Borrowing and Consumption over the Life Cycle

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.