Saturday, November 3, 2012


I will say something like: We have to stop using so much credit. You will disagree, because you know how much we need to use credit. But our "need" to use credit is a product of policy.

We must change policy. Policy must no longer be based on the notions that using credit is always good for growth; that using credit is good for growth but using money is not; and that money causes inflation but credit does not.

As we shift from a credit-based economy to a money-based economy, we reduce the cost of finance and leave more income in the productive sector. As soon as this change begins to occur, the good effects begin to be felt.

From Deleveraging Shocks and the Multiplier by Paul Krugman:

So, the simple but surely broadly correct story of the mess we’re in is that we had a period of excessive complacency about leverage, which came to a sudden end. Household debt in particular surged, then was suddenly perceived as excessive:

The crucial thing from a macroeconomic point of view is that leveraging and deleveraging are not symmetric in their effects. Leveraging up, other things equal, leads to high aggregate demand — but this can be and is in practice offset by the central bank, which can always raise rates. Deleveraging, on the other hand, can’t be offset equally easily; the central bank can cut rates, but only to zero, and unconventional monetary policy is both controversial and an iffy proposition (which doesn’t mean that it shouldn’t be tried).

So a large leveraging/deleveraging cycle is likely to be followed by a persistent shortfall in aggregate demand that can’t be cured using ordinary monetary policy; what I consider depression economics.

One major thing I can't accept in that analysis. If we agree debt is the problem, and we seem to agree on that, then really, the most important question is not why it's a problem or how to get out, but how we got into it.

Krugman touches on how we got into it, but it is only the lightest touch. "We had a period of excessive complacency about leverage," he writes. Excessive complacency.

It wasn't complacency.

I'm not sure what data Krugman used for his graph, but this is close enough:

Graph #2: Household Credit Market Debt Outstanding as a Percent of Personal Income

Same general uptrend as Krugman's graph. Same eruption at the end. Same resistance to uptrend from the mid-1960s to the early 1980s. Same graph, close enough.

I downloaded annual data from FRED for the debt series, the Personal Income series, and a Consumer Price Index series. Because we're dealing with consumer debt and personal income I thought it would be inappropriate to use the GDP deflator.

I use annual data because it simplifies the calculations for me, when I figure the Incremental Adjustment for Inflation.

The blue line on Graph #3 shows the same data as Graph #2, and the red shows the same data again, corrected for inflation. The blue lines are the same: start at 50, rise to 60, run flat for a while, bump up, rise for a while, and then the the sharp rise to a peak of around 110. The blue line on Graph #3 shows the same general uptrend, the same resistance to uptrend from the mid-1960s to the early 1980s, and the same final eruption, as seen on Graph #2.

Graph #3: Household Debt as a Percent of Income, Nominal (blue) and Inflation-Adjusted (red)

The red line shows eruption and a general uptrend. But from the mid-1960s to the early 1980s there is now a remarkable increase. The general uptrend is stronger in the red line than in the blue. Debt growth was strong and consistent.

But just before the eruption, where the blue line shows continuous (but not so rapid) increase, the red line instead shows decline. From about 1995 to 1999 or 2000, the red line briefly trends downward. You don't see that on the blue line!

Some significant differences between the two lines.

The blue line, the "nominal" representation, shows the actual burden of debt. It is based on three factors:
1. The increase of income over the years;
2. The increase of debt over the years; and
3. The fact that inflation boosts income but does not boost existing debt.

Inflation reduces the value of the debt-to-income ratio. It hides the actual growth of debt. Inflation makes it seem like we didn't really borrow as much as we did.

The red line "corrects" for inflation by removing it from the income and debt numbers. Income is a flow, so I used "aggregate" adjustment to remove the inflation from it. Debt is a stock, so I used "incremental" adjustment to remove the inflation from it, as discussed in several recent posts. The red line is the ratio of the adjusted numbers.

The red line shows how our accumulated debt would have changed if that debt was not being eroded by inflation, and nothing else was different. The lines veer apart between the mid-1960s and the early 1980s because those were the years of the "Great Inflation".

As far as that late-1990s downtrend of the red line... There was some unusually low inflation in those years, and economic growth was unusually good. So we have income growth holding the lines down, and less inflation-induced erosion bringing the lines closer together.

As for that eruption there at the end, the unusually large increase, all I can say is: On the red line it doesn't really look like an unusually large increase. It looks like there was an unusual decrease in the 1990s, and one in the 1960s, but otherwise there is pretty much a straight-line uptrend in that red line.

Good growth in the 1960s briefly pushed the red line down. And good growth in the 1990s briefly pushed the red line down. These were not remissions of debt. They were spurts of growth.

Other than that, inflation helped us out by helping to keep debt on the low side. But inflation aside, based on our borrowing and our income alone, our use of debt has trended upward at a remarkably stable rate.

Izabella Kaminska writes of a "complacent attitude to debt". Paul Krugman writes of "complacency about leverage". But it cannot be. If debt growth looked like the blue line, maybe. Maybe it snuck up on us and then whoosh! Eruption.

But that's not what happened. Debt growth was regular and consistent and relentless, as far back as the eye can see. That is not the result of complacence. It is the result of policy.

Policymakers think we need credit for growth, and more credit for more growth. So they made policy to enhance the availability of credit. And they made policy to enhance the use of credit.

Accumulated debt is the measure of the success of policy.

The same mental block that makes you want to reject the thought that we must reduce our reliance on credit, the same mental block prevents economists and policymakers from understanding how they have created the problem.

The last time this problem came to a head, Keynes described the mental block:

The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.

Related post: The Policies of the Venn Overlap


Greg said...

Nice post Art

" Debt growth was regular and consistent and relentless, as far back as the eye can see. That is not the result of complacence. It is the result of policy."

Complacency that there was nothing wrong with the policy. Complacency that real growth would, in the long run, stay ahead of credit growth and all would be ok.

Complacency is a good word here because it reflects the idea that youve got everything figured out, all bases covered so now you can just relax and let it go. Which is exactly what the great moderation mindset was about. The "Great moderaton" implied that credit growth can rise and rise as long as the prices of the assets that the credit is extended against continue to rise too.

You are correct that the error was policies that encouraged/enforced credit use but the ideas behind why that was okay stemmed from a complacency about credit money systems and their instability. The ideas, which mainly came form the Chicago school/Friedmanite types, ignored the real limits of credit money systems. Credit money can only grow as long as incomes can support them. No one can pay 2000$/month off out of 1800$/month income (Additionally, in our credit money sytem one persons income isoften the result of someone elses credit.... businesses borrow to make payroll) Greenspan and co reasoned that people would apply their own brakes when making credit choices and that it would self regulate.

So I would say both you and K&K are right. Its about policy AND complacency that the policy was founded on sound and firm understanding of our money system.

jim said...

Hi Art,
Good stuff as usual.

I think US households account for debt and income a little differently than your graph of household debt to income shows. This is how I would graph it:

That graph is debt as a ratio of disposable income plus annual gains in household assets. When households (or businesses) see their assets increase in value they count the annual increase as income for purposes of determining how much debt they can carry. By that metric household debt was at about 50% of income for 50 years.

The other thing that bugs me is that asset prices are not accounted for in inflation. That seems like at least as big a mistake as ignoring debt and treating gains in assets as not part of income.

It is also a mistake to make too much of household debt. That portion is only 25% of total US debt. Other entities (small business, large business, financial business and government) have most of the debt.

Clonal said...


The problem with asset pricing is that assets are not "cash." To treat them as such falls into the same trap as treating the current (paper) market value of your shares as your real wealth. They are both dependent upon the continued inflation of the asset bubble. Like any "Ponzi Scheme" the early adopters are the winners, while the late comers are left "holding the bag" when the Ponzi collapses, as it inevitably must.

Luke Smith said...

Some other cool related graphs would be TCMDO/M2 and PCE/TCMDO.

I look at the 2007 financial crisis as the overleveraging of the household. With real estate prices and gas prices on the rise, everyone felt their actual disposable income being squeezed by their bills. People were talking about inflation and hyperinflation when the Fed was printing money in 2008, but I think that it had already happened from 2002-2008. The reason it didn't happen (despite the increase money supply) is because banks needed to releverage and people were maxed out.


Good point. If the home value for a mortgage borrower goes down, their principal does not go down, and they instead may very well have an upside down mortgage or no room to refinance. Just as their principal does not go down neither does the value of the "asset" their mortgage is held within.

nanute said...

Slightly OT, but maybe not. I think one of the biggest factors that will limit growth going forward is the exorbitant amount of outstanding student debt. It has surpassed total credit card debt and is virtually impossible to extinguish through bankruptcy. The upcoming generation of consumers have a very large burden that will have to be addressed sooner or later.

The Arthurian said...

...and those private, for-profit schools advertise like crazy on TV. And lots of people buy in, hoping to improve their lot. A few do -- enough to populate the commercials with success stories, or at least with dreams. But until debt is adequately reduced, debt will continue to limit growth going forward.

Thanks, Nute.