Monday, May 24, 2004

Monetary Policy Watch: Do Debt Levels Constrain Bidding?

In my previous article, it was noted that an observer commenting on the UK pricing increases claimed that price itself would form a constraint against excessive bidding. However I would argue that the history of bubbles has shown that debt can act as a removal agent for this constraint. The role of speculation on margin is classic to the history of the markets.

Are we effectively encouraging speculative price rises on houses, cars, etc. and other big ticketitems by encouraging unrestricted and massively under-collateralized debt? Is this expansion of consumer credit lines in turn the proper role of central bank monetary policy management? The theory of capitalism includes the necessary for liquidation of assets in a business cycle phase. What happens if the central bankers attempt to eliminate the liquidation and consolidation phase in order to protect GDP growth? Is the result a price spiral and eventually asset-stripping through debt-title transfership? This may seem like an abstract question but as we will see we can apply it to something as concrete as car purchasing.

The CSM explores the role of debt in increasing price-spirals.

Higher prices and longer loans are pushing new-car buyers into a debt spiral. Here's how to climb out.

By Eric C. Evarts | Correspondent of The Christian Science Monitor

It sounds like a great deal: Buy a car and finance it for five, six, or even seven years. Payments are smaller. You can buy more car. And automakers and banks make it easy to do.
So what's the hitch? Long-term debt.

By not paying off their loans fast enough, car owners run two financial risks down the road. They could end up still owing money on their old car when they go to buy a new one. Worse, they might owe more on their vehicle than it is worth.

Such problems have become more pronounced as the price of new cars has risen - to more than $25,000 on average last year - and auto companies have eased credit terms to keep cars moving off the lot.

"It's a vicious cycle," says Peter Humleker, a former auto dealer and now consumer advocate and author of the e-book "Car Buying Scams." "Consumers just keep digging themselves a bigger, deeper hole."

The only way out is to buy a less expensive car or to hang onto the old one until it's paid off, says Rob Gentile, head of the car-buying service at Consumer Reports...Even without accelerated depreciation, a seven-year loan encourages buyers to pay off their cars more slowly than they depreciate. Owing more for a car than it is worth is known in the industry as being financially "upside down." (Bankers call it being "under water.") To make matters worse, longer loan terms often come with a higher interest rate. Rolling money owed on a trade-in into a new-car loan raises that rate further...

By accepting longer loan terms, more and more consumers end up buying new cars while still making payments on their old ones. In 2004, 38 percent of shoppers who bought a new car on credit still owed an average of $3,686 on their trade-in, according to, a consumer car-buying guide in Santa Monica, Calif. As a result, the money they owed on their trade-in was often rolled into the payments on the new car...

Many buyers who opt for long-term loans have little cash for down payments. "In reality, they're trying to buy more car than they can afford," says Phil Reed,'s consumer-advice editor and author of "Strategies for Smart Car Buyers." "Many car-shoppers today are making the mistake of thinking in terms of monthly payments rather than total cost."

Automakers say loans that last more than five years represent a small part of their business and are targeted at buyers of expensive "specialty" vehicles, such as conversion vans. At General Motors Acceptance Corp., GM's finance arm, only 1 percent of vehicles are financed for longer than 60 months. [emphasis]

When prices on housing, education, and cars are all rising and have been rising consistently higher than inflation I continue to wonder at the government statistics that insist that inflation has been "under control' or nonexistent the past few years. For toilet paper, yeah, the price has been steady or dropping. However you have to buy a lot of rolls of toilet paper in order to equal a car purchase. In addition, there has been a precipitious drop in the equity of assets that people have been purchasing. When you have to change careers to a less lucrative position after a college degree because you're forced out of an industry, that's a drop in the "equity" or lifetime expected earnings you expected to net against the liabilities or debt your incurred in deferred earnings and expenditures to pursue that degree.

If we try to track the net wealth of Americans and try to use that as a indicator of standard of living, and then consider inflation to be defined as the cost of living, then certainly inflation has increased against wages and other income by a substantial amount. This troubling trend of telling people that they're richer when what is really true is that they're more in debt is a stunning modern sales-job that's been done. I'm not against debt, but debt in this case is being used to transfer ownership and that's effectively a second mortgage against the American way of life.


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