Tuesday, 15 July 2014

Why did they borrow?

In my last post, I placed into a sectoral balances framework Piketty's argument that rising US inequality drove the financial crisis. This is not to say, as some do, that excessive savings from China fed directly through into excessive household debt in the US. If only it were that simple. My argument is that trade dynamics between the two countries fed a capital surplus in the US, which inevitably found its way into higher household borrowing because of a relatively tight fiscal position and a sustained surplus in the corporate sector. 

Various people have criticised this on the grounds that it is not microfounded. Philip Booth of the IEA, probably my severest critic, says is "not economics". I think this is a somewhat narrow definition of "economics": just because I have not given a microeconomic explanation for a macroeconomic argument doesn't mean the macroeconomics is wrong. But we do need a human explanation for the high borrowing of low-to-middle income US households that is widely recognised as a key driver of the financial crisis. Accounting identities and global flows alone are not enough. 

Firstly, though, I want to unpick the causes of the trade and capital imbalances. It is very easy to blame the US's trade deficit on "consumerism" and "profligacy", and praise the "prudent savers" in China and Germany. But this is to make a morality play out of economics and ignore the actions of policy-makers that encourage and even enforce high saving and/or high borrowing. The US trade deficit is pretty intractable largely because the two major surplus countries - China and Germany - do not have currencies that float with respect to the USD. Germany uses the Euro, which does float, but the Euro is persistently undervalued relative to fundamentals in Germany because of the presence of weaker countries in the union. If the currency cannot adjust, then neither the trade deficit nor the capital surplus can correct unless unit labour costs fall, which means very significant falls in wages and employment costs. This is what is happening in the Eurozone periphery: it has not happened in the US thus far because of the US's willingness to borrow and the world's willingness to lend to it. 

However, there is a cost. As Philip Booth points out, China will not be able to suppress inflation forever if its currency is under-valued. Germany, too, faces high inflation relative to others in the Eurozone if its economy is  out of equilibrium: the ECB's tight money policies keep German inflation below 2%, but this forces weaker countries into outright deflation. 

Booth also observes that "if there are positive balances in the US private, corporate and government sectors then the dollar can float down easily enough." I'm afraid this is not really true. The dollar cannot float down against the Chinese yuan because of the currency peg, and it cannot float down relative to the real exchange rate in Germany because the Euro is effectively fixed at too low a rate relative to fundamentals in Germany. This is why devaluing the dollar would not necessarily reduce the US's trade deficit, as Dean Baker thinks: China would simply adjust the yuan to maintain its desired exchange value, and Germany would tighten fiscal policy to stop a fiscal deficit developing as a consequence of a falling trade surplus in a low-demand economy. The only way to resolve the currency problem is for China to allow the yuan to float and Germany to abandon austerity. Hell might freeze over first. 

Booth's general position is that the trade imbalances between the US, China and Germany are due to low saving in the US.  I was implicitly taking the opposite position, that the trade imbalances are due to low demand in China and Germany. But In fact these are simply aspects of the same phenomenon. We can argue about whether lack of saving in the US or lack of demand in China and Germany is more important, but it is hard to do this without slipping into moral argument again: the irrational belief that saving is "prudent" and spending "profligate" is very, very strong. The truth is that for one person to be able to save, another person must spend: one person's savings are another person's debt: one country's surplus is the deficit of others. The US's deficit is as much a reflection of financial repression in China and wage repression in Germany as it is of consumerism and loose monetary policy in the US. 

Booth further argues, as do others, that if the US spent less and saved more, then its trade deficit would come down and the imbalances resolve themselves. This is true, but that wouldn't necessarily result in an increase in US exports. After all, Chinese and German demand doesn't have to rise to compensate for falling US demand. The result might simply be a reduction in everyone's trade. And to me this is NOT a good thing. It is global trade above all that pulls people out of poverty. I don't wish to see it reduce.

So that's the global macroeconomic context fleshed out a bit. Now for US domestic economics.

Johnson Nderi argues that loose monetary policy in the aftermath of the dot.com bubble bursting and the 9/11 tragedy expanded the US money supply and pushed down interest rates, encouraging borrowing. But this too succumbs to Booth's criticism - it does not explain WHY borrowing increased. After all, households don't have to borrow, and as Scott Sumner says, if their incomes are stagnating, they wouldn't really want to.  If they don't want to borrow, cutting interest rates is pushing on a string. So why did they borrow? There are several reasons.

1. Low interest rates. 

Falling interest rates give households the impression that they are better-off than they really are, because debt becomes more affordable. This is particularly true when there are variable interest rates. So they will borrow more even if their incomes are stagnating, because the debt is more affordable.
I don't find this a rational explanation. In fact I find it astonishing that the same people who think that temporary tax cuts are pointless because of Ricardian equivalence also think that cutting interest rates in the aftermath of a negative shock encourages higher borrowing. People are just as capable of understanding that interest rates can rise as they are of understanding that tax cuts can be reversed. And for this reason, I don't buy the frequently-used argument that household borrowing increased because of pressure from lenders or Wall Street, either. Household borrowing is a decision. In economics we assume that people make rational decisions. If households didn't perceive borrowing as being in their best interests, they wouldn't have borrowed.
So low interest rates alone won't do as an explanation. But they might be an amplifier for other effects.
2. Individual expectation of higher incomes. 
Booth asks: "Why would a poor individual wish to borrow if his income is not expected to increase?" But the fact that incomes were actually stagnating at that time says nothing about people's expectations. Individuals below the age of 50 tend to believe that their future income will be higher than their present one. This is a reasonable expectation, particularly for men: the incomes of prime working-age men do tend to rise as they acquire skills and experience. The picture is much less clear for women, many of whom drop down to lower income levels when they have children. Over-50s, too, tend to have declining income. And as we know - and Booth concedes - US income inequality did in fact rise during this period. So what the data actually tell us is that increasing income for some was balanced by falling income for others. The data do NOT tell us that individual incomes were stagnating, still less that individual incomes were expected to stagnate. 
For individuals to borrow in expectation of future income rises is clearly rational, even if incomes in aggregate are stagnating. Indeed, it was rational for people to believe that as growth improved, so would their incomes. The problem, of course, is that for many people their rational expectations of better jobs and higher incomes have been dashed by the reality of techological change, offshoring, and since the crisis recession, stagnation and unemployment. 
3. Wealth effects. 
Most household borrowing is against property. When house prices rise, households' net worth rises, they "feel" wealthier and are therefore more willing to borrow. 
Prior to the financial crisis, there had been no housing market correction in the US since the 1930s: households had no reason to believe that house prices might fall, especially as the Fed was giving the impression that it had monetary policy sorted and there would never be another crash. It is hardly surprising that they were willing to leverage their rising net worth. Nor is it surprising that lenders were willing to help them do this: lenders also believed that house prices would never fall, or if they did, the Fed would bail everyone out. Wealth effects don't just apply to households. 
4. Government. 
After the 9/11 shock, George Bush and others exhorted the American people to borrow and spend, claiming it was their "patriotic duty" to do so. Being a cynical Brit, I find it hard to believe that people would borrow and spend more simply because the President told them to do so. But I guess it is possible - not least because people are far more likely to do what a Government says if they think it helps the war effort. As a direct response to 9/11, the US invaded Afghanistan and later Iraq. Had there not been high household borrowing and a consumption boom during this period, the US government's borrowing would have been far higher. We could say that the tax revenue generated from the consumption boom went to finance the War on Terror.
So there are four reasons why households might have chosen to borrow and spend - some more rational than others. But their decisions should be placed in the context of the decisions of two other groups in the US: the corporate sector, and the government.

As the chart shows, the US government's fiscal position deteriorated sharply when the dot-com bubble burst. President Bush was under pressure from Congress to restore the budget balance that had been achieved under Clinton. Fiscal policy was therefore relatively tight during this period despite the war effort - note the reduction in the budget deficit from 2004-2008:

What is more mysterious is why the US corporate savings rate was rising for much of this period:

and why it was apparently investing its surplus more in US property and its derivatives than in overseas FDI. It is hard not to conclude that stagnating wages and a rising corporate surplus were related: it seems the corporate sector preferred to lend to its workforce (indirectly) rather than paying them. And Booth and Sumner are probably right that financial innovation encouraged the corporate sector to invest in US property-backed securities rather than supposedly riskier projects overseas - or even in much-needed infrastructure development in the US. A capital surplus is not necessarily well spent. 

It is astonishing that one paragraph in Piketty can generate so much debate. I don't pretend to have covered everything even though this is my third post on this subject and as usual it is far too long and rambling. Piketty may or may not be right that inequality was a principal cause of the high borrowing that led to the financial crisis: my analysis above suggests there is more to it than that. But clearly there is far more still to discuss: the reasons for the corporate surplus, for example - and above all, the effects of war.

Related reading:

Sumner on Piketty
Perverting Piketty - Unlearning Economics (Pieria)


  1. A few other reasons come to mind here, one of which is marketing. I remember that pre credit crunch, there were huge numbers of adverts inviting people to take out quite large secured loans. I also remember getting quite large quantities of spam mail offering me (dollar denominated) mortgages.

    In the UK I also remember there being a huge number of mortgage products and large numbers of mortgages being sold through brokers. Comparison sites we're auctioning off their referrals to the highest bidder (I was working for one at the time). I think one reason for all the borrowing would have been the huge effort put into selling it at the time.

    1. Yes, both secured and unsecured lending were aggressively sold, but that does not explain why households decided to borrow. Aggressive selling does not necessarily lead to sales.

    2. Clearly aggressive selling DOES lead to sales, otherwise vendors would not indulge in the practice. Marketing departments are not entirely filled with idiots.

    3. Think you will find that aggressive selling only leads to large sales increases when either there are large power imbalances (customers feel unable to refuse) or they were considering buying anyway.

    4. The law of the market, surely, is that one sells what the market wants to buy. In a market where the seller can confidently sell a product without actually needing to have the capacity to fulfill the obligation contained within the product which they are selling, then they can sell the customer whatever they want, regardless of whether this is actually deliverable or indeed at all sane.

      Attempting to analyse US borrowing as if it were based upon any sort of measurable logic is therefore, surely a complete waste of energy. In a market where the vendor is selling unicorns underwritten only by the hope that they can sell on the obligation to deliver unicorns to somebody else, must surely be a case study in futility.

  2. I don't have a firm grasp on the ideas and mechanisms but I'd guess part of it has to do with what Paterson says: there was a push by banks to get people borrow. The mortgage companies had a drive for fees and the regulatory agencies were MIA. The financial industry was pawning off mortgage backed assets as relatively safe with higher returns. They demanded more loans from the mortgage industry. We were told housing prices would never decline, so people made leveraged bets on that assumption. There was a complacency caused by years of boom which cause people to view debt as less risky.

    What I wonder - and I don't have an answer - is if the savings glut (from foreign trade and increased inequality) and increased supply of capital pushed down the real interest rate and rate of return so there was an impetus for finance to "reach for yield" via derivatives and MBS, since the tech stock bubble had turned out to be a dud. There was a push for higher returns on seemingly safe assets which turned out not to be safe. The risk was underpriced.

    "The only way to resolve the currency problem is for China to allow the yuan to float and Germany to abandon austerity." With Germany and China the solutions are unlikely given the political environment. DeLong advocates that the Fed target 4 percent inflation which would give Europe room to adjust. This would lead to inflation arriving sooner in China as well. Competitive devaluations would help the world economy. Inequality is preventing this in that the overriding priority of policymakers is to protect the purchasing power of incumbent creditors, which increase inequality.

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