Debt Surges Don't Cause Recessions...Excessive Aggregate Amounts Do

In a post titled Debt Surges don’t cause recessions, Scott Sumner, questions the following argument from Paul Krugman:

Second, a dramatic rise in household debt, which many of us now believe lies at the heart of our continuing depression. Here’s household debt as a percentage of GDP

Sumner says:

What do you see?  I suppose it’s in the eye of the beholder, but I see three big debt surges:  1952-64, 1984-91, and 2000-08.  The first debt surge was followed by a golden age in American history; the boom of 1965-73.  The second debt surge was followed by another golden age, the boom of 1991-2007.  And the third was followed by a severe recession.  What was different with the third case?

The difference is the aggregate amount of household debt compared with incomes (GDP). The use of credit (debt) instead of money (income + savings) has an extra cost associated with the interest payments. As the aggregate amount of debt rises, aggregate interest costs follow. To simply stem the rise in debt, let alone maintain the current level, an increasing percentage of income and savings becomes necessary to cover interest costs and/or pay back previous debt. These actions reduce the amount of income and savings available for consumption and investment, creating a drag on economic growth.

Since households are no longer in a position to drive growth, other sectors must pick up the slack to prevent incomes from stagnating or falling. If incomes struggle, many households will have to shift an even larger percentage of income to paying interest and debt, while others simply become unable to repay the full amount. This deleveraging worsens the contraction from the household sector and leads to losses within the corporate and financial sector. If those sectors are equally leveraged with debt (as was the case in the US) then the losses in income and capital may cause those sectors to reduce spending and lending, respectively. This process can ultimately generate a vicious cycle where attempts to deleverage by each group reduces the income of others and subsequently increases the burden of debt. Absent growth in income from either the public or external sectors, this cycle will eventually slow but at a much lower level of GDP.
Update: The Arthurian continues to dissect the Monetarist disregard of rising household debt levels:

During the famous flat spot of 1965-1983, the comparable rate of debt growth was 9.36%. That's near 90% of the growth rate for the 1952-1964 "debt surge" and it is higher than the growth rate for the third debt surge Sumner identifies.

There was no remission. Debt did not stop growing. It barely slowed.

Prices increased at a compound annual growth rate of 6.6% per year between 1965 and 1983, more than tripling during those years. There was no remission of debt. There was only erosion of debt because of the inflation.

Points of Public Interest

Ugly day in DC after a beautiful week, but more good NCAA basketball on TV. Good luck to those whose brackets still have a chance of winning!

1. “The Current Models Have Nothing to Say”

Should we be surprised? Policy makers continue to employ models of an economy with no financial system.

2. Economics without a blind-spot on debt

The aggregate level of debt, especially private, matters in

forecasting economic growth.

3. Consumer Credit Growing at Highest Rate in Past Decade: Unhealthy and Unsustainable?

Stopping addictive habits is not easy, but extending those actions will only make the eventual adjustment more difficult and painful.

4. The Japan debt disaster and China’s (non)rebalancing

Chinese consumers continue to increase savings in lieu of domestic consumption. Japan is attempting to rebuild its trade surplus, but which countries will allow their surplus to decline or deficit to increase? Global (and domestic) imbalances not addressed remain significant risks to the global economic outlook.

5. A step in the right direction

Scientific exploration incorporating complex systems and networks continues to move our understanding of reality forward.

6. It's not structural unemployment, it's the corporate saving glut

Businesses save instead of investing in labor when consumer demand is weak. Until policy focuses on improving the consumer balance sheet (e.g. debt write-downs), unemployment will remain high.

7. Wrong vs Early – Contrarians Bet on Natural Gas

The best investors are often early and patient.

8. The Real Problem with Microfoundations

Microeconomics is not especially sound in predicting all outcomes

either.

9. Principal writedowns of the day, mortgage edition

Positive for households but will Bank of America (and others) really accept the associated losses?

10. Why Using P/E Ratios Can Be Misleading

In early 2009, at the market bottom, the P/E jumped to over 100 as profits plummeted. Using E/P corrects for this issue and shows the market is slightly overvalued currently.

 

Saving is NOT Enough for Consumer Led Recovery

Over the past few years, public policy has relentlessly attempted to ensure the solvency and profitability of the financial sector, namely the largest financial institutions. Lost in these efforts is any recognition that the Great Recession was primarily due to a highly indebted household sector being pressured to reduce leverage. As shown in the graph below (from Fisher Dynamics in Household Debt: The Case of the United States, 1929-2011), household debt as a percentage of GDP increased from approximately 10% in 1945 to nearly 100% by 2007.
As an avid follower of new economic work being done in Post-Keynesianism, Modern Monetary Theory (MMT) and Modern Monetary Realism (MMR), I’ve often been perplexed by apparent inconsistencies in discussions regarding saving and leverage. My confusion stemmed, in part, from the notion that households are capable of saving and increasing leverage (debt as a share of GDP) at the same time. If you’re a bit confused at this point, don’t worry, I’ll explain the situation more simply in a moment.

Before moving on, it’s important to recognize that economic terminology often does not fit with typical usage of every day words. Here are some important economic terms to understand going forward:
Saving -  The difference between disposable income and consumption.
Disposable Income - Income minus taxes.
Consumption - The amount spent on non-durable goods (e.g. food, clothing) plus the amount spent on durable goods (e.g. autos) spread over the item’s life span. (Note: Purchasing a home is an investment, for which an imputed rent is counted as consumption.)

Using this definition of saving, it becomes clear that households can maintain a positive savings rate yet still be net borrowers, as long as that borrowing goes towards investments. Ramanan, a horizontalist, recently explained this concept in a wonderful post on Saving Net Of Investment [Updated]. From this perspective, the frequent comment that households must increase saving to reduce leverage is clearly false. The rise in household debt during the post-WWII period is apparently based on net borrowings, not the private savings rate.

This new found understanding has proved short-lived after reading the following Guest Post by JW Mason: The Dynamics of Household Debt over at Rortybomb. A new working paper finds

“that changes in borrowing behavior has played a smaller role in the growth of household leverage than is widely believed. Rather, most of the increase can be explained in terms of “Fisher dynamics” — the mechanical result of higher interest rates and lower inflation after 1980.”

Put in simpler terms, interest rates on household debt since 1980 have been consistently higher than income growth. Under these conditions, even without increasing borrowing, household leverage will increase.

Over the past few years, household leverage has been decreasing largely due to debt write-downs. With this process slowing, the scenario mentioned above is likely to return. Even though interest rates remain at or near historical lows, income growth has been practically stagnant. Without a drastic change in these variables, the large burden of household debt is likely to continue suppressing consumer demand well in to the future. Attempts by households to increase saving may inadvertently decrease income, exaggerating the problem. Simply put, significant debt write-downs (a modern day debt-jubilee) may be necessary to restore the household sector to a stronger, more stable, financial position.    

Quote of the Week

...is from Of the Influence of Consumption on Production by John Stuart Mill (h/t Russ Roberts of Cafe Hayek):

II.4

In opposition to these palpable absurdities, it was triumphantly established by political economists, that consumption never needs encouragement. All which is produced is already consumed, either for the purpose of reproduction or of enjoyment. The person who saves his income is no less a consumer than he who spends it: he consumes it in a different way; it supplies food and clothing to be consumed, tools and materials to be used, by productive labourers. Consumption, therefore, already takes place to the greatest extent which the amount of production admits of; but, of the two kinds of consumption, reproductive and unproductive, the former alone adds to the national wealth, the latter impairs it. What is consumed for mere enjoyment, is gone; what is consumed for reproduction, leaves commodities of equal value, commonly with the addition of a profit. The usual effect of the attempts of government to encourage consumption, is merely to prevent saving; that is, to promote unproductive consumption at the expense of reproductive, and diminish the national wealth by the very means which were intended to increase it.

II.5

What a country wants to make it richer, is never consumption, but production.

Nearly 200 years ago, Mill recognized the faulty logic in trying to stimulate wealth by encouraging individuals to increase consumption. Sadly this lesson remains unlearned, as far too many public policies today are directed at subsidizing consumption (ie. autos, houses, oil). What is worse, a great deal of discussion regarding this topic blatantly ignores that two types of consumption even exist. Partially due to this omission, incentives to consume are often directed towards the unproductive type.

At an early age I was taught the virtues of saving and the potential benefit of compound interest. It strikes me as odd that this lesson, generally taught to children, is reversed for adults on the macro scale. Holding large amounts of outstanding debt (auto loans, mortgages, student loans, credit cards) has seemingly become the norm and an expected outcome for many individuals. Compound interest works against the borrower, raising the level of outstanding debt and reducing chances of ever paying down principal balances. (This appears to be precisely how the private sector can maintain a positive savings rate while the ratio of private debt to GDP continually increases.)

The Great Recession was largely influenced by a massive accumulation of private/household debt that could not be repaid or refinanced when assets values, most notably homes, turned lower. Increasing the nation’s wealth, for more than a couple years, will not be attained by stimulating unproductive consumption. Policy discussion must now shift to encouraging a healthy level of saving and greater focus on reproductive consumption.