Tag: accounting

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!

 

Further Thoughts on Anti-Financialization

I want to amplify the last point from the previous post, about anti-financialization.

If we go back to the beginning of the national accounts in 1929, we find personal consumption accounts for around 75% of GDP. (This is true whether or not we make the C&F adjustments, since in 1929 the imputed and third-party component of consumption were either nonexistent or small.) During the Depression, the consumption share rises to 85% as business investment collapses, during the war it falls to below 50%, and it rises back to around two-thirds after 1945. It’s in the second half of the 1940s, with the growth of pension and health benefits and the spread of homeownership, that we start to see a large wedge between headline consumption and actual cash expenditures by households.

We can think of the ratio of adjusted consumption to GDP as a measure of how marketized the economy is: How much of output is purchased by people for their own use, as opposed to allocated in some other way? In this sense, the steady fall in adjusted consumption as a share of GDP represents a steady retreat of capitalist production in the postwar US. It was squeezed from both sides: from “above” by public provision of health care, education and retirement security, and from “below” by the state-fostered growth of self-provision in housing.

Consumption spending by households bottomed out at 47 percent of GDP in 1981. With the neoliberal turn, the process of de-marketization largely halted — but it did not reverse. Since then, consumption spending by households has hovered around 47-48% of GDP. The phenomena of household financialization, “markets for everything,” etc. are real — but only at the level of ideology.  Private life in the US has not become more commodified, marketized or financialized in recent decades; over a longer horizon the opposite. What has happened is that a thickening veneer of fictional market transactions has been overlaid on a reality of social consumption.

In reality, neither collective provision of health care (or of education, public safety, etc.) nor self-provision of housing has been replaced to any noticeable degree by market purchases. What we’ve had, instead, is the statistical illusion of rising private consumption spending — an illusion fostered by the distortion of the national accounts by the dominant economic theory. When health insurance is purchased collectively by government or employers, the national accounts pretend that people were paid in cash and then chose to purchase health coverage individually. When retirement savings are carried out collectively by government or employers, the national accounts pretend that people were paid in cash and then chose to purchase financial assets. When people buy houses for their own use, the national accounts pretend they are profit-maximizing landlords, selling the use of their houses in the rental market. When liquidity constraints force people to hold financial wealth in low-yield forms, the national accounts pretend that financial markets are frictionless and that they are receiving the market yield in some invisible form. Together, these fictional transactions now make up 20 percent of GDP, and fully a third of apparent household consumption.

Of course, that might change. The decline of homeownership and the creation of a rental market for single-family homes may turn the fiction of a housing sector of tenants and profit-seeking landlords into a reality. One result of Obamacare — intended or otherwise — will be to replace collective purchases of health insurance by employers with individual purchases by households. Maybe the Kochs and Mark Zuckerberg will join forces and succeed in privatizing the schools. But none of that has happened yet. What’s striking to me is how many critics of contemporary capitalism — including Cynamon and Fazzari themselves — have accepted the myth of rising household consumption, without realizing there’s no such thing. The post 1980s rise in consumption is a statistical artifact of the ideology of capitalism — a way of pretending that a world of collective production and consumption is a world of private market exchange.

The Nonexistent Rise in Household Consumption

Did you know that about 10 percent of private consumption in the US consists of Medicare and Medicaid? Despite the fact that these are payments by the government to health care providers, they are counted by the BEA both as income and consumption spending for households.

I bet you didn’t know that. I bet plenty of people who work with the national income accounts for a living don’t know that. I know I didn’t know it, until I read this new working paper by Barry Cynamon and Steve Fazzari.

I’ve often thought that the best macroeconomics is just accounting plus history. This paper is an accounting tour de force. What they’ve done is go through the national accounts and separate out the components of household income and expenditure that represent cashflows received and made by households, from everything else.

Most people don’t realize how much of what goes into the headline measures of household income and household consumption does not actually correspond to any flow of money to or from households. In 2011 (the last year covered by the paper), personal consumption expenditure was given as just over $10 trillion. But of that, only about $7.5 trillion was money spent by households on goods and services. Of the rest, as of 2011:

– $1.2 trillion was imputed rents on owner-occupied housing. The national income and product accounts treat housing on the principle that the real output of housing should be the same whether or not the person living in the house happens to be the same person who owns it. So for owner-occupied housing, they impute an “owner equivalent rent” that the resident is implicitly paying to themselves for use of the house.  This sounds reasonable, but it conflicts with another principle of the national accounts, which is that only market transactions are recorded. It also creates measurement problems since most owned residences are single-family homes, for which there isn’t a big rental market, so the BEA has to resort to various procedures to estimate what the rent should be. One result of the procedures they use is that a rise in hoe prices, as in the 2000s, shows up as a rise in consumption spending on imputed rents even if no additional dollars change hands.

– $970 billion was Medicare and Medicaid payments; another $600 billion was employer purchases of group health insurance. The official measures of household consumption are constructed as if all spending on health benefits took the form of cash payments, which they then chose to spend on health care. This isn’t entirely crazy as applied to employer health benefits, since presumably workers do have some say in how much of their compensation takes the form of cash vs. health benefits; tho one wouldn’t want to push that assumption that too far. But it’s harder to justify for public health benefits. And, justifiable or not, it means the common habit of referring to personal consumption expenditure as “private” consumption needs a large asterix.

– $250 billion was imputed bank services. The BEA assumes that people accept below-market interest on bank deposits only as a way of purchasing some equivalent service in return. So the difference between interest from bank deposits and what it would be given some benchmark rate is counted as consumption of banking services.

– $400 billion in consumption by nonprofits. Nonprofits are grouped with the household sector in the national accounts. This is not necessarily unreasonable, but it creates confusion when people assume the household sector refers only to what we normally think of households, or when people try to match up the aggregate data with surveys or other individual-level data.

Take these items, plus a bunch of smaller ones, and you have over one-quarter of reported household consumption that does not correspond to what we normally think of as consumption: market purchases of goods and services to be used by the buyer.

The adjustments are even more interesting when you look at trends over time. Medicare and Medicaid don’t just represent close to 10 percent of reported “private” consumption; they represent over three quarters of the increase in consumption over the past 50 years. More broadly, if we limit “consumption” to purchases by households, the long term rise in household consumption — taken for granted by nearly everyone, heterodox or mainstream — disappears.

By the official measure, personal consumption has risen from around 60 percent of GDP in the 1950s, 60s and 70s, to close to 70 percent today. While there are great differences in stories about why this increase has taken place, almost everyone takes for granted that it has. But if you look at Cynamon and Fazzari’s measure, which reflects only market purchases by households themselves, there is no such trend. Consumption declines steadily from 55 percent of GDP in 1950 to around 47 percent today. In the earlier part of this period, impute rents for owner occupied housing are by far the biggest part of the difference; but in more recent years third-party medical expenditures have become more important. Just removing public health care spending from household consumption, as shown in the pal red line in the figure, is enough to change a 9 point rise in the consumption share of GDP into a 2 point rise. In other words, around 80 percent of the long-term rise in household consumption actually consists of public spending on health care.

In our “Fisher dynamics” paper, Arjun Jayadev and I showed that the rise in debt-income ratios for the household sector is not due to any increase in household borrowing, but can be entirely explained by higher interest rates relative to income growth and inflation. For that paper, we wanted to adjust reported income in the way that Fazzari and Cynamon do here, but we didn’t make a serious effort at it. Now with their data, we can see that not only does the rise in household debt have nothing to do with any household decisions, neither does the rise in consumption. What’s actually happened over recent decades is that household consumption as a share of income has remained roughly constant. Meanwhile, on the one hand disinflation and high interest rates have increased debt-income ratios, and on the other hand increased public health care spending and, in the 2000s high home prices, have increased reported household consumption. But these two trends have nothing to do with each other, or with any choices made by households.

There’s a common trope in left and heterodox circles that macroeconomic developments in recent decades have been shaped by “financialization.” In particular, it’s often argued that the development of new financial markets and instruments for consumer credit has allowed households to choose higher levels of consumption relative to income than they otherwise would. This is not true. Rising debt over the past 30 years is entirely a matter of disinflation and higher interest rates; there has been no long run increase in borrowing. Meanwhile, rising consumption really consists of increased non-market activity — direct provision of housing services through owner-occupied housing, and public provision of health services. This is if anything a kind of anti-financialization.

The Fazzari and Cynamon paper has radical implications, despite its moderate tone. It’s the best kind of macroeconomics. No models. No econometrics. Just read the damn tables, and think about what the numbers mean.

FIRE in the Whole

Maybe the most interesting paper at this past weekend’s shindig at Bretton Woods was Duncan Foley’s. [1] He argues, essentially, that it’s wrong to include finance, real estate and insurance (FIRE) in measures of output. Excluding FIRE (and some other services) isn’t just conceptually more correct, it has practical implications — the big one being that an Okun’s law-type relationship between employment and output is more stable if we define output to exclude FIRE and other sectors where value-added can’t be directly measured.

It’s a provocative argument. He’s certainly right that the definition of GDP involves some more or less arbitrary choices about what is included in final output. (The New York Fed had a nice piece on this, a couple years ago, which was the subject of the one of the first posts on this humble blog.) However, I can’t help thinking that Foley is wrong on a couple key points. Specifically:

While in other industries such as Manufacturing (MFG) there are independent measures of the value added by the industry and the incomes generated by it (value added being measurable as the difference between sales revenue and costs of purchased inputs excluding new investment and labor), there is no independent measure of value added in the FIRE and similar industries mentioned above. The national accounts “impute” value added in these industries to make it equal to the incomes (wages and profits) generated. Thus when Apple Computer or General Electric pay a bonus to their executives, GDP does not change (since value added does not change–the bonus increases compensation of employees and decreases retained earnings), but when Goldman-Sachs pays a bonus to its executives, GDP increases by the same amount.

This seems confused on a couple of points. First, unless I’m mistaken, value-added in FIRE is calculated exactly in the way he describes — sale price of output minus cost of inputs. (The problem arises with government, where there is no sale price.) Second, I’m pretty sure there is no difference in the way wages are treated — total incomes in a sector always equal the total product of the sector, by definition. There is a question of whether executive bonuses are properly considered labor income or capital income, but that’s orthogonal to the issues the paper raises, and is not unique to FIRE. In any case, it is definitely not correct to say that higher compensation implies lower earnings in non-FIRE but not in FIRE.

It seems to me that there is a valid & important point here, but Foley doesn’t quite make it. The key thing is that there is no way of measuring price changes in FIRE. That’s what he should have said in place of the paragraph quoted above. The convention used in the national accounts is that the price of FIRE services rises at the same rate as the price level as a whole, so changes in nominal FIRE incomes relative total nominal income represent changes in FIRE’s share of total output. But you could just as consistently say that FIRE output grows at the same level as output as a whole, and deviations in nominal FIRE expenditure represent relative changes in FIRE prices. [2] There’s no empirical way of distinguishing these cases, it really is a convention. Doing it the second way would imply lower real GDP and higher inflation. I think this is the logically consistent version of Foley’s argument. And it would motivate the same empirical points about Okun’s Law, etc.

There’s another argument, tho, which I don’t quite have a handle on. Which is, what are the implications of considering FIRE services intermediate inputs rather than part of final output? If a firm pays more money to a software firm, that’s considered investment spending and final output is corresponding higher. If a firm pays more money to a marketing firm, that’s considered an intermediate good and final output is no higher, instead measured productivity is lower. I think that FIRE services provided to firms are considered intermediate goods, i.e. are already treated the way Foley thinks they should be. But I’m not sure. And there’s still the problem of FIRE services purchased by households. There’s no category of intermediate-goods purchases by households in the national accounts; any household expenditure is either consumption or investment, so contributes to GDP. This is a real issue, but again it’s not unique to FIRE; e.g. why are costs associated with commuting considered part of final output when if a business provides transportation for its employees, that’s an intermediate good?

He raises a third question, about the possibility that measured FIRE outputs includes asset transfers or capital gains. There is serious potential slippage between sale of financial services (part or GDP, conceptually) and sale of financial assets (not part of GDP).

Finally, it would be helpful to distinguish between services where measuring output is practically difficult but conceptually straightforward, and FIRE proper (and maybe insurance goes in the previous category). It seems clear that capital allocation as such should not be considered as part of final output. Whatever contribution it makes to total output (modulo the deep problems with measuring aggregate output at all) must come from higher productivity in the real economy. The problem is, there’s no real way to separate the “normal service” component of FIRE from the capital-allocation and representation-of-capitalist-interests (per Dumenil and Levy; or you could say rent-extraction) components.

But whatever the flaws of the paper, it’s pointing to a very important & profound set of issues. We can’t bypass the conceptual challenges of GDP, as Matt Yglesias (like lots of other people) imagines, with the simple assertion that labor is productive if it produces something that people are willing to pay for. Producing a consistent series for GDP still requires deliberate decisions about how to measure price changes, and how to distinguish intermediate goods from final output. Foley is absolutely right to call attention to these problems, that most social scientists are happy to sweep under the rug [3]; he’s right that they’re especially acute in the case of FIRE; and I think he’s probably right to say that to solve them we would do well to return to the productive/unproductive distinction of the classical economists.

[1] I wasn’t there, but a comrade who was thought so. And he seems to be right, based on the papers they’ve got up on the website.

[2] Or you could say that FIRE output is fixed (perhaps at 0), and all changes in nominal FIRE output represents price changes. Again, this problem can’t be resolved empirically, nor does it go away simply because you adopt a utility-based view of value.

[3] Bob Fitch had some smart things to say about the need to distinguish productive and unproductive labor.