Will consumers use debt correctly? Steve Waldman thinks they will make mistakes. The same mistakes Wall Street makes with leverage:

Consumers, like Wall Street quants, may inadequately extrapolate the distribution of their future income from recent observations. They have no access to the true distribution. The interest rates consumers pay for unsecured credit (think credit card rates) are often several times what they receive on money they save. In the world as it is, consumers ought to borrow only to counter severe downward shocks to income, pay off borrowings quickly, and build buffers of precautionary savings, since the cost of dissaving is much less then the cost of borrowing. (You lose 4% interest on your CD, rather than paying 12% interest on your credit card.)

Is debt a social security net? This is Waldman’s argument. A credit card gives you security. You can buy things when you lose your job. Pay the debt back when you get a job.

People don’t repay their debts. People do not use debt as a safety mechanism. Larger incomes cause larger debts. People use debt to optimize.

People use debt to live and invest beyond their means. Say homes appreciate at 10% per year. A person with a $100,000 home can make $10,000 a year. This same person may be able to borrow money for a larger home. He might borrow $500,000 at 5% interest. He buys a $500,000 home that gains $50,000; he pays $25,000 interest. He makes an extra $15,000. This person used debt to optimize his gains.

Optimization is not always good. Optimization comes with risk. The person is optimized for home appreciation; he is vulnerable to depreciation. Instead of losing $20,000, a 20% loss will cost him 100% of his capital: $100,000.

Millions are learning this today. It is a hard lesson.

Lower your debts. Lower your spending. Save.

This entry was posted on 2009-1-18 at 2:37 and is filed under Economy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.