The end of the binge

Mar 31st 2010
From The Economist print edition

The consumer boom defied fundamentals. Now economic rules are reasserting themselves


IT WASN’T supposed to happen. An academic study in 1991 predicted that as the baby-boomers aged, America’s saving rate would rise by one or two percentage points by the mid-2000s. Instead it fell. Between 1995 and 2000 the share of American households owning their home should have dropped by a percentage point as boomers passed their home-buying years. Instead it rose by 4.6 percentage points, with the sharpest increases among those under 45, according to Harvard University’s Joint Centre for Housing Studies.

The economic behaviour of Americans born in 1935-44 turned out to be a poor guide to their children’s conduct. According to a study by the McKinsey Global Institute, when the parents’ generation reached the age of 45 their saving rates rose sharply, to about 30% of disposable income. Yet when their children’s generation, born in 1955-64, reached the same age, their saving rates remained unchanged, at about 10% of disposable income.

This divergence is explained by two events, both dating back to the early 1980s. First, the Federal Reserve’s success in taming inflation resulted in two decades of falling real interest rates and rising share and property prices. As people’s assets rose in value, they felt less need to save for college, retirement or rainy days. Pricier homes provided more collateral against which to borrow.

Second, federal ceilings on deposit and loan rates were abolished, launching a period of deregulation that enabled banks and other institutions to offer countless new financial products and allow millions to borrow large sums of money for the first time. Automated underwriting enabled lenders to screen borrowers more efficiently (and also reduced the opportunity for racial discrimination). Securitisation—bundling mortgages, car loans and credit-card debts into securities and selling them on—helped lenders limit their risks. Policymakers smiled on all this because it allowed many more Americans to become homeowners at no cost to the taxpayer. In 1989 only 47% of middle-income households had a mortgage. By 2007 about 60% did.

The Asian financial crisis of 1997-98 accentuated these trends. It sent oil down sharply and the dollar up, raising Americans’ purchasing power and their taste for imports and oil. In its aftermath Asian countries held down their exchange rates and began to accumulate huge trade surpluses, both to bolster growth and as protection against future crises (and the humiliating strictures of the IMF). They ploughed those surpluses into America’s bond market, holding down interest rates and inflating the housing bubble.

The return to earth began long before the riskiness of all this became obvious. In 2002 the dollar began to fall. In 2004 oil headed upwards. In 2006 the housing market turned down. Hopes that the transition would be gentle evaporated as the crisis erupted, leading to the recession of 2007-09. Many companies realised too late how much they had depended on credit-fuelled profligacy. GE, for instance, eventually relied on financial services for half its profits. Last year Jeff Immelt, the conglomerate’s chief executive, admitted that “we let it get too big.” Citigroup’s boss, Vikram Pandit, explained in 2008 how his company got into such a mess: “We had a large, long US consumer position.” Unfortunately, he added, so did the entire world.

Where consumers rule

Consumers have always dominated the American economy. Since 1950 their share of spending (including housing) has ranged from 66% to 76%. What was different about the pre-crisis era was the role of credit: in myriad new forms it made it possible for consumers to spend well beyond their income.

Consumption will recover, but it will no longer grow faster than income, as it did persistently for the two decades before the crisis; indeed, it should grow more slowly. With their shares and homes worth far less than they were, baby-boomers must now save harder for retirement. Lenders demand higher credit scores, bigger deposits and more stringent proof of income. Policymakers, who had cheered looser lending standards on the way up, are now tightening them further on the way down. True, Barack Obama has pleaded for banks to do more lending and put a government guarantee behind much of the mortgage market. But he is also bent on establishing a powerful Consumer Financial Protection Agency to scrutinise lenders’ offerings. Regulators are planning to hold banks to stiffer capital and liquidity rules.

The more that an industry depended on consumers’ access to credit, the harder it has been hit. As home ownership drops, developers are building smaller, simpler homes (see chart 3). Steve Hilton, the boss of Meritage Homes, is keeping the price of his houses down to at most 15% more than comparable existing ones to compete with the flood of foreclosures. On the garage doors of his company’s show homes hang garish banners advertising the “no-tricks” monthly mortgage payment: $1,480 for the three-bedroom, two-bathroom Harrison, for example. “It used to be taboo to talk about the payment,” says Mr Hilton. But nowadays buyers are looking for a place to live, not an investment, and knowing what the monthly repayment will be lets them compare the cost of owning and renting more easily.

Cars, like houses, are usually bought on credit, with either a loan or a lease. During the credit boom the terms of such deals were exceptionally attractive, but not any more, thanks to tight credit generally and the woes of GMAC, the financing arm of General Motors and Chrysler, which has been laid low by bad mortgage lending. In most years since 1960 some 7-8% of driving-age Americans bought a car. Last year only 4% did, according to IHS Global Insight, a consultancy. It forecasts that when the market has recovered the figure will settle at about 6% in any given year.

Cut up those credit cards

The recession also marked a “coda” to the credit-card industry’s first 50 years, says David Robertson of the Nilson Report, an industry newsletter. The popularity of credit cards was bound to wane as baby-boomers moved on from their highest-spending years, he says: “Instead of gliding to a manageable end, it wound up blowing up.” The number of holders of Visa, MasterCard, American Express and Discover cards shrank by 32m, or 11%, last year, according to Nilson. Outstanding revolving credit (mostly credit cards and personal lines of credit) fell by $92 billion, or 10%, the largest such drop since records began in 1968. That will have an effect on consumer spending more generally.

Credit-card companies attracted their share of the anger directed at Wall Street. With effect from February, the Federal Reserve and Congress banned a wide range of card-company practices, such as raising a borrower’s interest rate when he defaults on a loan extended by another organisation. Parents must now give their consent before their children under 21 can get a card. “At a time when our economy is in a crisis and consumers are struggling financially, credit-card companies are gouging them,” said Chris Dodd, chairman of the Senate Banking Committee.

Noxious as some of the card-companies’ practices were, they did allow many more people to hold credit cards. Bankers say the new restrictions may cut the number of credit-card holders by up to 45m. That is almost certainly an exaggeration, but there is bound to be a drop.

The changed economic and regulatory environment has certainly affected card companies’ strategy. American Express, for instance, had long favoured charge cards over credit cards, but in 1999 it launched its “Blue” credit card with a charity concert in New York’s Central Park featuring Sheryl Crow, Eric Clapton and Sarah McLachlan. The card was aimed at technologically savvy young consumers and contained a microchip to deter identity theft and encourage internet shopping. In subsequent years Amex followed up with a series of cards aimed at niche borrowers, from newlyweds to young Chicago professionals.

But the push into credit cards cost Amex dear as delinquencies mounted during the recession. Under new accounting rules it will have to hold additional capital for the off-balance-sheet vehicles used to securitise credit-card debts. Having agreed in 2008 to be regulated by the Federal Reserve, in part to qualify for bail-out funds (which it has since repaid), it may face stiffer liquidity and capital requirements than it would have done otherwise.

It has now ditched many of its new credit cards except Blue and returned to its roots in charge cards and services such as electronic payments. “There are going to be segments, not just subprime but [of] the middle class, that are not going to have access to credit, and when they get credit it’s going to be a lot more expensive,” Ken Chenault, Amex’s boss, said last summer. “The charge card is even more a product for these times than…three years ago.” The company is now offering features that help cardholders control spending. It lets them pay for groceries with reward points and impose spending limits on kids with supplemental cards. If consumers espouse frugality instead of ostentatious spending, Amex wants to be there.

Copyright © 2010 The Economist Newspaper and The Economist Group. All rights reserved.