Credit Cards

Historically Low Interest Rates? Not For Consumer Credit

Headlines about low interest rates abound. The Federal Reserve Board has promised that interest rates near zero will remain in place through this year and next. Yet consumer credit card interest rates are still usurious. For an economy struggling to free itself from a balance sheet recession and based in large part on consumer purchases, a focus on lowering consumers’ debt burdens by lowering the interest rate paid on consumer debt instead of focusing on the overnight funds rate makes sense.

Balance Sheet Recession
Everyone knows that a recession is a slowdown in economic activity. But less appreciated is that there are number of different types of recessions. That is, there are a number of events that can lead to the economic slow down. For example, when there is an unexpected significant surge in the price of oil, it can cause a temporary slowdown in the economy as the market absorbs the higher cost of the commodity and spreads out the resultant increase in prices. Similarly, if interest rates are escalated quickly, there can be a slow down in economic activity as capital costs restrict borrowing and money that could be used for business growth is diverted to service debt at an increased cost.

A balance sheet recession is different. A balance sheet recession is caused when there is a period of increased access to capital, incentives to access the capital (normally in the form of low interest rates), disincentives to save (also normally in the form of low interest rates), and, in the present case, a consumer culture that favors consumption over savings. This access to cheap credit results in economic growth fueled by the debt spending. Unfortunately, the debt spending cannot continue forever. At some point, the credit runs out and spending slows as a result. Generally, the recession will last so long as the debt remains.

This Balance Sheet Recession
The above-described pattern has played itself out. The United States economy grew on the shoulders of consumer consumption fueled by increasing amounts of credit card debt. Once the credit became more difficult to obtain, whether through refinancing of real estate or reduced access to credit cards, the consumer lacked the means to continue the spending binge. Unfortunately, at the same time that the consumer was spending tomorrow’s pay check, the United States economy was continuing to move more and more jobs overseas. Consequently, tomorrow’s pay check never arrived.

Responses to Recessions Must Address the Cause
When a recession is caused by wide-spread unemployment, it makes sense that the response address employment. So when, as here, the recession is caused by consumers carrying too much debt (and therefore unable to buy consumer goods), then the response needs to assist consumers in unwinding their debt.

Lower Consumer Interest Rates
One way to assist consumers during a balance sheet recession is to force the reduction of interest rates on their debt or to subsidize the interest paid. This lowers serves two important purposes. First, by lowering the interest rate, you lower the monthly payments that are required to keep the debt from expanding. Second, lowering the interest rate lowers the total payment that the consumer must pay to extinguish the debt.

Of course, with every approach, there is a consequence. Here, the brunt of the reduction in interest is felt by either the bank that holds the debt (if interest rates are forced lower) or the taxpayer (if the interest is lowered by subsidy). Given the amount of money that has been handed over to the banks, they have no room to complain. Part of the cause of this recession is the incredible and irresponsible amounts of credit that the banks extended. While each person who accumulated debt should be responsible for their choices, the banks cannot shirk their responsibilities by trumpeting the need for the personal responsibility of others.

At first glance, the idea of using taxpayer subsidies to reduce interest rates seems problematic. In essence, doing so takes money from the taxpayer and hands it to the two sides that created the balance sheet problem to begin with, the banks and the debtors. However, when one considers the wealth created during the credit bubble and the concentration of that wealth in the hands of very few, it follows that the unwinding of the debt problem should be shared broadly.

In either instance, what is clear is that the Federal Reserve is talking about the wrong interest rates to stimulate this economy. Rather than worrying about the overnight rate, policy makers need to concentrate on the interest rate paid by the consumer if they want to end this recession.