would take just under 100 years to pay off the balance in full with no additional purchases. The new minimum payment reduces the payoff period to just under 12 years. Thus, the amortization period for credit cards at Chase was reduced by roughly 88%.

In the long run, restraining consumer credit may be good policy. But, in the short run, the change in policy was dramatic. The change in credit card minimum payments was equivalent, for example, to going form a regime where 30 year mortgages are the norm, to one in which four year mortgages are the norm (a term that was actually quite common a century and a half ago). A 30 year mortgage on a $300,000 home purchased with a 20% down payment at current mortgage interest rates is about $1,250 a month of principal and interest; a 4 year mortgage that is otherwise identical is about $5,500 of principal and interest a month.

The impact of larger minimum payments was re-emphasized by a reduction in unused credit limits for a large swath of credit card holders.

Interest only mortgages, negative amortization mortgages, and mortgages with longer than thirty year amortization periods (i.e. periods in which the loan will be paid off in full) have gone from common to rare with the demise of the shadow banking system that powered the housing boom and died in the financial crisis. A shorter amortization period and a bigger monthly payment for the same amount of debt are the same thing if the interest rate is otherwise identical.

Increased minimum payment percentages and shorter amortization rates dramatically reduce the amount of consumer debt that a consumer can keep outstanding without defaulting, which at the aggregate levels means more principal payments (which are equivalent to savings in the savings rate) and a dramatic reduction in the availability of consumer debt.

The economic impact of increased minimum payments on credit cards has probably had a much larger effect on consumer spending than any possible change in interest rate policy, and unlike interest rates, which change gradually, the increase in minimum payments hit almost everyone in the nation who was making monthly credit card payments less than 4-5% of the outstanding balance (about 40% of credit card holders at any one time are making minimum payments) all at once, and did so retroactivity, applying the new minimum payments to spending decisions madeby consumers who had no inkling that the increased payments would be required.

The people affected by the change (i.e. those people carrying balances on credit cards who would otherwise pay less than 4%-5% of the balance each month), of course, are the very people least able to afford to make the payments.

While consumers were used to the fact that interest rates could and would be changed without notice on crediit cards to reflect interest rates in the large economy, last year was the first and only time in the lives of most credit card users who don't pay their balances in full that minimum payments could be increased on existing balances.

The amazing thing is not that the bankruptcy rate has increased, but that it hasn't increased by more than it has, given that so many people are paying two to two and a half times as much as they bargained for when they borrowed money on credit cards, given the fact that unemployment remains very high, and given the fact that a large share of mortgage holders have no equity to loose by surrending their homes.

This change in credit card terms, in addition to driving up the savings rate, is very likely an important factor in driving default rates on consumer loans to record levels and is probably slowing economic growth in what is usually a consumer spending driven economy, particularly for the kinds of goods usually purchased with credit cards.

A less clumsy approach to this change, for example, applying the new credit card terms only to new balances or only on a deferred basis, could conceivably have greatly reduced consumer loan defaults and could have produced a less tepid economic recovery.

The reform in credit card minimum balances, because it was retroactive and unexpected by those most impacted by it, may have been the policy response to the financial crisis which has produced the most harm to the economy and the most pain for average Americans. If this reform had been introduced during a strong economic boom, it might have helped to restrain irrational exuberance in the economy. But, implementing this reform during a bust has undermined millions of families for whom credit card debt served as a de facto welfare/unemployment system, with debt funded spending that could have served as an automatic stablizer for the economy if government policy had not closed this door.