Borrowing and Consumption over the Life Cycle-Becker

The types of loans available to consumers have grown at unprecedented rates during the past 40 years. These include credit card debt, expanded availability of mortgages, student loans, payday loans, reverse mortgages, and many other types. The provocative social commentator and columnist David Brooks, in the article referred to by Posner, laments this development- he calls his column "The Great Seduction". He believes that one of its main consequences is that individuals use credit to consume too much when they are younger instead of saving at these ages so that they can consume more at later ages. Obviously, some individuals borrow too much, and get caught in a spiral of high interest rate payments, bankruptcy, and insufficient assets as they age. Nevertheless, on the whole the growth of credit instruments available to consumers has been a positive development that helps finance investments in education and other human capital, and produces a more optimal consumption profile over the lifecycle. In the earlier times mentioned by Brooks, many families were farmers with incomes that fluctuated greatly because of changes in the weather, and because of pests and diseases. Urban workers also faced severe risks due to the threat of unemployment and other difficulties in labor markets. Families had little opportunity to get commercial credit to help tide them over the bad times. They had either to borrow from relatives, accumulate assets that could protect them against future risks, or suffer much during the bad times. They would have saved less and welcomed credit cards, mortgages, and harvest loans as more effective ways to adjust to these risks. Until the past 50 years, children from well off families had a large advantage in going to college because their studies were in large measure financed by their parents. The great boom in college education (that we wrote about last week) has seen many more students from modest income backgrounds entering and often completing college. They typically finance their education by working while in school and by borrowing with student loans and credit card debt, or their parents borrow in various ways to help them out. Without such credit, many of these students would be unable to get the college education that is so crucial to success in modern economies. The debt of college students does not simply pay for tuition, but also helps cover living expenses while in school. College students earn little then and in the first decade or so after they enter the labor force, while they earn much more when they are older. For this reason, the most forward looking and least impulsive college educated individuals want to borrow, not save, when they are young in order to raise their consumption then, and thereby help smooth out their consumption as they age. In addition, most men and women have greater consumption pressures when they are in their thirties and early forties because they raise their children then, and often provide financial support to elderly parents. Most young people who do not go to college are high school graduates, and they too have lower earnings and greater family responsibilities during their thirties and forties. They also would like to borrow at younger ages to raise their consumption at these ages to more appropriate levels compared to their consumption when they are older. Studies by my colleague Erik Hurst show that consumption of Americans beyond age 65 is generally not low relative to consumption at younger ages; apparently, they save enough when younger to enable them to consume generously when retired. In earlier time, families had to save to provide for their old age consumption since social security and company pensions were non-existent. A few other factors have contributed to the borrowing boom in recent decades. The decline in family stability has reduced the access to credit from relatives during bad times. Commercial credit has substituted for the family credit that was formerly available. Improvements in the capacity of lenders to track and monitor their loans, and to compensate restaurants and other businesses for their short term loans to credit card users, has reduced effective interest rates to consumers on small loans much below what they were in the past. Household Finance and other lenders of small amounts to consumers used to charge over 30 percent annual interest, and more when that was legal. In a rational world, much lower interest rates on consumer debt would induce considerable additional borrowing, and it has. Every new form of credit brings with it abuse from some borrowers and lenders. This has clearly been the case with the expansion in consumer credit instruments, but the benefits from this expansion seem to have far outweighed the costs.

Comments

[Jake]

Prof. Becker is absolutely correct.

[Brian Davis]

In the '20's or '30's of the last century, a brilliant man named Guy B. Fisher, from deep East Texas, penned a marvelous little book entitled "Facts About Money." I commend it to anyone with an interest in the Coinage Clause of our U.S. Constitution's Article I (Congress's powers), the Banks of the United States, the economic trauma wrought by the Civil War, the 1864 National Banking Act, the Federal Reserve Act, gold and gold clauses (and their New Deal demise), the Basel Accords, etc. Fisher's advice was to save and invest one's currency of the realm in tangible assets, like real estate, timber, and minerals - take title directly and accept the responsibility of stewardship. Likewise, he advised to never give a banker your financial statement (the Bankruptcy Code itself (in sec. 523) contains reason enough for why that advice was sound. Instead, if you need credit, put up some precious metals or growing timber or a oil royalty interest. But NEVER pledge your personal residence for anything except a first-lien purchase money mortgage loan, fully-amortizing. Loan sharks and sleazy lending schemes of all stripes exist because most people in contemporary lack the self-discipline to observe a self-made man's considered dicta. Reclaiming one's economic dignity can be tough love but remember what one of the Framers said, Franklin maybe, "It's a Republic, if you can keep it." The same goes for one's economic dignity. Condemn squander and those who seek reward by enabling it.

[Jim]

What is it that I am missing here? Haven't prices risen inexorably since Keynesianism was adopted after WWII? Isn't Keynesianism inexorably inflationary? Aren't the government and the private sector equally responsible for continuing to deficit spend (borrow, credit, whatever you wish to call it)? The politicians are constantly pandering to "You deserve everything". The commercial sector is constantly doing the same, "You deserve not to have pimples". Is it possible that early Americans were relying on phiosophical and religious proscriptions against extravagance based on historical experience? And now we have a government which doesn't have the political will do stabilize the cost-price-value curve and a population which is totally materialistic. Now we have influential thinkers saying that is just fine. Great! Personally, I lean toward Ravi Batra's view in his "Great American Deception" and that of Marvin Harris in "Why nothing works".

By the by, I wonder what the asset ratio is between 60 to 80 year olds to 40 to 60 year olds now compared to some previous years, say 1920 and 1960 and how much asset transfer is going on before death between those age groups.

Best regards to all.

[David R. Henderson]

Dear Gary,

Good point. I remember being turned down by VISA for a credit card I applied for in 1974. The limit I applied for? $250. I was a Ph.D. student at UCLA who got through college on my own with zero student debt, which meant that I didn't have a credit record. That was before the federal court decision that said credit card companies issuing credit cards across state lines could be under the usury laws in their states of issue. That's why so many credit cards come from South Dakota and Nevada. When that happened, it was much easier for me to get a credit card. My life in graduate school would have been substantially better had I had a credit card. You should have seen the suit I wore to the AEA meetings in San Francisco for my job interviews.

Best,

David

[Floccina]

I am a big saver by nature but I remember my grandmother advising spend your money when you are young and can really enjoy it. I may be over saving but I am very lazy and so hope to quit work so much in a few years (BTW I am 51 years old).

[Matt]

Re: Jim - "Population which is totally materialistic".

What are we here for, if not to consume?

[Jim]

Matt,

I hope your tongue is in your cheek!

Even if you have no essential philosophical motives, WASTEFUL consumtion based on DEFICIT spending cannot serve a society well in the long run. I believe that deficit spending has become so ingrained in the United States that it has perverted the government's purpose, debased the currency and given politicians their sole operating princple, "vote for me and I will make sure you can feed at the public trough".

[profscam]

As usual, Becker is long on theory and short on facts. He says, Urban workers also faced severe risks due to the threat of unemployment and other difficulties in labor markets. Families had little opportunity to get commercial credit to help tide them over the bad times.

If we are talking about the late 19th and early 20th centuries, the claim in the second sentence is false. Commercial credit, in the form of salary and chattel mortgage loans, was widely available in big cities like Chicago. These were the businesses for which the term "loan shark" was invented. They charged high rates for small sums and trapped many borrowers in debt. The products were constructed in such a way as to operate as interest-only cash advances.

At the end Becker says, Every new form of credit brings with it abuse from some borrowers and lenders. This has clearly been the case with the expansion in consumer credit instruments, but the benefits from this expansion seem to have far outweighed the costs.

About loansharking (a.k.a. payday lending) in its original incarnation one ought to be more cautious. It is doubtful that the benefits of salary lending far outweighed the costs. That result was only achieved through regulations like the Uniform Small Loan Law, which brought into existence the licensed personal finance industry (HFC, for example). The licensed lenders had their rates capped at 42% a year, were required to assess ability to repay, and amortized their product to make repayment more feasible for people with modest incomes.

Though the regulations produced losers as well as winners, winners vastly outnumbered losers. Millions of working people were able to borrow small sums at rates well below the typical loan shark price of 240% a year.

One could tell the same story about unregulated payday lending today. The number of customers who use the product once or twice is small. The number who roll over their loans again and again, and who borrow from one lender to pay another, is large.

Unlike Brooks, I wouldn't ban payday lending. But I also wouldn't trust the free market to maximize well-being for this type of product. The problem with the Becker/Posner position is that it makes sweeping claims without much attention to facts. What works in the prime mortgage market won't work in the small loan market that caters to cash-strapped consumers.

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