“Just finance it!” This has been the advice that the U.S. has given to young people for decades now. We borrow money to go to college, to buy houses, to buy cars and even to make everyday purchases. We’re bombarded by internet ads and junk mail offering new mortgages, auto loans, low-rate credit cards. Student loan sales agents meet freshmen in front of the student union on the first day of orientation. Public thinking seems to have shifted accordingly. Where someone from a bygone generation might judge their solvency by how much they have in the bank, we look at our monthly cash flow — if more money comes in than goes out, we breathe a sigh of relief.
As a result, Generation X and older millennials are the most debt-laden people in U.S. history. Back in 2014, researchers at the Federal Reserve Bank of St. Louis looked at how debt levels varied by the age of the head of household. Their findings confirm that despite aggressive deleveraging since the financial crisis, the problem remains acute:
“Generation X (born between 1965 and 1980) were the most aggressive borrowers prior to the financial crisis, and their cumulative debt increases to date remain the largest in percentage terms among all age groups… Early (millennials) also borrowed aggressively.”
What is the true cost of all this household debt? Most people know — many through grim experience — that when their incomes don’t grow as much as they expected, debt can magnify the pain. This is just a way of saying what everyone in finance knows — leverage increases risk. Another problem is that unexpectedly low inflation, like the kind the U.S. has had in recent years, can be hard on debtors. Low inflation means a dollar’s value is little changed, and since debt often requires fixed payments every month, borrowers don’t enjoy the benefit of repaying with cheaper dollars that result from inflation.
But there’s one more cost of debt that gets discussed less often — loss optionality. If I’m a young person with a bank account in the black, my life choices are many. I can start a business, bum around teaching English in Europe, go to grad school, or try to become a musician. But if I have tens of thousands of dollars in student loan debt, I have to get a job, in order to make my monthly payments.
Similarly, suppose I’m 38 years old, with a secure job at a company, and I’m loaded down with a mortgage, car loans and credit-card debt. For me to leave my employer to start a business, even if I have a good idea, would be an incredible risk — one lapse in venture funding, and I would miss my monthly payments, and my credit rating would go down the tube.
Option value, as any finance professor knows, is important. Debt reduces it. One fundamental reason for this is borrowing constraints — it isn’t so easy to just take out more debt to make monthly payments on existing debt. That means debt forces you to choose a lifestyle that maintains monthly cash flow. Another reason is that debt has an all-or-nothing structure — if you miss one payment, you’re technically in default. Your credit rating instantly begins to suffer, and you may incur other penalties. That means even a little risk-taking can be intolerable for someone with lots of debt.
When debt kills your life optionality, your employer also has much more power over you. If you demand a raise, your boss may turn you down, knowing that if you quit you’ll miss your mortgage payments. You may have to put in those extra hours of night or weekend time. Your outside options are just less attractive, given the millstone of debt.
Standard economics, as usual, says that these aren’t much of a problem. Rational people will take on exactly as much debt as they want, and encouraging them to borrow less would simply get in the way of their freedom to choose. But there are two big reasons why this could be wrong.
First of all, people might just not be smart about debt. They might underestimate their true risk of losing their job or taking a pay cut — in fact, plenty of research says overoptimism is pervasive. Or they might simply ignore the importance of optionality. How many undergrad students, having never held a full-time job, can imagine how student loans will yoke them to their employers 10 years down the line?
Next, excessive household debt might be sucking the dynamism out of the economy. Economists are fretting about the steadily declining rate of new business formation in the U.S. Since about 2000, fewer new companies have been started. Because fast-growing startups employ lots of people, invent new technologies, and disrupt highly concentrated markets, we want a lot of them. Spiraling household debt levels may be a big part of the reason why we’re not getting them.
So it’s probably a good idea to change the American culture of borrowing. Instead of subsidizing student loans, the government should consider limiting the amounts students can borrow (possibly replacing loans with grants for poor students). Elsewhere, it isn’t clear what policies could discourage excessive borrowing on credit cards and the like. Let’s hope the financial crisis created a long-lasting cultural shift away from carefree borrowing, but if not, we need to find some way to nudge people not to sign away their economic freedom.
Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.