Thursday, January 2, 2014

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 ratioContribution of nominal income growthAggregate-demand expenditureNon-demand   expenditureDefaults
1950-2010 mean1.5-4.989.117.7-0.9
Difference from mean:

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.


  1. Nice post.

    By the way since you are talking of defaults, the sources/uses of funds equation will need to be modified to include defaults.

    1. Or maybe not! - depends on how one defines the terms in the equations... so.

  2. Ramanan,

    I don't think so. Default reduces the subsequent flow of interest payments, but it doesn't itself constitute a source (or use) of funds.

  3. Agree as per my second comment which didn't notice your January 2, 2014 at 5:13 PM

    However this is not as trivial.

    For something to be a "source of fund", there needn't be an actual flow of money in one's person's bank account - for example a credit card usage to consume is a source and a use, respectively.

    Defaults is also a default on the principal. So I can think of a person consuming everything he earns and defaulting on a house loan in one period. So one could say his net incurrence of liabilities (net borrowing in your terminology) is negative and this is balanced in the financial account with a flow of default.

    I guess the 2008 SNA (which I like) doesn't do it like that and instead records writeoffs in the "other changes in the volume of assets accounts".

    1. Yes, you could regard a default as a paired source and use of funds. It's just a convention not to do so. But I think it's a helpful convention.

      On the credit card example of course you are right and this is an important point -- even households today routinely operate on the liability side as well as the asset side of their balance sheets. This is a change since the mid-20th century, when there was a very small number of transactions -- basically home and auto purchases -- which households could finance by issuing new liabilities. Among other things, the existence of transaction credit means the idea of a quantity of "money" is not applicable to modern economies.

      None of this matters for the point I'm making in this post, tho, I don't think.

  4. It seems to me that the most relevant counterfactual to ponder is what would have happened to final demand had households devoted more of their incomes to paying down debt post-1980 , such that debt/gdp remained at the 50% level. I have to think that would have had some negative effect on consumption.

    Also missing from this discussion is the effect of the distribution of debt , as noted by Cynamon et al and others. Aggregate debt ( and consumption ) dynamics are by definition not the same for disparate groups within that aggregate. For example , within , say , the bottom 80% of the income distribution , it's unlikely that "purchase of financial assets " accounted for much of the non-demand expenditure , ever.

    " This has caused some adjustment in my view of the permeability of the "mainstream-heterodox" divide....."

    Do you really not understand why the mainstream would welcome this paper with open arms ?

    1. It seems to me that the most relevant counterfactual to ponder is what would have happened to final demand had households devoted more of their incomes to paying down debt post-1980 , such that debt/gdp remained at the 50% level. I have to think that would have had some negative effect on consumption.

      Households did devote more of their income to debt service after 1980, and this did have a negative effect on consumption and residential investment. That's the whole point.

      Also missing from this discussion is the effect of the distribution of debt , as noted by Cynamon et al and others. Aggregate debt ( and consumption ) dynamics are by definition not the same for disparate groups within that aggregate.

      This is what people say every time I present this work. It is possible that more unequal distribution of income contributed to higher new borrowing in the housing bubble period -- tho it needs to be shown more rigorously than I think it has been so far, even by Fazzari and Cynamon (whose stuff I like a lot). But for the 1980s, I don't think there is a consistent way to tell that story.

      within , say , the bottom 80% of the income distribution , it's unlikely that "purchase of financial assets " accounted for much of the non-demand expenditure , ever.

      I wouldn't be so confident. The biggest piece was reduced transactions accounts. But yes, in general the bottom part of the distribution isn't contributing much to any of the financial aggregates.

      Do you really not understand why the mainstream would welcome this paper with open arms ?

      I don't. Explain?

      Anyway, from my point of view the interesting thing is that this is a paper with no econometrics, no discussion of optimizing by anybody or of welfare or utility, no formal modeling of any kind. So at least methodologically it seems well outside what we think of as "mainstream" economics.

    2. Oh hey also would you mind using a handle of some kind?

  5. (Second paragraph, first line, your "recent work" link returns an error page.)

    From your second paragraph: "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."

    In Standards of evidence Steve Waldman writes: "Real interest rates have collapsed since the early 1980s."

    And again, in his earlier Inequality and demand SRW shows a couple graphs and describes "the slow and steady decline in real rates that began with but has outlived the 'Great Moderation'."

    It sounds like you are disagreeing with Steve Waldman on the direction of real rates. Does the contradiction arise because you are looking at real interest rates relative to growth rates, while Waldman is looking at real rates relative to the history of real rates?

    Even when I take Waldman's real interest estimate MORTG - MICH and subtract from it the rate of real GDP growth, I still see a downtrend.

    Can you explain the contradiction for me?

    ps, I put up a couple short posts related to yours here.

    1. The difference is because Arjun and I are not looking at market rates, but effective rates -- that is, total interest payments divided by the outstanding flow of debt. That's the appropriate measure for this kind of accounting exercise. Effective rates fell much more slowly than market rates, partly because of the existing stock of fixed-rate debt, partly because of a shift in the composition of debt toward higher rates.

      Arjun and I have another paper we're working on that explores this question specifically. Why have average rates faced by households (and nonfinancial business remained high) when headline rates have come down so much?

  6. If I get tour point correctly, you say that, to nave an increase in total debt, it is not necessarious that households go in a consumption binge: it suffices that, holding consumption fixed, real interest rate increase.
    This is important when one analises the cause of the increase of debt.
    However, as anonymous notes above, if households couldn't increase their debt level, they would have been forced to lower consumption at a 1 to 1 ratio to de debt that they instead incurred in, so from this point of view new debt still added directly to consumption.
    So while you are correct, this doesn't change the Keen/Krugman hypothesis IMHO.

  7. Yes, it does.

    The K-K position is that if debt ratios were rising at, say, 2% a year over 1983-2007, and we expect them to be flat going forward, then we need G or X-M to be 2 points higher to make up for the lost demand. (from debt-financed household expenditure.) But that assumes that interest, growth and inflation rates are the same in the future as they were over that period. If there is also reason to think that nominal interest less nominal growth rates will be 2 points lower in the future than in the 1983-2007 period, then stable debt ratios do not imply any reduction in demand. More generally, to the extent that historical variation in debt ratios is driven by changes if inflation, growth and interest rates, it's not informative about the sources of demand.

  8. Yes, I guess you can say that ceteris paribus a reduction in borrowing will translate into a reduction in consumption and housing demand. But it's a mistake to apply that reasoning to concrete historical data, because cet. is not par.

  9. Whoops I get it now (I hope).
    However it seems to me that it isn't high inflation that does the trick, but rather higer than expected inflation that erodes debt/old interest/adds to demand, while lower than expected inflation adds to the debt burden/increases old interest in real terms/potentially subtracts from demand.
    This is a problem from a policy point of view, because you can't really beat inflation expectations upward everytime (though having a bout of inflation today would be great news, as long as it is the classic wage driven inflation).