Month: September 2022

Fisher Dynamics Revisited

Back in the 2010s, Arjun Jayadev and I wrote a pair of papers (one, two) on the evolution of debt-income ratios for US households. This post updates a couple key findings from those papers. (The new stuff begins at the table below.)

Rather than econometric exercises, the papers were based on a historical accounting decomposition —  an approach that I think could be used much more widely. We separated changes in the debt-income ratio into six components — the primary deficit (borrowing net of debt service payments); interest payments; real income growth; inflation; and write downs of debt through default — and calculated the contribution of each to the change in debt ratios over various periods. This is something that is sometimes done for sovereign debt but, as far as I know, we were the first to do it for private debt-income ratios.

We referred to the contributions of the non-borrowing components as “Fisher dynamics,” in honor of Irving Fisher’s seminal paper on depressions as “debt deflations.” A key aspect of the debt-deflation story was that when nominal incomes fell, the burden of debt could rise even as debtors sharply reduced new borrowing and devoted a greater share of their income to paying down existing debt. In Fisher’s view, this was one of the central dynamics of the Great Depression. Our argument was that something like a slow-motion version of this took place in the US (and perhaps elsewhere) in recent decades.

The logic here is that the change in debt-income ratios is a function not only of new borrowing but also of the effects of interest, inflation and (real) income growth on the existing debt ratio, as well as of charge offs due to defaults.

Imagine you have a mortgage equal to double your annual income. That ratio can go down if your current spending is less than your income, so that you can devote part of your income to paying off the principal. Or it can go down if your income rises, i.e. by raising the denominator rather than lowering the numerator. It can also go down if you refinance at a lower interest rate; then the same fraction of your income devoted to debt service will pay down the principal faster. Our of course it can go down if some or all of it is written off in bankruptcy.

It is possible to decompose actual historical changes in debt-income ratios for any economic unit or sector into these various factors. The details are in either of the papers linked above. One critical point to note: The contributions of debt and income growth are proportional to the existing debt ratio, so the higher it already is, the more important these factors are relative to the current surplus or deficit.

Breaking out changes in debt ratios into these components was what we did in the two papers. (The second paper also explored alternative decompositions to look at the relationship been debt ratio changes and new demand from the household sector.) The thing we wanted to explain was why some periods saw rising debt-income ratios while others saw stable or falling ones.

While debt–income ratios were roughly stable for the household sector in the 1960s and 1970s, they rose sharply starting in the early 1980s. The rise in household leverage after 1980 is normally explained in terms of higher household borrowing. But increased household borrowing cannot explain the rise in household debt after 1980, as the net flow of funds to households through credit markets was substantially lower in this period than in earlier postwar decades. During the housing boom period of 2000–2007, there was indeed a large increase in household borrowing. But this is not the case for the earlier rise in household leverage in 1983–1990, when the debt– income ratios rose by 20 points despite a sharp fall in new borrowing by households.

As we explained:

For both the 1980s episode of rising leverage and for the post-1980 period as a whole, the entire rise in debt–income ratios is explained by the rise in nominal interest rates relative to nominal income growth. Unlike the debt deflation of the 1930s, this ‘debt disinflation’ has received little attention from economists or in policy discussions.

Over the full 1984–2011 period, the household sector debt–income ratio almost exactly doubled… Over the preceding 20 years, debt–income ratios were essentially constant. Yet households ran cumulative primary deficits equal to just 3 percent of income over 1984–2012 (compared to 20 percent in the preceding period). The entire growth of household debt after 1983 is explained by the combination of higher interest payments, which contributed an additional 3.3 points per year to leverage after 1983 compared with the prior period, and lower inflation, which reduced leverage by 1.3 points per year less.

We concluded:

From a policy standpoint, the most important implication of this analysis is that in an environment where leverage is already high and interest rates significantly exceed growth rates, a sustained reduction in household debt–income ratios probably cannot be brought about solely or mainly via reduced expenditure relative to income. …There is an additional challenge, not discussed in this paper, but central to both Fisher’s original account and more recent discussions of ‘balance sheet recessions’: reduced expenditure by one sector must be balanced by increased expenditure by another, or it will simply result in lower incomes and/or prices, potentially increasing leverage rather than decreasing it. To the extent that households have been able to run primary surpluses since 2008, it has been due mainly to large federal deficits and improvement in US net exports.

We conclude that if reducing private leverage is a policy objective, it will require some combination of higher growth, higher inflation, lower interest rates, and higher rates of debt chargeoffs. In the absence of income growth well above historical averages, lower nominal interest rates and/or higher inflation will be essential. … Deleveraging via low interest rates …  implies a fundamental shift in monetary policy. If interest-rate policy is guided by the desired trajectory of debt ratios, it no longer can be the primary instrument assigned to managing aggregate demand. This probably also implies a broader array of interventions to hold down market rates beyond traditional open market operations, policies sometimes referred to as ‘financial repression.’ Historically, policies of financial repression have been central to almost all episodes where private (or public) leverage was reduced without either high inflation or large-scale repudiation.

These papers only went through 2011. I’ve thought for a while it would be interesting to revisit this analysis for the more recent period of falling household debt ratios. 

With the help of Arjun’s student Advait Moharir, we’ve now brought the same analysis forward to the end of 2019. Stopping there was partly a matter of data availability — the BEA series on interest payments we use is published with a considerable lag. But it’s also a logical period to look at, since it brings us up to the start of the pandemic, which one would want to split off anyway.

The table below is a reworked version of tables in the two papers, updated through 2019. (I’ve also adjusted the periodization slightly.) 

Due to …
Period Annual PP Change in Debt Ratio Primary Deficit Interest Growth Inflation Defaults
1929 – 1931 3.7 -5.5 2.9 2.8 2.9 *
1932 – 1939 -1.2 -1.5 2.4 -1.6 -0.7 *
1940 – 1944 -3.8 -1.6 1.3 -2.5 -1.9 *
1945 – 1963 2.6 2.5 2.6 -1.5 -0.8 *
1964 – 1983 0.0 0.8 5.1 -2.4 -3.5 *
1984 – 1999 1.7 -0.3 7.5 -2.9 -2.1 -0.4
2000 – 2008 4.5 2.4 7.2 -1.7 -2.5 -0.8
2009 – 2013 -5.4 -3.7 5.8 -3.1 -2.3 -2.4
2014 – 2019 -2.0 -1.4 4.6 -3.4 -1.3 -0.6

Again, our central finding in the earlier papers was that if we compare the 1984-2008 period of rising debt ratios to the previous two decades of stable debt ratios, there was no rise in the primary deficit. For 1984-2008 as a whole, annual new borrowing exceeded debt service payments by 0.7 percent of income on average, almost exactly the same as during the 1964-1983 period. (That’s the weighted average of the two sub-periods shown in the table.) Even during the housing boom period, when new borrowing did significantly exceed debt service, this explained barely a third of the difference in annual debt-ratio growth (1.6 out of 4.5 points).

The question now is, what has happened since 2008? What has driven the fall in debt ratios from 130 percent of household income in 2008 to 92 percent on the eve of the pandemic?

In the immediate aftermath of the crisis, sharply reduced borrowing was indeed the main story. Of the 10-point swing in annual debt-ratio growth (from positive 4.5 points per year to negative 5.4), 6 points is accounted for by the fall in net borrowing (plus another 1.5 points from higher defaults). But for the 2014-2019 period, the picture is more mixed. Comparing those six years to the whole 1984-2008 period of rising debt, we have a 4.7 point shift in debt ratio growth, from positive 2.7 to negative 2. Of that, 2.1 points is explained by lower net borrowing, while almost 3 points is explained by lower interest. (The contribution of nominal income growth was similar in the two periods.) So if we ask why household debt ratios continued to fall over the past decade, rather than resuming their rise after the immediate crisis period, sustained low interest rates are at least as important as household spending decisions. 

Another way to see this is in the following graph, which compares three trajectories: The actual one in black, and two counterfactuals in red and blue. The red counterfactual is constructed by combining the average 1984-2008 level of net borrowing as a fraction of income to the actual historical rates of interest, nominal income growth and defaults. The blue counterfactual is similarly constructed by combining the average 1984-2008 effective interest rate with historical levels of net borrowing, nominal income growth and defaults. In other words, the red line shows what would have happened in a world where households had continued to borrow as much after 2008 as in the earlier period, while the blue line shows what would have happened if households had faced the same interest rates after 2008 as before. 

As the figure shows, over the 2008-2019 period as a whole, the influence of the two factors is similar — both lines end up in the same place. But the timing of their impact is different. In the immediate wake of the crisis, the fall in new borrowing was decisive — that’s why the red and black lines diverge so sharply. But in the later part of the decade, as household borrowing moved back toward positive territory and interest rates continued to fall, the more favorable interest environment became more important. That’s why the blue line starts rising after 2012 — if interest rates had been at their earlier level, the borrowing we actually saw in the late 2010s would have implied rising debt ratios. 

As with the similar figures in the papers, this figure was constructed by using the law of motion for debt ratios:

where b is the debt-income ratio, d is the primary deficit, i is the effective interest rate (i.e. total interest payments divided by the stock of debt), g is income growth adjusted for inflation, π is the inflation rate, and sfa is a stock-flow adjustment term, in this case the reduction of debt due to defaults. The exact sources and definitions for the various variables can be found in the papers. (One note: We do not have a direct measurement of the fraction of household debt written off by default for the more recent period, only the fraction of such debt written down by commercial banks. So we assumed that the ratio of commercial bank writeoffs of household debt to total writeoffs was the same for the most recent period as for the period in which we have data for both.)

Starting from the actual debt-ratio in the baseline year (in this case, 2007), each year’s ending debt-income ratio is calculated using the primary deficit (i.e. borrowing net of debt service payments), the share of debt written off in default, nominal income growth and the interest rate. All but one of these variables are the actual historical values; for one, I instead use the average value for 1984-2007. This shows what the path of the debt ratio would have been if that variable had been fixed at its earlier level while the others evolved as they did historically.  In effect, the difference between these counterfactual lines and the historical one shows the contribution of that variable to the difference between the two periods.

Note that the interest rate here is not the current market rate, but the effective or average rate, that is, total interest payments divided by the stock of debt. For US households, this fell from around 6 percent in 2007 to 4.4 percent by 2019 — less than the policy rate did, but still enough to create a very different trajectory, especially given the compounding effect of interest on debt over time. So while expansionary monetary policy is not the whole story of falling debt ratios since 2008, it was an important part of it. As I recently argued in Barrons, the deleveraging of US households is unimportant and under appreciated benefit of the decade of low interest rates after the crisis.

 

At Barron’s: What’s At Stake in the Labor Market?

(I am now writing a monthly opinion piece for Barron’s. This one was published there in August.)

The labor market is exceptionally tight, at least by the standards of recent history. That matters for monetary policy, but its importance goes beyond inflation, or even material living standards. We are used to a world where workers compete for jobs. A world where businesses compete for workers would look very different.

Today’s 3.5% unemployment rate is lower than any time between 1970 and 2019. While the prime-age employment-population ratio is still shy of its prepandemic level, other measures imply a labor market even hotter than at the height of the late-90s boom. Both the historically high rate of workers quitting their jobs and the nearly two job openings for each unemployed worker suggest that this could be the best time to be looking for a job in most Americans’ working lives.

How long this will continue depends in large part on the Federal Reserve, where the question often comes down to whether inflation expectations are anchored. If businesses and households come to believe that prices will rise rapidly, the argument goes, they will behave in ways that cause prices to rise, validating those beliefs and making it harder to bring inflation back down.

Curiously, there is little discussion of all the other expectations that can also be anchored in different ways, which suggest a very different set of trade-offs.

Businesses that expect growth to be weak, for example, are unlikely to invest in raising capacity—which makes strong growth much harder to achieve. Workers who feel it’s impossible to find a job may stop looking for one, making expectations of weak employment growth self-confirming. Both these expectational shifts played a role in the “lost decade” after the 2007 crash.

Today’s tight labor markets are reshaping expectations in a different direction, which could lead to lasting changes in employment dynamics. As economist Julia Coronado observes, one lesson businesses seem to have learned is that staffing up may be slower and more difficult than in the past. This in turn makes businesses more hesitant to lay off workers, even when demand slackens.

Fewer layoffs, of course, contribute to tighter labor markets—another example of self-confirming expectations. But those new expectations also mean a different kind of employment relationship. A business that expects labor to be cheap and abundant has little reason to invest in recruiting, retaining and training its employees. Conversely, a business that can’t count on quickly hiring workers with whatever skills are needed has to focus more on developing and holding on to the workers it has. These qualitative changes in the organization of work aren’t captured in the aggregate numbers on employment and wages.

To be clear, there is not a labor shortage in any absolute terms. One thing we have clearly learned over the past year is that total employment isn’t just a matter of how many people are willing to work. Back in spring 2021, some economists argued that generous pandemic unemployment assistance was holding back job growth. When some states ended unemployment assistance early, that offered the perfect controlled test of this theory. It was decisively refuted. As the labor economist Arin Dube has shown, employment growth was no faster in the states that ended pandemic unemployment relief earlier than in those that kept it longer.

What is true, though, is that the kinds of jobs people will take may depend on their other options. For the economy as a whole, today’s high rate of movement between jobs is a clear positive. A big reason people can get raises by changing jobs is, presumably, that their new work is more valuable than what they were doing before. But from the point of view of employers, this is a process with winners and losers. Some businesses will adapt, offering higher wages—as many food service and retail giants are already doing—and nonpecuniary benefits such as predictable schedules and pathways for advancement. Tight labor markets will also favor higher-productivity businesses, which can afford to pay higher wages. Those that are wedded to a model that treats labor as cheap and disposable, on the other hand, may struggle or fail.

It isn’t only employers that need to adjust to tight labor markets, of course. There is little doubt that the upsurge of union organizing we’ve seen in recent years owes a great deal to labor market conditions. When jobs are plentiful, the fear of losing yours is less of a deterrent to standing up to the boss. And people who are reasonably confident of at least getting a paycheck may begin to wonder if that is all their employer owes them.

Historically, periods of rapid union growth have followed sustained growth, not depressions and crises. During the 1972 strike at GM’s Lordstown plant—one of the high points of 1970s labor militancy—one union leader explained why the younger workers were so ready to walk off their jobs:

“None of these guys came over from the old country poor and starving, grateful for any job they could get. None of them have been through a depression …They’re just not going to swallow the same kind of treatment their fathers did. That’s a lot of what the strike was about. They want more than just a job for 30 years.”

Strikes like Lordstown are rooted not just in conditions at the particular workplace, but also in the ways a prolonged high-pressure economy shifts what workers expect from a job. Significantly, the Lordstown strikers’ demands included a say in the design and organization of the plant, as well as better pay and benefits.

Not everyone would welcome a revived U.S. labor movement, of course, or a move toward German-style co-determination. While some people see unions as a pillar of democracy and counterweight to corporations’ political power, others see them as an illegitimate intrusion on the rights of business owners. Either way, whether organized labor can reverse its decline is a question with consequences that go far beyond next month’s inflation numbers. And it depends a great deal on how long today’s tight labor market lasts.

It might seem utopian to imagine a transformation of the workplace when the headlines are dominated by inflation and recession fears. But the real fantasy is to imagine we could reap the benefits of a high-pressure economy—faster productivity growth, a more equal distribution of income, more resources to solve our most pressing problems—without making any changes to how firms and labor markets are organized.

In his most recent press conference, Federal Reserve Chair Jerome Powell said, “we all want to get back to the kind of labor market we had before the pandemic.” Do we really all want that, or could we aim higher? But in any case simply turning back the clock isn’t an option. An economy adapted to slow growth and cheap, abundant workers can’t adjust to tight labor markets without changing in profound ways.

Some may welcome an economy where chronically scarce labor means that businesses are under constant pressure to raise productivity and attract and retain employees. Others may hope for a deep recession to reset expectations about the relative scarcity of workers and jobs. One way or the other, those are the stakes.

 

At Barron’s: What We Don’t Talk About When We Talk About Inflation

(I am now writing a monthly opinion piece for Barron’s. This one was published there in July.)

To listen to economic policy debates today, you would think the U.S. economy has just one problem: inflation. When Federal Reserve Chairman Jerome Powell was asked at his last press conference if there was a danger in going too far in the fight against inflation, his answer was unequivocal: “The worst mistake we could make is to fail—it’s not an option. We have to restore price stability…because [it’s] everything, it’s the bedrock of the economy. If you don’t have price stability, the economy’s really not going to work.”

Few would dispute that rising prices are a serious problem. But are they everything?

The exclusive focus on inflation acts like a lens on our view of the economy—sharpening our attention on some parts of the picture, but blurring, distorting, and hiding from view many others.

In the wake of the Great Recession, there was a broadening of macroeconomic debates. Economists and policy makers shifted away from textbook truisms toward a more nuanced and realistic view of the economy. Today, this wide-ranging conversation has given way to panic over rising prices. But the realities that prompted those debates have not gone away.

In the clamor over inflation, we’re losing sight of at least four big macroeconomic questions.

First, does the familiar distinction between supply and demand really make sense at the level of the economy as a whole? In the textbooks, supply means the maximum level of production in the economy, labeled “full employment” or “potential output,” while demand means total spending. The two are supposed to be independent—changes in spending don’t affect how much the economy can produce, and vice versa. This is why we are used to thinking of business cycles and growth as two separate problems.

But in the real world, supply often responds to demand—more spending calls forth more investment and draws people into the labor force. This phenomenon, known by the unlovely name “hysteresis,” was clearly visible in the slowdown of labor force and productivity growth after the Great Recession, and their recovery when demand picked up in the years before the pandemic. The key lesson of this experience—in danger of being forgotten in today’s inflation panic—was that downturns are even more costly than we thought, since they not only imply lost output today but reduced capacity in the future.

Hysteresis is usually discussed at the level of the economy as a whole, but it also exists in individual markets and industries. For example, one reason airfares are high today is that airlines, anticipating a more sustained fall in demand for air travel, offered early retirement to thousands of senior pilots in the early stages of the pandemic. Recruiting and training new pilots is a slow process, one airlines will avoid unless it’s clear that strong demand is here to stay. So while conventional wisdom says that rising prices mean that we have too much spending and have to reduce it, in a world with hysteresis a better solution may be to maintain strong demand, so that supply can rise to meet it. In the textbook, we can restore price stability via lower demand with no long-run costs to growth. But are we sure things work so nicely in the real world?

The second big question is about the labor market. Here the textbook view is that there is a unique level of unemployment that allows wages to grow in line with productivity. When unemployment is lower than this “natural rate,” faster wage growth will be passed on to rising prices, until policy makers take action to force unemployment back up. But in the years before the pandemic, it was becoming clear that this picture is too simplistic. Rising wages don’t have to be passed on to higher prices—they may also come at the expense of profits, or spur faster productivity growth. And not all wages are equally responsive to unemployment. Younger, less-educated, and lower-wage workers are more dependent on tight labor markets to find work and get raises, while the incomes of workers with experience and credentials rise more steadily regardless of macroeconomic conditions. This means that—as Powell has acknowledged—macroeconomic policy has unavoidable distributional consequences.

In his classic essay “Political Aspects of Full Employment,” the great Polish economist Michal Kalecki argued that even if it were economically feasible to eliminate unemployment, this would be unsustainable, since employers’ authority in the workplace depends on “the threat of the sack.” Similar arguments have been made by central bank chiefs such as Alan Greenspan, who suggested that low unemployment was sustainable in the 1990s only because workers had been traumatized by the deep recession of the decade before.

Some would argue that it’s unnecessarily wasteful and cruel to maintain labor discipline and price stability by denying millions of people the chance to do useful work—especially given that, prior to the pandemic, unemployment had fallen well below earlier estimates of the “natural rate” with no sign of accelerating inflation. But if we wish to have a permanent full-employment economy, we need to answer a difficult question: How should we manage distributional conflicts between workers and owners (and among workers), and motivate people to work when they have little to fear from losing their job?

A third set of questions concerns globalization. There are widespread fears that renewed Covid lockdowns in China may limit exports to the U.S. and elsewhere. Seen through the inflation lens, this looks like a source of rising prices and a further argument for monetary tightening. But if we take a step back, we might ask whether it is wise to organize the global economy in such a way that lockdowns in China, a war in Ukraine, or even a factory fire in Japan leave people all over the world unable to meet their basic needs. The deepening of trade and financial links across borders is sometimes presented as a fact of nature. But in reality it reflects policy choices that allowed global production of all kinds of goods—from semiconductors to Christmas decorations and latex gloves—to be concentrated in a handful of locations. In some cases, this concentration is motivated by genuine technical advantages of larger-scale production, in others by the pursuit of low wages. But either way, it reflects a prioritization of cost minimization over flexibility and resiliency. Whatever happens with inflation, this is a trade-off that will have to be revisited in coming years, as climate change makes further disruptions in global supply chains all but inevitable.

Then there is climate change. Here, the inflation lens doesn’t just recolor the picture but practically reverses it. Until recently, the conventional wisdom was that a carbon tax was the key policy tool for addressing climate. An Obama-era economist once quipped that the big question on climate was whether a carbon tax was 80% of the solution, or 100%. A carbon tax would increase the prices of energy, which still mainly comes from fossil fuels, and of travel by private car. As it happens, this is exactly what we have seen: Autos and energy have increased much faster than other prices, to the point that these two categories account for a majority of the excess inflation over the past year. In effect, we’ve seen something like a global carbon tax. But far from welcoming the disproportionate rise in the prices of carbon-intensive goods as a silver lining of inflation, both policy makers and the public see it as an urgent problem to be solved.

To be clear, people are not wrong to be unhappy at the rising cost of cars and energy. In the absence of practical alternatives, these high prices inflict real hardship without necessarily doing much to speed the transition from carbon. One reasonable lesson, then, is that a carbon tax high enough to substantially reduce emissions will be politically intolerable. And indeed, before the pandemic, many economists were already shifting away from a carbon-price-focused approach to climate policy toward an investment-centered approach.

Whether via carbon prices or investment, the only way to reduce carbon emissions is to leave fossil fuels in the ground. Yet an increasing swath of the policy conversation is focused on how to encourage more drilling by oil-and-gas companies, not just today but into the indefinite future. As a response to today’s rising energy prices, this is understandable, given the genuine limitations of renewable energy. But how can measures to boost the supply of fossil fuels be consistent with a longer-term program of decarbonization?

None of these questions have easy answers. But the danger of focusing too single-mindedly on inflation is that we may not even try to answer them.