Swimming in the Stream: How Economic Forces Force Household Indebtedness

Update 4/7: Josh brings home the very same point, but regarding sovereign debt, in a new post.

If you’re a fish merrily swimming in a stream, is it your fault if a flood — say from a large release from the dam upstream — causes you to be washed out through the sluicegates? Or if a drought leaves you trapped in a shrinking pool from which you cannot escape?

That’s the question that comes to my mind when reading J. W. Mason and Arjun Jayadev’s paper, “Fisher Dynamics in Household Debt: The Case of the United States, 1929-2011.” I’m prompted to write about this now by Carola Binder’s response (“Wealth and the Motivations for Saving”) to Noah Smith’s Atlantic column, “Building the Wealth of the Poor and Middle Class.”

Mason and Jayadev look at household debt the way that (responsible) economists look at sovereign debt: considering primary surpluses/deficits (borrowing vs. payoffs before interest), and the effects of economic forces on household indebtedness: 1. growth, 2. interest, and 3. inflation rates. The whole thing is informed by an intimate understanding, analysis, and explication of sectoral financial balances.

These three variables — over which households have absolutely no control — often, and in some periods completely, overwhelm the borrowing/saving decisions of individuals. They are the stream in which those individuals swim, and over which they have no control.

I’ll just excerpt two passages about recent periods that make this reality manifest (emphasis mine):

1981-1999 During this period, households switched to primary surpluses, but as a result of financial deregulation and higher interest rates following the Volcker shocks, household debt ratios rose at about half the rate of the postwar years (1.4 percent annually compared with 2.6 percent). This increase took place despite primary surpluses averaging 1.4 percent of household income. With growth rates essentially unchanged from the previous period, the growth of leverage was entirely due to higher real interest rates, with higher nominal interest rates contributing two thirds of the increase and lower inflation the other third. It is striking to realize that over this period, accounting for about half of the post-1980 increase in leverage, saw the lowest levels of household spending relative to income of the whole postwar period. Leverage rose only because of the effect of higher real effective interest rates on households’ existing stock of debt.

2000-2006 This was the only sustained period since 1980 in which households ran primary deficits. Household leverage rose by 5.2 points per year, by far the fastest rate of increase in the twentieth century. (Before 2001, there had been only three years in total in which household leverage increased by more than four points; this period included six in a row. During the 1920s, to which this period is sometimes compared, annual increases in household leverage averaged 1.7 points, and never exceeded 3 points.) About two thirds of this was due to primary deficits, so the conventional assumption that increases in debt are driven by higher borrowing does hold good for this period. But about a third of the extraordinary rise in household leverage in this period can be attributed to real interest rates continuing to exceed real growth, a gap that added about two points annually to household leverage.

To summarize: the miracle of compounding interest.

Carola points out that most people just don’t get it. They put income from savings (interest, dividends) at the bottom of their priority lists. (Making Noah’s suggestions for education quite commendable.) Which leaves the notion of rational actors, with realistic lifetime expectations and plans, in a stagnant and imaginary intellectual cesspool.

This also skewers the morality-play representations of economics espoused even by good guys like Paul Krugman, with his “patient” (read: responsible, upstanding) savers and “impatient” (read: feckless) borrowers. Is the person who turned 30, got married, and bought a house in 2003 more patient and responsible than the one who turned 30, got married, and bought a house in 2006?

I’ll leave it to my gentle readers to consider policy recommendations based on that reality.

Cross-posted at Angry Bear.