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Driven to Debt

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Driven to Debt

Too-low interest rates caused unsustainable growth not just in the auto market, but in the economy at large. January 10, 2023
Economy, finance, and budgets

America has suffered stock-market bubbles and housing-market bubbles—but a car bubble? Last month, Tesla/Twitter impresario Elon Musk casually called the recent upheaval in the trillion-dollar-plus auto-loan market “potentially, the biggest financial crisis ever.” Musk overstates the case, or rather confuses it. The country doesn’t have a car-loan crisis, but an overall consumer-debt crisis. Crazy levels of auto lending are just an example he knows well. The broader question is: Can a country addicted to cheap debt adjust to normal interest rates?

The idea of a car bubble, as opposed to a stock or housing bubble, is on one level absurd. Stocks and houses may become overvalued from time to time—like, probably, right now. But stocks and houses are assets with at least some chance of rising in value over time. Cars, by contrast, are not long-term appreciating assets, but wasting assets. Buying a car is more like buying a refrigerator or a washing machine: its highest value is on the day you buy it. It has a use, but it will steadily wear out with that use, and you’ll sell it for far less than you spent to maintain, insure, and fuel it. Nobody buys a car, even a “luxury” model, as an investment.

There is a sound, though not optimal, case for borrowing to purchase a car. Most people don’t start out their working lives with, say, $30,000 to purchase sturdy, unflashy, reliable workhorses like a Toyota Camry. If borrowing to purchase a reliable car earns you more income by granting you access to more potential places of employment, then it makes sense to borrow to purchase a car. As you move up in the working world and save money, you can theoretically afford to purchase future cars with cash.

But that is not how the U.S. car-debt market works. Encouraged by cheap debt, Americans have borrowed ever-greater amounts of money for their cars. At the turn of the millennium, Americans had less than $600 billion in motor-vehicle loans outstanding, according to the Federal Reserve Bank of St. Louis. By mid-2005, they had borrowed $825 billion. Car loans outstanding actually started falling even before the housing crisis that began in 2007—an early sign that Americans were tapped out with home debt. They bottomed out at just under $700 billion in late 2010. Since then, though, it’s been a straight line up. As of the third quarter of 2022, Americans owed just shy of $1.4 trillion on car and SUV debt, a full doubling in barely a decade.

One might think that car debt grew because cars and SUVs have simply gotten more expensive. But the average vehicle didn’t get that much more expensive, at least until the pandemic. From the mid-1990s until 2010, the price of a new vehicle remained flat; after 2010, the price rose by about 8 percent, in total, until early 2020. On the eve of the pandemic, used car and truck prices were lower than they had been decades earlier. In 2000, Americans spent $334 billion on new and used cars and trucks, not adjusted for inflation, according to the Bureau of Transportation Statistics; in 2019, they spent $463 billion, growth of 39 percent, even as inflation rose 52 percent, and the number of vehicles registered for highway use rose by 22 percent. In real (inflation-adjusted) terms, people were getting more cars for less money.

Instead of banking these savings, however, Americans borrowed more money per vehicle—from about $26,000 in 2010 to $32,000 in 2019—and for longer terms. People once repaid their new-car loans over five years, according to the Edmunds car-shopping data center. Even before the pandemic, they were borrowing for an average of six years.

The driver behind all this debt was low interest rates. Between 2000 and 2007, the Federal Reserve’s interest-rate policy kept overall lending rates at what were, up until then, historic lows, as the economy struggled after the bursting of the tech bubble and 9/11. After 2007, the Fed pushed rates even lower, expanding the supply of money in the economy and thus keeping the rate at which banks borrow from one another close to zero until 2016. Because banks could borrow cheaply, they, in turn, lent to consumers cheaply. After 2016, the Fed gradually raised rates, but more slowly than the economic growth of the time required; it abruptly cut rates again in the early pandemic months.

Until the pandemic, cheap financing wasn’t pushing up the price of cars themselves. No scarcity of parts or labor existed, and automakers were willing and able to produce as many vehicles as needed to supply the market. After 2020, though, automakers have struggled to secure parts, particularly semiconductors. Cheap money chasing fewer cars has had a predictable result: abruptly higher prices. The price of new cars rose 20 percent between early 2020 and November 2022, the sharpest increase on record. The average price is now pushing $50,000. The price of used cars rose by an even steeper 56 percent through early mid-2022, another record.

People might have used this post-2020 price signal to purchase smaller, cheaper cars, but low interest rates worked against that rational impulse. Many people who want to spend less even find themselves stymied by dealers and lenders pushing good financing terms only for “luxury” models, not basic ones.

Since early 2022, the Fed has been hiking interest rates to combat inflation. Car-loan rates, too, are rising—with financing for a new car now at 5.7 percent, up from 4.3 percent in 2021, says Edmunds. The average new car payment is now $703, up from $630 in 2021—and that’s with a longer repayment term. Interest rates for used-car loans have gone from 7.4 percent to 9 percent in a year, and monthly payments from $506 to $565. Seven-year loans are gaining in popularity. Not everyone can shoulder the higher monthly payments, as well as higher down payments, so car sales, and car prices, are falling.

How can this create the “biggest financial crisis ever,” as Musk put it? By itself, it can’t. The car-loan market, at about $1.4 trillion, is a fraction of the size of the home-mortgage market, at $13.2 trillion. Unlike with the housing market in 2007 and 2008, people have not borrowed money to purchase multiple cars based on the idea that they would soon “flip” them for a profit. Unless they lose their jobs or their income, people will not surrender their cars to the bank, as they need them to earn income.

Yes, defaults will rise, from rates of well below 1 percent, as people with marginal credit find they can’t afford their loans. But repossessed cars will simply add to the supply of high-quality used cars, contributing to the softening in used-car prices over the past few months.

What Musk describes is not a financial crisis akin to 2008. In shouting meltdown!, he is thinking of his own business interests. He wants the Fed to panic and lower interest rates, thus keeping buyers for his expensive vehicles coming. The Fed will put up with a recession once in a while, he knows, but it is terrified of financial crises, as its extraordinary response to the 2008 meltdown proved.

This situation isn’t financial, though, but economic. A car-loan-induced recession would come not because of financial panic, as in 2008 with the housing market, but because people rationally keep their existing cars for longer, or buy new-ish used cars, forcing carmakers to cut jobs. People could also cut back on other consumer spending, such as restaurant meals, to keep up with their existing car payments, thus further harming the economy. People with poor credit, in particular, will suffer. Poorer workers unable to keep their existing cars or borrow to buy cheaper, reliable used vehicles will have to contend with the country’s terrible mass-transit systems.

Just as this isn’t a financial crisis, the broader problem has nothing to do with cars. It has to do with America’s now decades-old reliance on cheap debt—to keep pushing up housing prices, thus making people feel wealthier; and to mask the fact that, until the past couple of years, most Americans had seen their inflation-adjusted incomes stagnate or fall.

With inflation flirting with double digits for the first time in a generation, the Fed has no choice but to keep pushing up interest rates, cutting off the cheap-money spigot. The real question is: What’s next for the American economy if near-zero interest rates remain a thing of the past—not just in the car market, but across the country? For that, we have no road map.

Photo by FREDERIC J. BROWN/AFP via Getty Images

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