Saving and Borrowing: A Response to Klein

Matthew Klein has a characteristically thoughtful post disagreeing with my new paper on income distribution and debt. I think his post has some valid arguments, but also, from my point of view, some misunderstandings. In any case, this is the conversation we should be having.

I want to respond on the specific points Klein raises. But first, in this post, I want to clarify some background conceptual issues. In particular, I want to explain why I think it’s unhelpful to think about the issues of debt and demand in terms of saving.

Klein talks a great deal about saving in his post. Like most people writing on these issues, he treats the concepts of rising debt-income ratios, higher borrowing and lower saving as if they were interchangeable. In common parlance, the question “why have households borrowed more?” is equivalent to “why have households saved less?” And either way, the spending that raises debt and reduces saving, is also understood to contribute to aggregate demand.

This conception is laid out in Figure 1 below. These are accounting rather than causal relationships. A minus sign in the link means the relationship is negative.


We start with households’ decision to consume more or less out of their income. Implicitly, all household outlays are for consumption, or at least, this is the only flow of household spending that varies significantly. An additional dollar of household consumption spending means an additional dollar of demand for goods and services; it also means a dollar less of savings. A dollar less of savings equals a dollar more of borrowing. More borrowing obviously means higher debt, or — equivalently in this view — a higher debt-GDP ratio.

There’s nothing particularly orthodox or heterodox about this way of looking at things. You can hear the claim that a rise in the household debt-income ratio contributes more or less one for one to aggregate demand as easily from Paul Krugman as from Steve Keen. Similarly, the idea that a decline in savings rates is equivalent to an increase in borrowing is used by Marxists as well as by mainstream economists, not to mention eclectic business journalists like Klein. Of course no one actually says “we assume that household assets are fixed or nonexistent.” But implicitly that’s what you’re doing when you treat the question of what has happened to household borrowing as if it were the equivalent of what has happened to household saving.

There is nothing wrong, in principle, with thinking in terms of the logic of Figure 1, or constructing models on that basis. Social science is impossible without abstraction. It’s often useful, even necessary, to think through the implications of a small subset of the relationships between economic variables, while ignoring the rest. But when we turn to  the concrete historical changes in macroeconomic quantities like household debt and aggregate demand in the US, the ceteris paribus condition is no longer available. We can’t reason in terms of the hypothetical case where all else was equal. We have to take into account all the factors that actually did contribute to those changes.

This is one of the main points of the debt-inequality paper, and of my work with Arjun Jayadev on household debt. In reality, much of the historical variation in debt-income ratios and related variables cannot be explained in terms of the factors in Figure 1. You need something more like Figure 2.

Figure 2 shows a broader set of factors that we need to include in a historical account of household sector balances. I should emphasize, again, that this is not about cause and effect. The links shown in the diagram are accounting relationships. You cannot explain the outcomes at the bottom without the factors shown here. [1] I realize it looks like a lot of detail. But this is not complexity for complexity’s sake. All the links shown in Figure 2 are quantitatively important.

The dark black links are the same as in the previous diagram. It is still true that higher household consumption spending reduces saving and raises aggregate demand, and contributes to lower saving and higher borrowing, which in turn contributes to lower net wealth and an increase in the debt ratio. Note, though, that I’ve separated saving from balance sheet improvement. The economic saving used in the national accounts is quite different from the financial saving that results in changes in the household balance sheet.

In addition to the factors the debt-demand story of Figure 1 focuses on, we also have to consider: various actual and imputed payment flows that the national accounts attribute to the household sector, but which do not involve any money payments to or fro households (blue); the asset side of household balance sheets (gray); factors other than current spending that contribute to changes in debt-income ratios (red); and change in value of existing assets (cyan).

The blue factors are discussed in Section 5 of the debt-distribution paper. There is a much fuller discussion in a superb paper by Barry Cynamon and Steve Fazzari, which should be read by anyone who uses macroeconomic data on household income and consumption. Saving, remember, is defined as the difference between income and consumption. But as Cynamon and Fazzari point out, on the order of a quarter of both household income and consumption spending in the national accounts is accounted for by items that involve no actual money income or payments for households, and thus cannot affect household balance sheets.

These transactions include, first, payments by third parties for services used by households, mainly employer-paid premiums for health insurance and payments to healthcare providers by Medicaid and Medicare. These payments are counted as both income and consumption spending for households, exactly as if Medicare were a cash transfer program that recipients then chose to use to purchase healthcare. If we are interested in changes in household balance sheets, we must exclude these payments, since they do not involve any actual outlays by households; but they still do contribute to aggregate demand. Second, there are imputed purchases where no money really changes hands at all.  The most important of these are owners’ equivalent rent that homeowners are imputed to pay to themselves, and the imputed financial services that households are supposed to purchase (paid for with imputed interest income) when they hold bank deposits and similar assets paying less than the market interest rate. Like the third party payments, these imputed interest payments are counted as both income and expenditure for households. Owners’ equivalent rent is also added to household income, but net of mortgage interest, property taxes and maintenance costs. Finally, the national accounts treat the assets of pension and similar trust funds as if they were directly owned by households. This means that employer contributions and asset income for these funds are counted as household income (and therefore add to measured saving) while benefit payments are not.

These items make up a substantial part of household payments as recorded in the national accounts – Medicare, Medicaid and employer-paid health premiums together account for 14 percent of official household consumption; owners’ equivalent rent accounts for another 10 percent; and imputed financial services for 4 percent; while consolidating pension funds with households adds about 2 percent to household income (down from 5 percent in the 1980s). More importantly, the relative size of these components has changed substantially in the past generation, enough to substantially change the picture of household consumption and income.

Incidentally, Klein says I exclude all healthcare spending in my adjusted consumption series. This is a misunderstanding on his part. I exclude only third-party health care spending — healthcare spending by employers and the federal government. I’m not surprised he missed this point, given how counterintuitive it is that Medicare is counted as household consumption spending in the first place.

This is all shown in Figure 3 below (an improved version of the paper’s Figure 1):

The two dotted lines remove public and employer payments for healthcare, respectively, from household consumption. As you can see, the bulk of the reported increase in household consumption as a share of GDP is accounted for by healthcare spending by units other than households. The gray line then removes owners’ equivalent rent. The final, heavy black line removes imputed financial services, pension income net of benefits payments, and a few other, much smaller imputed items. What we are left with is monetary expenditure for consumption by households. The trend here is essentially flat since 1980; it is simply not the case that household consumption spending has increased as a share of GDP.

So Figure 3 is showing the contributions of the blue factors in Figure 2. Note that while these do not involve any monetary outlay by households and thus cannot affect household balance sheets or debt, they do all contribute to measured household saving.

The gray factors involve household assets. No one denies, in principle, that balance sheets have both an asset side and a liability side; but it’s striking how much this is ignored in practice, with net and gross measures used interchangeably. In the first place, we have to take into account residential investment. Purchase of new housing is considered investment, and does not reduce measured saving; but it does of course involve monetary outlay and affects household balance sheets just as consumption spending does. [2] We also have take into account net acquisition of financial assets. An increase in spending relative to income moves household balance sheets toward deficit; this may be accommodated by increased borrowing, but it can just as well be accommodated by lower net purchases of financial assets. In some cases, higher desired accumulation of financial asset can also be an autonomous factor requiring balance sheet adjustment. (This is probably more important for other sectors, especially state and local governments, than for households.) The fact that adjustment can take place on the asset as well as the liability side is another reason there is no necessary connection between saving and debt growth.

Net accumulation of financial assets affects household borrowing, but not saving or aggregate demand. Residential investment also does not reduce measured saving, but it does increase aggregate demand as well as borrowing. The red line in Figure 3 adds residential investment by households to adjusted consumption spending. Now we can see that household spending on goods and services did indeed increase during the housing bubble period – conventional wisdom is right on that point. But this was a  spike of limited duration, not the secular increase that the standard consumption figures suggest.

Again, this is not just an issue in principle; historical variation in net acquisition of assets by the household sector is comparable to variation in borrowing. The decline in observed savings rates in the 1980s, in particular, was much more reflected in slower acquisition of assets than faster growth of debt. And the sharp fall in saving immediately prior to the great recession in part reflects the decline in residential investment, which peaked in 2005 and fell rapidly thereafter.

The cyan item is capital gains, the other factor, along with net accumulation, in growth of assets and net wealth. For the debt-demand story this is not important. But in other contexts it is. As I pointed out in my Crooked Timber post on Piketty, the growth in capital relative to GDP in the US is entirely explained by capital gains on existing assets, not by the accumulation dynamics described by his formula “r > g”.

Finally, the red items in Figure 2 are factors other than current spending and income that affect the debt-income ratio. Arjun Jayadev and I call this set of factors “Fisher dynamics,” after Irving Fisher’s discussion of them in his famous paper on the Great Depression. Interest payments reduce measured saving and shift balance sheets toward deficit, just like consumption; but they don’t contribute to aggregate demand. Defaults or charge-offs reduce the outstanding stock of debt, without affecting demand or measured savings. Like capital gains, they are a change in a stock without any corresponding flow. [3] Finally, the debt-income ratio has a denominator as well as a numerator; it can be raised just as well by slower nominal income growth as by higher borrowing.

These factors are the subject of two papers you can find here and here. The bottom line is that a large part of historical changes in debt ratios — including the entire long-term increase since 1980 — are the result of the items shown in red here.

So what’s the point of all this?

First, borrowing is not the opposite of saving. Not even roughly. Matthew Klein, like most people, immediately translates rising debt into declining saving. The first half of his post is all about that. But saving and debt are very different things. True, increased consumption spending does reduce saving and increase debt, all else equal. But saving also depends on third party spending and imputed spending and income that has no effect on household balance sheets. While debt growth depends, in addition to saving, on residential investment, net acquisition of financial assets, and the rate of chargeoffs; if we are talking about the debt-income ratio, as we usually are, then it also depends on nominal income growth. And these differences matter, historically. If you are interested in debt and household expenditure, you have to look at debt and expenditure. Not saving.

Second, when we do look at expenditure by households, there is no long-term increase in consumption. Consumption spending is flat since 1980. Housing investment – which does involve outlays by households and may require debt financing – does increase in the late 1990s and early 2000s, before falling back. Yes, this investment was associated with a big rise in borrowing, and yes, this borrowing did come significantly lower in the income distribution that borrowing in most periods. (Though still almost all in the upper half.) There was a debt-financed housing bubble. But we need to be careful to distinguish this episode from the longer-term rise in household debt, which has different roots.


[1] Think of it this way: If I ask why the return on an investment was 20 percent, there is no end to causal factors you can bring in, from favorable macroeconomic conditions to a sound business plan to your investing savvy or inside knowledge. But in accounting terms, the return is always explained by the income and the capital gains over the period. If you know both those components, you know the return; if you don’t, you don’t. The relationships in the figure are the second kind of explanation.

[2] Improvement of existing housing is also counted as investment, as are brokers’ commissions and other ownership transfer costs. This kind of spending will absorb some part of the flow of mortgage financing to the household sector — including the cash-out refinancing of the bubble period — but I haven’t seen an estimate of how much.

[3] There’s a strand of heterodox macro called “stock-flow consistent modeling.” Insofar as this simply means macroeconomics that takes aggregate accounting relationships seriously, I’m very much in favor of it. Social accounting matrices (SAMs) are an important and underused tool. But it’s important not to take the name too literally — economic reality is not stock-flow consistent!


14 thoughts on “Saving and Borrowing: A Response to Klein”

  1. Ah, “saving…” The eternal discussion.

    What a great diagram. Perhaps most revealing: “saving” doesn’t *go* anywhere.

    Shouldn’t there be a blue “disposable income” box upper left pointing to saving?

    1. Perhaps most revealing: “saving” doesn’t *go* anywhere.

      Yes – that’s definitely a main point.

      Shouldn’t there be a blue “disposable income” box upper left pointing to saving?

      I’m not sure. On the one hand, yes, holding spending flows constant, an increase in income will lead to higher saving and a more positive balance sheet position. On the other hand, I think it may be ok to leave that implicit here – the diagram is cluttered enough, and consumption and investment are understood as relative to income. On the third hand, in the next figure I normalize by GDP, which means disposable income is an independent source of variation. Hm.

      1. I think a lot of people might look and say, “where in the hell is income?” Might dismiss (or not understand) as a result. So IMO, worth the slight additional clutter. I also just think it makes the diagram more accurately complete.

    2. “Perhaps most revealing: ‘saving’ doesn’t *go* anywhere.”

      I’m not following that, because saving can definitely go toward “net purchase of financial assets”. It can also go toward reduction in debt, and perhaps some other places that aren’t coming to mind.

      1. saving can definitely go toward “net purchase of financial assets”. It can also go toward reduction in debt, and perhaps some other places that aren’t coming to mind.

        This comment depresses me a bit, because it shows you’ve missed the whole point of the post. My fault, I’m sure, not yours.

        If money income exceeds money outgo then your balance sheet position improves. This is what Cynamon and Fazzari call “financial saving”. It can take the form of reduced net borrowing, or higher net accumulation of financial assets. (And nothing else.) But what we call “saving” in both the national accounts and economic theory, is not at all the same as this. First, saving includes purchases of housing (and in some frameworks, durables) which, from a balance sheet perspective, is no different from consumption. in particular, an increase in new housing purchases will tend to raise both measured saving and credit-market borrowing. Second, there are a number of imputed and third-party payments that affect measured household saving but have no effect on household balance sheets. Third, financial asset and debt positions can change autonomously (symmetrically), without any change in either “saving” or financial saving. So the fact that measured saving is higher or lower, really doesn’t allow us to infer anything about changes in aggregate demand balance sheets.

  2. Oh and shouldn’t borrowing be net borrowing? Or: add a box for loan payoffs? Or is that implicit in net purchase of financial assets? If yes, better to make it explicit so more understandable?

  3. At best of my understanding, my savings are someone else’s debt and the reverse, so if we take a macro view, increased debt and increased savings non only are not opposites but actually are the same thing under a different name. In fact it would be better to speak of a “more leveraged” or “less leveraged” system.

    So at a macro level if the system is saving more then it is also going more into debts.

    I think that in this contest it would be better to distinguish between debt/credit properly end other assets; the problem is that “saving” is something that only affects directly debt/credit, but it cannot cause an accumulation of other assets, whereas the “unconscious theory” is that “saving” is an action that cause an accumulation of other assets.

    For example: suppose that a tomato farmer produces 100 tomatoes in summer, and saves 20 for the winter. This means that he is actually stockpiling tomatoes, that would count as inventory in our terms, not as savings.
    Then the farmer sells other 20 tomatoes to someone, and gets 20$ of “credit” in exchange, whereas the other guy eats the tomatoes but is stuck with the debt. This counts as “saving” for the farmer and “dissaving” for the other guy in our terms, but there is no stockpiling of tomatoes, no accumulation of assets other than credit/debt.

    In our private life we are only part of a system so we count debt and credit as two opposites, and we tend to think that “saving” is the accumulation of “something” (like the stockpiling of tomatoes), but in reality it isn’t, and this in my opinion causes much confusion.

    1. “At best of my understanding, my savings are someone else’s debt and the reverse”

      That can be true, but it’s highly incomplete. It definitely doesn’t have the case.

      As one prominent example, my savings can also be directed into owning equity rather than owning debt instruments. My savings also be directed into other assets, whether that’s a house or directly into what I’ll call “income-generating non-financial assets”: for example, my savings can go into directly buying assets that I use in a sole proprietorship.

    2. my savings are someone else’s debt and the reverse

      No, they really aren’t, and that’s the whole point.

      The root of the problem is that we have four different systems here. First, the various concrete activities involving paying and receiving money. Second, the system, of private accounts we use to record those money flows at the level of the individual business or household. Third, the national accounts. And fourth, economic theory. It would be nice if all of these lined up nicely — if, let’s say, “saving” involved a well-defined set of transactions that were grouped together in both private accounts and national accounts and corresponded to the equivalent concept in theory.

      But the real world is not so nice. “Saving” at an individual level includes a range of activities that improve your balance sheet position; the national accounts calls a different mix of activities saving and economic theory something else. People assume everyone is speaking the same language but we aren’t.

      Concretely: If you buy a house, that is going to show up as higher saving in the national accounts. But it does not involve anyone else owing a debt to you; in fact it probably increases your debt to someone else. On the other hand, if the market rent for that house later rises, this will be treated in the national accounts as an increase in imputed spending, meaning lower saving. Even though your financial position hasn’t changed at all.

      Of course we all have ideas about what these terms ought to mean. But if you want to use any kind of data, you can’t assume that the definitions of terms there are even roughly equivalent to the ones you’re using.

      The rest of your comment is spot on though. You’re absolutely right that a lot of confusion comes from treating financial saving as if it were a stockpiling of real goods.

      1. Thanks, now I understand the point of the different definitions of “savings”.

        However, I think that if we are speaking of effects on demand, or underconsumptionist theory, only “financial savings” are relevant.

  4. “The trend here is essentially flat since 1980; it is simply not the case that household consumption spending has increased as a share of GDP.”

    Well, that’s the case after stripping out a lot of the spending on one particular component of consumption (healthcare) that has increased as a share of GDP over this time period, which strikes me as an arbitrary decision.

    1. Did you even read the post? What I remove is healthcare *that is not paid for by households.*. Money paid by someone else, can’t affect your balance sheet. Nothing arbitrary about it.

  5. There are at least a few papers published online relating to the use of an economic balance sheet for making household financial plans. One paper is called Human Capital and the Balance Sheet. If you agree that most households use debt to finance assets then I suggest reading some papers on that subject in the financial planning context. In reality in the US the government subsidized student loan portfolio generates a statistical group that makes all education payments on schedule, a statistical group that must refinance to avoid default, and a statistical group that defaults with stiff imposed financial penalties; meanwhile there is no capitalized value of the human capital recorded on any balance sheets. Recent financial reports of the Department of Education show that it borrows from Treasury and collects revenue from students in repayment so the federal government is a financial intermediary between households that lend to the government and households that owe the government for direct student loans or defaulted guaranteed student loans. The least sophisticated borrowers are making investment decisions for education and the more sophisticated households are gaining cash flow guarantees via federal government unless a tax program is earmarked for the subsidized loss on a national student loan portfolio. So the aggregate household balance sheets should have levels of financial assets and liabilities that depend on the historical evolution of federal credit policies and the provision or lack of discharge in bankruptcy.

  6. Based on conventional accounting customs each household or household sector should have a simplified balance sheet:

    W = K + F – L

    W, net worth
    K, nonfinancial assets (house, etc.)
    F, financial assets (stocks, bonds, etc.)
    L, liabilities (loans, payables, etc.)

    In a hypothetical economy with only two sectors, a net creditor household, and a net debtor household, liabilities of the debtor household would be equal to the financial assets of the creditor household. The meaning of “saving” in the income and product accounts seems to have something to do with changes in K both in households and firms, while the meaning of “saving” in the financial accounts seems to have something to do with the net accumulation of financial assets due from other units with matching liabilities in the economy.

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