The term “consumer debt” refers to debt that is obtained for the purpose of consumption or possession rather than investment. Debt instruments such as credit cards and personal loans can be used for profit-generating purposes, but generally they are used to make unnecessary consumption-related purchases. An increase or decrease in consumer debt in the country can have both negative and positive effects on the economy.
Money Multiplier Effect
One advantage of consumer debt is what is termed the money multiplier effect. The philosophy behind this concept is that increasing consumer spending boosts income for a string of businesses and individuals. Each additional consumption purchase funded by debt generates more money for the business selling the product, the business's employees, its suppliers and its suppliers' employees, not to mention the income for the lending organization and its employees.
In the United States, the Federal Reserve loosely controls interest rates in the economy by setting the Federal Funds Target Rate. The target rate affects the prime interest rate—the rate at which banks extend short-term loans to each other—which in turn affects rates for retail and institutional borrowers.
A decrease in consumer debt can alert the Federal Reserve that people are spending less on products and services in the economy, to which they often react by lowering the Federal Funds Target Rate to encourage more borrowing, which is thought to encourage spending and investment. This can have spillover effects throughout the rest of the economy, as interest rates can influence home buying, business startups, higher education and investing.
Savings and Investment
Consumer debt is completely unproductive by definition, meaning it does not generate a profit, or even revenue, for the borrower. Higher levels of consumer debt can translate into lower levels of debt used for investments. If a person is mired in expensive credit card payments each month, for example, he is less likely to save money to invest in real estate or a 401(k). This can shift demand in the economy from industries like financial services and real estate to consumption-driven industries like fast food and entertainment.
If consumer debt grows too large in the economy, with a large number of households owing many times their annual income levels, loan defaults can cause ripple effects throughout the economy. One of the first dominoes to fall during the economic crises of 2008 was a higher-than-expected mortgage default rate. Rampant defaults in the credit markets can cripple banks, which can reduce the supply of debt funding in the system and possibly cause banks to tap into federal insurance to fund customers' withdrawals. This in turn can cause people to withdraw their money and close their accounts, leaving even less money in the lending pool, which, as mentioned above, can slow spending and investment trends.