Leverage is commonly referred to as borrowing money with the hope of increasing returns to equity. A business takes out a loan to increase its inventory so as to sell more goods and increase its profits. A consumer might take a mortgage on a larger home so that as the home appreciates, the return on his or her original investment is magnified.
Margin is another example. You buy stock and then borrow against it to buy more stock so that when (if) the stock rises your return is enhanced. These are wonderful strategies but only when under certain conditions and best of all of course is when they work.
The past 2 years are classic examples of when these strategies have failed completely. A good many homes have fallen below the purchase price, the stock market has tanked and business has certainly been curtailed. Add to that, low returns for cash invested and you have a complete turn around in consumer attitudes.
This can be reflected in this months consumer debt figures released by the Federal Reserve http://www.federalreserve.gov/releases/G19/Current/ While the government is busy trying to pump up the economy by issuing huge amounts of public debt, the American consumer is deleveraging as fast as possible. Consumer debt has dropped three out of the last four quarters and for this quarter revolving debt dropped on an annualized rate by a whopping 9.7%.
Revolving debt is dropping because of analysis by the consumer. The simplest is to take a look at what yield you are getting on your savings account and what you are paying for non tax deductible interest on your credit card. If you are getting 2% yield and are in a 28% tax bracket, after state and federal taxes your net yield is about 1.4%. If you are paying between 9 and 15% on your credit card, it simply makes no sense to carry any kind of a balance on your card.
Well that's great but what if you don't have a savings account at the moment? The most tax efficient way to reduce your leverage is to cut up your card and refinance your home ( if you have equity) to both a lower rate as well as shifting that revolving debt into either a home equity loan or a first mortgage. The numbers are much more attractive. Your 9% card interest now costs some where in the 4.5% to 5.5% range and the interest is deductible. Again if your in a 28% tax bracket, a 5.5% cost of money now becomes somewhere near 3.7% after state and federal deductions.
This is all well and good if you have options such as money in the bank and equity in your home. The answer of course for all of us and the country in general is to stop spending money we don't have. Yes, it may slow the recovery and a new national attitude toward debt might mean slower economic growth off into the future.
That growth however would be real growth, not the illusion of a pumped up economy roaring along built on the false foundation of borrowed money. The reason we are in the economic straits we are today is excessive debt in almost all segments of our economy, consumers, businesses, non profits, municipalities, and state and federal governments have all been on a spending spree which has resulted in the entire nation having some sort of a mortgage.
Perhaps the current strategy of pumping more borrowed government money into the system is the right one to revive the U.S. and world economies, however when we get things straightened out a bit, the nation and indeed even each of us as individuals has to address the idea of using enormous debt as the foundation of a sound personal and national economy. It simply will not work over the long haul.
In Ben Franklin's book, The Way to Wealth, he says this about debt, "when you run in debt, you give another power over your liberty." The Chinese currently own over a trillion dollars in our government bonds, is that a good thing?
