On Other Blogs, Other Wonders

Some things worth reading:

1. Ozgur Orhangazi on the coming balance of payments crisis in Turkey:

Since the late 1970s, “developing and emerging economies” (DEEs) have experienced boom-bust cycles of private capital flows... The latest boom began in the aftermath of the 2008 U.S. financial crisis, fed by the quantitative easing policies of the Federal Reserve and the European Central Bank (ECB). Much of Fed’s injections of credit into the system ended up in the stock markets of advanced economies and even more in the DEEs.
This latest wave of capital flows into DEEs led to currency appreciations, growing current account deficits, credit expansions and asset bubbles. ...  

Turkey is a case in point. While in the last decade it gained praise for its strong growth performance, now it is considered to be among the “fragile five”, together with Brazil, India, Indonesia, and South Africa. The biggest concern is the large current account deficit (reaching as much as 7.5 percent of the GDP by the end of November 2013) that is being financed mostly by short-term volatile capital inflows. ... 

Starting right after the Fed’s announcement in May 2013, the Turkish lira began losing its value. ... From May to the beginning of this week, the lira lost about 30 percent of its value, forcing the Central Bank, which so far has been resistant to increasing interest rates, to sharply increase interest rates at midnight after an emergency meeting on January 28. 

What is next? While the Central Bank’s sharp interest rate hike has, at least for now, stopped the free fall of the lira, the future does not seem very rosy... the depreciation of the lira will create serious problems for the firms that have borrowed in foreign currencies. ... This is likely to lead to, at the very least, payment problems; and most probably to many bankruptcies...

There's been a lot of discussion of whether low interest rates in the US and other developed countries contribute to excessive credit expansion and asset bubbles here. But it's worth remembering that these problems are much worse for developing countries, which -- in a world of free financial flows -- share in the credit conditions of the rich countries whether they want to or not. One can be skeptical of particular forms of the "far too low for far too long" argument and still recognize that if aggregate expenditure is to be stabilized solely through conventional monetary policy, the shifts in interest rates  required may be big enough to be destabilizing on other dimensions.

2. Martin Rapetti on the coming balance of payments crisis in Argentina: 

In July 2011, the stock of FX reserves was around U$ 52 billions. The exchange rate was 4.1 pesos per dollar... In August 2011 —three months before the presidential election— the Central Bank started losing reserves. In November 2011, just a few weeks after Cristina Kirchner was re-elected, FX reserves were U$ 46 billions. Since the depletion of FX reserves showed no sign of stopping, the authorities started to implement a series of measures to limit the demand for foreign currency. The controls triggered the blossoming of black markets. FX reserves kept falling, very rapidly since early 2013. In November 2013, after a poor mid-term election, the president fired the governor of the Central Bank and put in charge a new economic team. FX reserves were U$ 33 billions and the exchange rate had reached 6 pesos per dollar.... a week ago, the price of US dollar jumped to 8 pesos. FX reserves are now close to U$ 28 billions. The Central Bank has managed to keep the exchange rate at 8 pesos at the cost of loosing U$ 150/200 millions of reserves per day. There are still widespread expectations of further devaluation and few believe that authorities can sustain the exchange rate at the new level, especially because the rate of inflation has accelerated above 30% annually. In short, FX reserves have so far fallen by 46% and the exchange rate has risen by 95%. If it looks like a dog, walks like a dog and barks like a dog, then… it's probably a balance of payments crisis.

In Martin's telling, the root of the problem here is not monetary policy in the developed world, but rather the difficulty of using the exchange rate as a nominal anchor to control inflation.

3. Laura Tanenbaum on how nostalgia, real estate and race have shaped the idea of "Brooklyn":

Brooklyn nostalgia has done more than sell hot dogs and baseball memorabilia. ... in the early 1960s a flourishing literature of ... “urban pastoralism” challenged developers and urban renewal through nostalgic appeals to the authenticity of “urban villages” and daily street life. These writings by artists, activists, and academics, most famously Jane Jacobs’s The Death and Life of Great American Cities, inspired and shaped the views of “brownstoners,” homeowners who sought to resist the tide of suburbanization and white flight. But by the 1970s, ... coalitions between brownstoners and low-income residents had unraveled; Democratic New York City mayor Ed Koch turned this politics toward conservative ends. Koch “reveled in ethnic kitsch and cultivated a folksy image of a neighborhood New Yorker” while complaining about “poverty pimps.” It was the Southern strategy with an outer-borough accent. 

More than thirty years later, the crush of development marches forward. Brooklyn is a global brand: overpriced trinkets to be sold at Brooklyn Pizza in Manila, Brooklyn Coffeeshop in Curitiba, Brazil, or one of the other global Brooklyns featured in New York magazine’s retrospective of the Bloomberg era. But hip culture in the United States has long had a deep romantic and nostalgic streak, and the hipster’s most recent incarnation, central to the current branding of Brooklyn, has been no exception. 

The role of artists and hipsters in gentrification — specifically, their degree of complicity in the resulting displacement of low-income residents — has been endlessly debated. Were they the developers’ dupes, their victims, or their willing accomplices? Less often commented upon is the implicit equation behind these questions: associating artists with gentrification suggests that an artist has to be white. This is a particularly bitter irony for a borough and a city that has historically been and remains home to some of the most important African-American artists, musicians, filmmakers, writers, and intellectuals in the country. Looking at hipster culture in relationship to their work offers alternative ways of thinking about how the city changes, how we remember it, and what it might mean to oppose the march of neoliberal development without relying on a nostalgia that reflects our memories and desires more than our actual history.

It's a great piece. Read the whole thing, as they say.

What Do People Need to Know About International Trade?

On the first day of my trade class, we read Paul Krugman's article "What Do Undergrads Need to Know About Trade?" In an admirably succinct four pages, it captures all the important things that orthodox trade theory claims to tell us about trade policy. I don't think orthodox views on trade policy have changed at all in the 20 years since it was written. [1]

So what's Krugman's answer? What undergrads need to know, he says, is just what Hume and Ricardo were saying, 200 years ago: If relative costs of production are different in two countries, then total world output, and consumption in each individual country, will always be greater with trade than without, and prices will adjust so that trade is balanced. Free trade is always beneficial for all countries involved.

Krugman's additions to this Ricardo-Hume catechism are mostly negative -- a list of things we don't need to talk about when talk about trade.

Don't worry about development. The idea that a country can benefit from changing the sectors or industries it specializes in is, he says "a silly concept." Yes, we look around the world and see workers in rich countries producing things like airplanes and software, which are worth a lot, and workers in poor countries putting the same effort into producing agricultural goods and textiles, which are worth much less. But

Does this mean the rich country's high standard of living the result of being in the right sector, or that the poorer country would be richer if it tried to emulate the other's pattern of specialization? Of course not.

Of course not. This blanket dismissal is rather odd, since the work Krugman won the Nobel for explicitly supports an affirmative answer to both questions. [2] It's a case of esoteric versus exoteric knowledge, I guess -- some truths are not meant for everyone. Or as Krugman delicately puts it, "the innovative stuff is not a priority for undergrads."

Don't worry about demand. In debates over policy, "the central issue is employment" in the arguments on both sides. But this is wrong, he says:

The level of employment is a macroeconomic issue, depending in the short run on aggregate demand and depending in the long run on the natural rate of unemployment, with policies like tariffs having little net effect. Trade policy should be debated in terms of its impact on efficiency…

It's not immediately obvious why the claim that employment depends on aggregate demand is inconsistent with the claim that trade flows have important employment effects. After all, net exports are a component of demand. The implicit assumption is evidently that the central bank (or some other domestic policymaker) is maintaining the level of demand at the full-employment level, and will offset any effects from trade. [3]

Don't worry about trade deficits, and the financing they require. "The essential things to teach students are still the insights of Ricardo and Hume. That is, trade deficits are self-correcting…"

The whole piece is frankly polemical -- it's clear that the goal is not to educate in the normal sense, but to equip students to take a particular side in public debates. This is not specific to Krugman, of course. If anything, most contemporary textbooks are even worse. [4] One  reason I am using Caves and Frankel in my class is that it has less obnoxious editorializing than other texts I looked at. But less is still a lot.

Enough Krugman-bashing. What's the alternative? What should people know about international trade? Matias Vernengo has one good alternative list. Here is mine.

There are three frameworks or perspectives in which we can productively think about international trade. The questions we ask in each case will depend on whether we are thinking of trade flows as the adjusting variable, or as reflecting an exogenous change to which some other variable(s) must adjust.

1. Trade flows are part of aggregate expenditure. On the one hand, a good way to predict trade flows is to assume that a fixed fraction of each dollar of spending goes to imported goods. As Joan Robinson and others have stressed, in the short run at least, adjustment of trade balances comes mainly or entirely through income changes. (This is also the perspective developed in Enno Schroeder's work, which I've discussed here before.) On the other hand, if we can't assume there is some level of full employment or potential output to which to which the economy always returns, then we have to be concerned with trade flows as one factor determining the level of aggregate income. This might be only a short-run phenomenon, as in mainstream Keynesian analysis, or it might be important to economic growth rates over the long run, as in models of balance of payments constrained growth.

2. Trade flows are part of the balance of payments. In a capitalist world economy, there are many different money payments and obligations between countries, of which trade flows are just part. In a world of liquidity constraints, certain configurations of money payments or money commitments are costly, or cannot be achieved at all. That is, a country in the aggregate cannot in general borrow unlimited amounts at "the" world interest rate. The tighter the constraints on a country's financial position, the more positive a trade balance it must somehow achieve. On the other hand, for a given level of financing constraint, a more positive trade balance allows for more freedom on other dimensions. This interaction between trade flows and financial constraints is central to the balance of payments crises that are such a prominent feature of the modern world economy.

3. Trade flows involve specialization. Thinking now in terms of baskets of goods rather than money flows, the essential thing about international trade is that it allows a country's consumption and production decisions to be made independently. Given that productive capacities vary more between countries than the mix of consumption goods chosen at a given income and prices, in practice this means that trade allows for specialization in production. If we take productive capacities as given, it follows that trade raises world output and income by allowing countries to specialize according to comparative costs. This is the essential (and genuine) insight of Ricardo. On the other hand, if we think that inherent differences between countries are small and that differences in productive capacity arise mainly through production itself, then international trade will lead to a historically contingent pattern of international specialization in which some positions are more advantageous than others. If causality runs from trade patterns to productive capacities and not just vice versa, then there is a case for including activity trade policy in any development strategy.

The orthodox trade theory has legitimate value and deserves a place in the curriculum. As we'll discuss in the next post, simple textbook models of the Ricardo-Mill type can be used to tell stories with more interesting political implications than the usual free-trade morality tales. But they are only part of the picture. Much of what matters about trade depends on the fact that it involves flows of money and not just exchanges of goods.


[1] Have Krugman's views changed since he wrote this? As reflected in his textbooks, no they have not. As reflected in his blog, seems like sometimes yes, sometimes no. Someone should ask him.

[2] For example, one of Krugman's more widely cited articles is this one, which develops a model in which an innovating region ("the North") develops new products, which it exports to a non-innovating region ("The South"). In the model,

Higher Northern per capita income depends on the quasi-rents from the Northern monopoly of new products, so the North must continually innovate not only to maintain its relative position but even to maintain its real income in absolute terms. 

This is hard to distinguish from the arguments for industrial policy that Krugman dismisses as silly.

[3] What's especially odd here is that orthodox theory says that in a world of mobile capital, the only tool the central bank has to maintain full employment is changes in the exchange rate. In standard textbooks (including Krugman's own), it is impossible for monetary policy to boost employment unless it improves the trade balance.

[4] For example, David Colander's generally undogmatic intro textbook includes a section titled "If trade is so good, why do so many people oppose it?"The answer turns out to be, they're just confused.

International Trade: What Are the Questions?

This semester, I'm teaching an upper-level class at Roosevelt on international trade. Trade is an interest of mine, but not something I've ever taught. So it will be a learning experience for me at least as much as for the students.

One way to organize a class like this is to start with the orthodox approach and then present the various heterodox alternatives. I don't know if that's the best way to do things; but it is what I am doing. So we divide things up:

1. Orthodox trade theory. Orthodox approaches to trade (the first half of any standard textbook; we are using Caves and Frankel) treat trade as an exchange of goods for goods. We assume that trade is always balanced and that all resources are fully employed, and show how specialization by different countries in their preferred activities leaves everyone better off. We can divide this approach into Ricardian models, which treats countries preferred activities as dictated by inherent differences in productive capacities, on the one hand; and on the other, the Heckscher-Ohlin models that regard countries as having the same productive technology but different "endowments" of (a relatively small number of) "factors of production." As far as I can tell, these two kinds of models are not associated with distinct schools of thought in any larger sense; but it seems to me that the tension between them is one of the more interesting things in the orthodox theory.

2. Keynesian approaches. Here the important thing is the systematic relationship between income-expenditure and trade flows. On the one hand, we think a predictable fraction of incremental expenditure will fall on imports, and on the other, net exports are a form of autonomous demand boosting income. The short-run version of this approach used to be fully respectable; one very good presentation is Dornbusch's 1980 textbook, Open Economy Macroeconomics. [1] The long-run version of the Keynesian approach is Thirlwall's model of balance-of-payments constrained growth. I don't know that this has ever been respectable but I think it's useful and sensible and, I hope, teachable.

3. New trade theory. The starting point here is that while orthodox theory says that the biggest gains come from trade between countries that are most different (in terms of productive capacities or factor endowments), what we see in the real world is that most trade is between basically similar industrialized countries. The explanation, according to this approach, is that most trade is not in fact driven by comparative advantage, but by increasing returns, which reward specialization even in the absence of any inherent differences between countries or regions. This is the stuff Paul Krugman got his prize for. One puzzle about the new trade theory is that its practitioners almost all endorse the same free-trade policy orthodoxy underwritten by the old trade theory, even though the substantive content would seem to undermine it. What the new theory says is, first, that the pattern of specialization between countries is in some important respect arbitrary and at least potentially shaped by choices; and second, that the global distribution of income is a function of who ends up with which specialty. in this sense, there is some affinity between the new trade theory and Marxist theories of imperialism, dependency and unequal exchange. I'd wondered for a while if anyone had written about this connection. The answer turns out to be yes: Krugman himself. He even cites Lenin!

4. Development, dependency and unequal exchange. There is a large body of radical theory here, which I admit I have not quite got my arms around. For current purposes, let's think in terms of two strands of analysis -- or at least two sets of questions, which may or may not correspond to different schools or bodies of theory. First, there is the relationship between trade and economic development. Historically, we could put this at the very beginning of the list, since it seems that many of the earliest writers on what we now call economics were centrally concerned with this question. But for our purposes, we are interested in the tradition that runs from Hamilton to Friedrich List to Gerschenkron to Dani Rodrik and Ha-Joon Chang. These mostly pragmatic analyses, associated politically with rising rivals to the current hegemon, include a mix of infant industry/"import protection as export promotion" arguments, and trade restrictions as devices to expand the domestic policy space (the positive side of mercantilism emphasized by Keynes.) Second, there are the various theories that go under the names of dependency and unequal exchange. The key claim here is that there is a systematic movement of prices that favors the North and disfavors the South. We may further subdivide these theories into Prebisch-Singer and related approaches, and more Marxist analyses from Hobson, Lenin and Luxembourg through Baran to Frank, Wallerstein, Amin and Emmanuel.

Another way of looking at this: Among the assumptions of the orthodox theory are that all resources are fully employed, that prices always adjust so as to balance trade (or equivalently, that goods trade directly for goods), and that countries' productive capacities can be taken as exogenous and determine the pattern of trade. Keynesian approaches reject the first two of these assumptions, the new trade theory rejects the third; the various development/dependency approaches also reject the third assumption and in some versions the first two as well.

There reason I'm posting this here is I'd like to integrate my teaching more with this blog. So the hope is to have a bunch of posts about all this over the next few months. I'm sure I'll get a lot of things wrong; maybe the readers of the blog can correct some of them.

[1] On the other hand, this contemporary (and very admiring) review of the Dornbusch book does chide him for starting with 

a nonmonetary "Keynesian" model with rigid prices, fixed exchange rates, and unemployment ... The basic consideration is short-run full employment; long-run problems of allocation and prices are left in the background. Economists with a more "classical" turn of mind may be a little disconcerted to find tariffs introduced as instruments to raise employment and to see real wages explained by the "claims" of trade unions. They would probably prefer to start out with the long-run picture, linking monetary aspects firmly to the pure theory of international trade. 

So maybe it wasn't ever fully respectable. One thing I'd like to understand better is exactly when and to what extent "Keynsian" theory was accepted among academic economists.

Debt and Demand

One interesting issue in the ongoing secular stagnation debate is the relationship between debt and aggregate demand. In particular, there's been a revival of the claim that there is something like a one to one relationship between changes in the ratio of debt to income, and final demand for goods and services.

I would like to reframe this claim a bit, drawing on my recent work with Arjun Jayadev. [1] In a nutshell: Changes in debt-income ratios reflect a number of macroeconomic variables, and until you have a specific story about which of those variables is driving the debt-income ratio, you can't say what relationship to expect between that ratio and demand. We show in our paper that the entire post-1980 rise in household debt ratios can be explained, in an accounting sense, by higher real interest rates. Conversely, if the interest rates faced by households are lower in the future, debt-income ratios will decline without any fall in demand for real goods and services.

You might not know it from the current discussion, but there is an existing literature on these questions. The relationship between leverage -- especially household debt -- and aggregate demand was explored in a number of papers around the time of the last US credit crisis, in the late 1980s. Perhaps I'll write a proper review of this material at some point; a short list would include Benjamin Friedman (1984 and 1986), Caskey and Fazzari (1991), Alfred Eichner (1991) and Tom Palley (1994 and 1997). It's unfortunate that these earlier papers don't get referred to in today's discussion of debt and demand, by either mainstream or heterodox writers. [2]

For most of these writers, the important point was that the effect of debt on demand is two-faced: new borrowing can finance additional expenditure on real goods and services, but on the other hand debt service payments (in the presence of credit constraints) subtract from the funds available for current expenditure. Eichner, for instance, uses the equation E = F + delta-D - DS, or aggregate expenditure equals cashflow plus debt growth minus debt service payments.

More generally, to think systematically about the relationship between debt and household expenditure, we need to start from a consistent set of accounts. The first principle of financial accounting is that, for any economic unit, total sources of funds must equal total uses of funds. There are many ways of organizing accounts, at the level of the individual household or firm, at the level of the sector, or at the level of the nation, but this equality must always hold. You can slice up sources and uses of funds however you like, but total money coming in must equal total money going out.

The standard financial accounts for the United States are the Flow of Funds, maintained by the Federal Reserve. A number of alternative accounting frameworks are reflected in the social accounting matrixes developed by the late Wynne Godley and Lance Taylor and their students and collaborators.

Here's one natural way of organizing sources and uses of funds for the household sector:

compensation of employees

+

capital income

+

transfer receipts

+

net borrowing 

=

consumption (including consumer durables)

+

residential investment

+ 

tax payments

+

interest payments

+ 

net acquisition of financial assets

The items before the equal sign are sources of funds; the items after are uses. [3] The first two uses of funds are included in GDP measured as income, while the latter two are not. Similarly, the first two uses of funds are included in GDP measured as expenditure, while the latter three are not.

When we look at the whole balance sheet, it is clear that borrowing cannot change in isolation. An increase in one source of funds must be accompanied by some mix of increase in some use(s) of funds, and decrease in other sources of funds. So if we want to talk about the relationship between borrowing and GDP, we need a story about what other items on the balance sheet are changing along with it. One possible story is that changes in borrowing are normally matched by changes in consumption, or in residential investment. This is the implicit story behind the suggestion that lower household borrowing will reduce final demand dollar for dollar. But there is no reason in principle why that has to be the main margin that household borrowing adjusts on, and as we'll see, historically it often has not been.

So far we have been talking about the absolute levels of borrowing and other flows. But in general, we are not interested in the absolute level of borrowing, but on the ratio of debt to income. It's common to speak about changes in borrowing and changes in debt-income ratios as if they were synonyms. [4]  But they are not. The debt-income ratio has a denominator as well as a numerator. The denominator is nominal income, so the evolution of the ratio depends  not only on household borrowing, but on real income growth and inflation. Faster growth of nominal income -- whether due to real income growth or inflation -- reduces the debt-income ratio, just as much as lower borrowing does.

In short: For changes in the debt-income ratio to be reflected one for one in aggregate demand, two things must be true. First, changes in the ratio must be due mainly to variation in the numerator, rather than the denominator. And second, changes in the numerator must be due mainly to variation in consumption and residential investment, rather than variation in other balance sheet items. How true are these things with respect to the rise in debt-income ratios over the past 30 years?

To frame the question in a tractable way, we need to simplify the balance sheet, combining some items to focus on the ones we care about. In our paper, Arjun and I were interested in debt ratios, not aggregate demand, so we grouped together all the non-credit flows into a single variable, which we called the household primary deficit. We defined this as all uses of funds except interest payments, minus all sources of funds except borrowing.

Here, I do things slightly differently. I divide changes in debt into those due to nominal income growth, those due to expenditures that contribute to aggregate demand (consumption and residential investment), and those due to non-demand expenditure (interest payments and net acquisition of financial assets.) For 1985 and later years, I also include the change in debt-income ratios attributable to default. (We were unable to find good data on household level defaults for earlier years, but there is good reason to think that household defaults did not occur at a macroeconomically significant level between the Depression and the Great Recession.) This lets us answer the question directly: historically, how closely have changes in household debt-income ratios been linked to changes in aggregate demand?

Figure 1 shows the trajectory of household debt for the US since 1929, along with federal debt and non financial business debt. (All are given as fractions of GDP.) As we can see, there have been three distinct episodes of rising household debt ratios since World War II: one in the decade or so immediately following the war, one in the mid-1980s, and one in the first half of the 2000s.

Figure 1: US debt-GDP ratios, 1929-2011

Figure 2 shows the annual change in the debt ratio, along with the decomposition described above. All variables are expressed as deviations from the 1950-2010 average. The heavy black line is the change in the debt-income ratio. The solid red line is final-demand expenditure, i.e. non-interest consumption plus residential investment. The dashed and dotted blue lines show the contributions of nominal income growth and non-demand expenditure, respectively. And the purple line with diamonds shows the contribution of defaults. (Defaults are measured relative to the 1985-2010 average.)

Figure 2: Decomposition of changes in the household debt-income ratio, 1949-2011

It's clear from this figure that there is an important element of truth to the Keen-Krugman view that there is a tight link between the debt-incoem ratio and demand. There is evidently a close relationship between household demand and changes in the debt ratio, especially with respect to short-term variation. But that view is also missing something important. In some periods, there are substantial divergences between final demand from household and changes in the debt ratio. In particular, the increase in the household debt ratio in the 1980s (by about 20 points of GDP) took place during a period when consumption and residential investment by households were near their lowest levels since World War II. The increase in household debt after 1980 has often been described as some kind of "consumption binge"; this is the opposite of the truth.

The ambiguous relationship between household debt and aggregate demand can be seen in Table 1, which compares the periods of rising household debt with the intervening periods of stable or falling debt. The numbers are annual averages; to facilitate comparisons between periods, the averages for sub periods are again expressed as deviations from the 1950-2010 mean. (Or from the 1985-2010 mean, in the case of defaults.) The numbers are the contributions to the change i the debt-income ratio, so a positive value for nominal income growth indicates lower inflation and/or growth than the postwar average.


Table 1: Decomposition of changes in the household debt-income ratio, selected periods

	Change in debt-income ratio	Contribution of nominal income growth	Aggregate-demand expenditure	Non-demand   expenditure	Defaults
1950-2010 mean	1.5	-4.9	89.1	17.7	-0.9
Difference from mean:
1949-1963	1.3	2.3	2.9	-4.3	N/A
1964-1983	-1.6	-1.4	-1.8	1.1	N/A
1984-1989	1.4	-0.3	-2.1	3.8	0.4
1990-1998	-0.5	0.3	-0.8	0.3	0.2
1999-2006	3.2	-1.2	3.1	1.7	0.1
2007-2010	-3.5	1.7	-1.4	-2.0	-1.3

What we see here is that while the first and third episodes of rising debt are indeed associated with higher than average household expenditure on real goods and services, the 1980s episode is not. The rise in debt in the 1980s is explained by a rise in non-demand expenditures. Specifically, it is entirely due to the rise in interest payments, which doubled from 3-4 percent of household income in the 1950s and 1960s to over 8 percent in the late 1980s. (Interest payments continued around this level up to the Great Recession, falling somewhat only in the past few years. The reason "non-demand expenditures" is lower after 1990 is because the household sector sharply reduced net acquisition of financial assets.) Also, note that while the housing booms of 1949-1963 and 1999-2006 saw almost identical levels of household expenditure on real goods and services, the household debt ratio rose nearly twice as fast in the more recent episode. The reason, again, is because of much higher interest payments in the 2000s compared with the immediate postwar period. Finally, as I've pointed out on this blog before, the deleveraging since 2008 would have been impossible without elevated household defaults, which approached 4 percent of outstanding household debt in 2009-2010 -- partly offset by the sharp fall in household income in 2009, which raised the debt-income ratio.

Figure 3, from our paper, offers another way of looking at this. The heavy black line is the actual trajectory of the household debt-income ratio. The other lines show counterfactual scenarios in which non-interest household expenditures are at their historical levels, but growth, inflation and/or interest rates are held constant at their 1946-1980 average levels.

Figure 3: Counterfactual scenarios for the evolution of household-debt income ratios, 1946-2010

All these counterfactual scenarios show a spike in the 2000s: People really did borrow to pay for new houses! But the counterfactual scenarios also show lower overall trends of household debt, indicating that slower income growth, lower inflation and higher interest rates all contributed to the rise of household debt post-1980, independent of changes in borrowing behavior. Most interestingly, the red line shows that new borrowing after 1980 was lower than new borrowing in the 1950s, 60s and 70s; if households had engaged in the exact same spending on consumption, residential investment and financial assets as they actually did, but inflation, growth and interest rates had remained at their pre-1980 levels, the household debt-income ratio would have trended gradually downward.

To the extent that rising debt-income ratios after 1980 were the result of higher interest rates and disinflation, they were not contributing to aggregate demand. And if lower interest rates and and, perhaps, higher inflation and/or higher default rates bring down debt ratios in the future, deleveraging will not be a headwind for demand. 

It is customary to see rising debt as the result of private choices to finance higher expenditures by issuing new credit-market liabilities. But historically, it is equally correct to see rising debt as the result of political choices that increase the real value of existing liabilities.








[1] I'm pleased to report that a version of this paper has been accepted for publication by American Economic Journal: Macroeconomics. This has caused some adjustment in my view of the permeability of the "mainstream-heterodox" divide.

[2] This neglect of the earlier literature is especially puzzling since several of the protagonists of the 1990-era discussion are active in the sequel today. Steve Fazzari, for instance, in his several superb recent papers (with Barry Cynamon) on household debt, does not refer to his own 1991 paper, tho it is dealing with substantially the same questions. 

[3] Only a few minor items are left out. This grouping of sources and uses of funds essentially follows Lance Taylor's social accounting matrices, as presented in Reconstructing Macroeconomics and elsewhere. Neither the NIPAs nor the Flow of Funds present household accounts in exactly this way. The Flow of Funds groups all three sources of household income together, treats consumer durables as a separate category of household investment, and treats interest payments as consumption. The NIPAs treat residential investment and mortgage interest payments as their own sector, separate from the household sector, and omits borrowing and net acquisition of financial assets. The NIPAs also include a number of noncash items, of which the most important is the imputed flow of housing services from the owner-occupied housing sector to the household sector and the corresponding imputed rental payments from the household sector to the owner-occupied residential sector.

[4] For example, a recent paper on the causes of "The Rise in U.S. Household Indebtedness" begins with the sentence, "During the past several decades in the United States, signi ficant changes have occurred in household saving and borrowing behavior," with no sign of realizing that this is a different question than the one posed by the title.