Is Contracting Consumer Credit a Good or Bad Thing?

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by: John Lounsbury

The following graph from the Federal Reserve shows how outstanding consumer credit has contracted from the $2.582 trillion peak in July, 2008 to $2.415 trillion in May, 2010. This decline has continued for 23 months with only three intervening months with very small increases. These increases came in September, 2008 and the two Januaries, very likely a Christmas effect.

There has been $167 billion removed from consumer credit in this decline, which is unprecedented in the post World War II period.

During World War II total consumer credit contracted by 15%, but the numbers are too small to show on the scale of the graph from the Fed. The only other significant decline occurred with the recession of 1973-75 when total consumer credit outstanding declined by 1.8% (from $199.6 billion to $196.0 billion) from September, 1974 to June, 1975, a period of nine months. In this recession the decline has been over 23 months so far and has reached 6.5%.

Barry Ritholtz, at The Big Picture, wrote this commentary about the data:

The US consumer continues to shed and incrementally use less debt. May Consumer Credit outstanding fell by $9.1b, almost $7b more than expected and April was revised to a decline of $14.9b from the initial report of a rise of $1b. The decline was led by a $7.3b fall in revolving credit outstanding while non revolving credit fell by $1.8b. The sharp downward revision to the April figure was led by a drop in the non revolving category. Overall consumer credit outstanding now stands at $2.415T, the lowest since March ‘07 and has fallen for 18 of the last 20 months. A combination of debt paydown, more savings and reduced credit access has the consumer doing the tough but rational thing of deleveraging. The resulting higher savings rate, while a crimp to consumer spending, is the seed of investment and is the long term offset to the short term economic impact to 70% of the US economy.

The question I have about this is quite simple: How much of the decline in total consumer credit outstanding is due to default?

Changes in consumer credit outstanding will be determined by the three things:

Total Credit Outstanding = Previous credit + New credit
- Sum of debt repaid - Sum of defaults

Jim Quinn has a post that estimates there have been $346 billion in consumer credit wrtieoffs and that new consumer credit has increased by about $200 billion. I have not found any other dollar amounts for defaulted consumer credit, but the S&P/Experian Consumer Credit Default Indices give a clear indication that defaults have increased dramatically. These indices provide a measure of the balance-weighted proportion of consumer credit accounts that go into default for the first time each month. The following graph shows the large increase in the bank cards default index since the consumer credit peak in July, 2008.

Contracting consumer credit can slow economic recovery because spending by the consumer is more 60% of the U.S. economy. However, increased saving (and paying down debt is a form of saving) is generally considered a good thing in the long run. While consumer credit contraction could be good if it indicated debt being paid off faster than new credit is issued, how healthy is it if the decline has a significant component from increased defaults? This can create significant losses for banks and for retail, especially consumer discretionary.

An aside to this discussion should address the unprecedented expansion of the money supply. Unwinding credit bubbles takes money, and some of the money actually disappears in the form of write-offs by creditors. You might say that some of the money involved in resolving the bubble is money that has already been spent. The current discussion addresses consumer credit, but, multiplied by a factor of 10 or 20 or 30, the concept can be applied across many forms of debt. That is why massive deleveraging can be accompanied by major currency expansions while deflationary forces are still ongoing.

This example stops when it comes to sovereign debt. When sovereign debt gets monetized the deflationary forces are quickly overcome by currency devaluation, otherwise known as hyperinflation.

Disclosure: No positions