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!