Thursday, July 26, 2012

Representative Agents and Credit-Constrained Households

An interesting debate has broken out recently in the econ blogosphere between mainstream (e.g. Simon Wren-Lewis) and heterodox (e.g Lars P Syll) macroeconomists. Earlier today, Chris Dillow jumped into the conversation with the following:
Simon Wren-Lewis asks heterodox economists a question: how do you answer the question "what do consumers do if they are told that taxes are rising temporarily?" without some appeal to representative agents?
My answer is: I would start from a representative agent model (which predicts consumption smoothing) but I wouldn't stop there. On this issue, as on most other macro ones, I'd ask two further questions.
One is: do we have any reason to suspect that the representative agent perspective might be wrong? For example, some households might not have savings to run down in response to a tax rise, and might be unable to borrow; this is true for a minority (pdf).These people might be forced to cut spending.In this sense, heterogeneity matters, because models in which everyone is credit-constrained or nobody is are both wrong.
As an aspiring heterodox economist, I don’t deny that thinking in terms of representative agents can be useful. My opposition to mainstream macroeconomics, similar to Dillow’s, is that much analysis stops at that perspective. To understand macroeconomics, one has to consider that representative agent models may be wrong and in that case, find other models that better represent reality.

Dillow’s first question (read the full post for the second) addresses an issue that I’ve previously discussed as allowing heterodox economists to correctly predict the financial crisis and ensuing stagnation. Households burdened with excessive debt can become unable or unwilling to borrow regardless of low interest rates and bank liquidity. Monetary stimulus, which targets credit expansion through bank liquidity and lowering interest rates, has therefore been largely unsuccessful since liquidity was restored in the heart of the crisis. The lack of new loans and household (or private sector) deleveraging creates a deflationary drag on economic growth.

A recent quote from a July 2012 Euro Area Bank Survey highlights this issue:
Turning to loan demand developments, euro area banks continued to report, on balance, a significant fall in the demand for loans to enterprises in the second quarter of 2012, although the balance was somewhat less negative than in the first quarter of 2012 (-25%, compared with -30% in the first quarter). As in the first quarter, according to reporting banks, the fall in the second quarter was mainly driven by a substantial negative impact from fixed investment on the financing needs of firms. The ongoing decline in net demand for loans to households for house purchase abated in the second quarter compared with the first quarter (-21%, from -43% in the first quarter), whereas net demand for consumer credit remained broadly unchanged (-27%, compared with -26% in the first quarter). Looking ahead to the third quarter, banks expect a continued decline in the net demand for loans, both for enterprises and households, even if less negative than in the second quarter.
Despite the ECB’s efforts, loan demand continues to fall throughout Europe. Delusional Economics (which provided the above link/quote) sums it up best:
So, once again, this looks far more like a demand side issue than as supply side one. In fact these poor results appear to have even surprised the banks who were expecting far less of a deterioration. But are these results really surprising? Not to me. With private sectors in many economies under financial strain from deteriorating economic conditions and , in many a cases, rising tax burdens this is completely expected behaviour in my opinion. Households under stress don’t have the capacity to take on new credit, no matter what the rates and business therefore have little reason to invest.
Importantly, what this data suggests is that this problem isn’t really something that monetary policy, no matter how unconventional, is going to solve. This looks very much like a job for fiscal because until private sector balance sheets are repaired monetary policy is a lame duck. Obviously the fiscal compact is not going to provide this fiscal relief.

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