America runs on credit. Before the recession in 2008, the U.S. consumer powered the economy forward with plenty of conspicuous consumption. Housing prices were on the rise, paychecks were plentiful, and the economy purred along as people used home equity loans and plastic to outspend their incomes.
Three years seems like a lifetime ago. Since the fall of 2008, our relationship with credit has changed dramatically: More Americans have been cutting up their credit cards than opening new ones, according to data from the New York Federal Reserve. During the last 12 months, people cancelled 199 million credit cards and only opened 168 million new accounts. And since peaking at the end of 2008, the average balance has declined more than 20%.
Unfortunately, our newfound fiscal restraint is killing the economy.
Good News/Bad Economy
Let's give high-fives and promotions to the millions of Americans reducing their reliance on credit cards and paying off their high-interest debt. They're doing the best thing for their families and futures. But more money in people's pockets ironically means less overall spending in the economy.
The fancy name for this phenomenon is "the paradox of thrift." If lots of individuals start saving more money to improve their own lives, the group could actually suffer, because less overall consumption leads to lower total savings.
If MasterCards (MA) and Visas (V) get swiped less frequently at stores across America, overall consumption drops. When people stop buying homes from PulteGroup (PHM) or McMansions from Toll Brothers (TOL), overall consumption drops.
America needs some level of savings to provide investment capital for its economy. We just don't need everyone to start saving or reduce their spending, all at the same time.
It's About Confidence
As the consumer goes, so goes our economy. We want happy consumers. Scratch that: We need happy consumers. Their spending keeps our economy running smoothly. Consumer spending makes up about 70% of our gross domestic product (GDP).
During the recession, frightened households reduced their spending. As the fear subsided, consumption returned. After all, consumers who aren't worried about losing their jobs, losing their houses, or collecting their next paychecks are much more likely to swipe their plastic and maintain reasonable balances.
Unfortunately, our confidence is waning once again. Recent Gallup polls show that upper-, lower-, and middle-income groups ($90,000 is the dividing line between upper and middle) cut back their average daily spending in August as their confidence in the economy fell. This may be a short-term blip, but it's not a good sign.
Student and Auto Loans -- That's a Different Story
American consumers may have gone on a credit bender in the second quarter, but the long-term trend for credit cards still looks slightly down to flat at best. Student and auto loans, however, continue to increase.
Going to school has always been a way to improve our lots in life. A good education helps us land that first job, earn that promotion, or change careers altogether. But with American businesses pulling all of their "We're Hiring" signs from the windows, going back to school today could be a risky endeavor if hiring doesn't pick up soon.
And while it's great to see people taking out loans to buy more cars -- after all, we've got to be able to drive to work or to the grocery store -- there's a dark cloud obscuring the silver lining. As the numbers of student and auto loans have risen, so have their 90+ day delinquency rates.
Type of Borrowing
Q4 2008 delinquency rate
Today's delinquency rate
Source: New York Federal Reserve, "Household Debt and Credit Report," August 2011.
The table above is a stark reminder. Debt, even in a low-interest environment, can cause lots of problems when it can't be repaid. With many Americans still trying to dig out from under the debt amassed in the early part of the last decade, the shock of the recession has brought even more pain as delinquencies spike and bankruptcies rise.
Keeping our economy on the path to recovery and avoiding another recession absolutely depends on loosening our collective purse strings and letting the money, and credit, flow. But we must do so in moderation. If delinquency rates rise again, credit will tighten back up and spending will go back down, increasing the likelihood of another recession.
It's a Catch-22 situation: The very thing that can help the economic recovery in the short term could end up hurting it even more down the road.
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The Motley Fool's David Meier is Associate Advisor for Million Dollar Portfolio. He does not own stock in any of the companies mentioned. Motley Fool newsletter services have recommended buying shares of Visa.
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