Debt Loads and Low Interest Rates

There have been several articles appearing in the papers raising alarm at the increasing amount of consumer debt in Canada and other industrialized countries. There is a concern that if, and when, interest rates begin to rise, the cost of servicing the debt will cause hardship among a large percentage of the population. We cannot help but wonder why the growing debt load is a surprise to anyone, except for the Keynesians (or maybe it’s the Kenyans – still working on that one). (See previous blog)

In the Keynesian consumption model, a reduction in disposable income is accompanied by a reduction in both consumer spending and savings. Aggregate spending in the economy decreases and leads us down the path to depression unless the government stimulates the economy with expansionary fiscal policy. Only large decreases in income are expected to cause large increases in debt load.

According to Milton Friedman’s Permanent Income Hypothesis, however, consumption will only be affected to the extent that individuals consider the reduction in incomes to be permanent. If the recession is expected to be temporary, then savings decreases dramatically (or debt increases) to maintain the level of consumption. When the economy rebounds, consumption does not rise. Instead, savings increases and debts are repaid. This is likely what is happening in Canada where we escaped most of the banking crisis. The story in the US is very different where projections suggest that the labour market may not recover for ten years.

There is also a microeconomic model that helps. Here, the basic premise is that a pizza today is worth more than a pizza in the future. For each individual, the difference between the two is known as the rate of time preference. When the interest rate is below the rate of time preference, we are better off by borrowing and consuming now. If the interest rate is higher, then we tend to save. Interest rates are at historically low levels and so we would expect individuals with stable incomes to be borrowing now and repaying later.

Articles:

Bank of Canada comment in Financial Post

Bloomberg report on Canadian debt relative to US debt

Ottawa Business Journal reporting on comments by the Superintendent of Bankruptcy