Thursday, March 01, 2007

Debt Service to Income

The theory was that lower interest rates (short term and long term) should allow us to purchase more house, more car and more, well, anything because we are able to afford the lower interest payments and therefore take out a larger loan allowing us to buy larger things.
And this is true. You are able to buy a nicer house or a fancier car with lower interest rates.
However, when these loanable dollars all flooded the housing market it drove housing prices rather high which meant you still pretty much got the same bang for your buck as you did before. It's kind of like when Wall Street pays its bonuses everything in New York gets more expensive so you really don't have that much of an increase in purchasing power.

The only problem is everybody started withdrawing all the equity out of these inflated home prices of theirs and drove their loan payments even higher.

So the true measure of our ability to afford these big fancy things we like to buy is not so much the ticket price of the item, but how much does it cost us to keep up with our debt payments relative to the amount we make.

Yes, a recession is certainly possible.

1 comment:

Anonymous said...

This scale of the chart is a little bit misleading. The debt payment rate was at 12% in the 80s, now it is at 14.5%. That does not look like a big difference.

Concerning the looming recession, if history wants to tell us something, it is that every cycle of economic growth in the last two decades, i.e. since the US has got proper monetary policy, has had a mid-term slow down before it turns into a recession.