Number of the Week 122%

122%: U.S. household debt as a share of annual disposable income

U.S. consumers are paring down their debts faster than many economists had expected. To understand what that means, though, it helps to know how they’re doing it.

As of the end of March, the average U.S. household’s total mortgage, credit-card and other debt stood at 122% of annual disposable income, meaning it would take a bit more than 14 months to pay it all off if everyone stopped spending money on anything else. That sounds like a lot, but it’s better than it was before: At its peak in the first quarter of 2008, the debt-to-income ratio stood at 131%. Economists tend to see 100% as a reasonable level, so we’re almost a third of the way there.

The falling debt burden conjures up images of a nation seeking to repent after a decade of profligacy, conscientiously paying down mortgages and credit-card balances. That may be true in some cases, but it’s not the norm. In fact, people are making much more progress in shedding their debts by defaulting on mortgages and reneging on credit cards.

Since household debt hit its peak in early 2008, banks have charged off a total of about $210 billion in mortgage and consumer loans, including credit cards. If one assumes that investors suffered at least that much in losses on similar loans that banks packaged and sold as securities (a very conservative assumption), then the total — that is, the amount of debt consumers shed through defaults — comes to much more than $400 billion.

Problem is, that’s more than the concurrent decrease in household debts, which amounts to only $372 billion, according to the Federal Reserve. That means consumers, on average, aren’t paying down their debts at all. Rather, the defaulters account for the whole decline, while the rest have actually been building up more debt straight through the worst financial crisis and recession in decades.

In a sense, people who default on onerous debts — including the “strategic defaulters” who still have jobs and could pay — are doing the economy a favor. They’re freeing up cash to spend on other things, which can boost demand and give companies the confidence they need to start hiring again. If everybody just hunkered down and tried to pay their insurmountable debts, we might never have gotten out of the recession. Defaults are bad for the banks, but taxpayers already covered the cost of the losses through federal bailouts.

The bigger question, though, is what we as a society will learn from the experience. The lesson seems to be that the way to get ahead in the world is to take huge risks — buy a house you can’t afford with no money down, or invest huge amounts of borrowed money in risky loans — but let somebody else pick up the bill if things go wrong. As the growing U.S. federal debt demonstrates, that’s not a sustainable way to run an economy.