November 08, 2003

Is Debt a Problem?

The Economist flirts with Austrian theories of the business cycle as it fears that the U.S. economy will not boom. The key problem it sees is that "it is... odd... at the beginning of... recovery [for] many indicators—low saving, rampant household borrowing, record house-building and uncomfortably high stockmarket p/e ratios to name but a few—[to] have more the look of a cycle that is drawing to a close."

I've never been able to convince myself that such "Austrian" views have significant traction in the real world. It's always seemed to me that what Hayek and von Mises call "overinvestment" can just as easily be called "too high an interest rate"--that modern central banks have enough control over the prices of financial assets to prevent a Hayekian cycle from taking hold. That said, it certainly seems true that it is hard to see how a sustained boom could be driven by a sustained increase in consumption as a share of national income, and hard to see how a sustain boom could be driven by rising business investment given that a large chunk of financing for such investment would have to come from an expansion of the U.S. trade deficit.

All in all, interesting but--in my view--unpersuasive. However, Richard Kingsley Crump might want to write his dissertation about these and related issues. So I need to start having clever thoughts in this area, and need to start having them soon... | America's economy: But the main reason for doubting that America is back on a path of strong, sustainable growth is that it has failed to purge the excesses of its previous boom. It is, to say the least, odd that at the beginning of an economic recovery many indicators—low saving, rampant household borrowing, record house-building and uncomfortably high stockmarket p/e ratios to name but a few—have more the look of a cycle that is drawing to a close.

Debt provides the best example. In the year to the second quarter (the latest figures available), borrowing by households rose by 11%, its fastest pace in real terms since 1985. Economists wearing rose-tinted spectacles point out that interest rates today are low, so households can afford to borrow more. The main snag with this argument (but by no means the only one) is that, despite low interest rates, households' debt-service payments are alarmingly high as a percentage of their income. The Federal Reserve has recently revised its measure of household debt-service. In contrast to the old figures, this now shows that the debt-service ratio is higher than at its previous peak in the 1980s.

When interest rates inevitably rise to normal levels, debt-service ratios will rise higher still. But even while interest rates remain low, debt service will eat up a rising share of income if households keep borrowing more. Sooner or later, consumers will need to save more and spend less.

This week, both the Reserve Bank of Australia and the Bank of England raised interest rates largely because of concerns about soaring household debt. The Fed has instead signalled that it intends to keep interest rates low for some time in order to support the recovery. Given America's greater economic slack and hence the risk of deflation, that is understandable.

Why has this situation arisen? Austrians are in vogue in America, at least in California, so perhaps it is a good time to dust down Austrian business-cycle theory. This helps to explain why this economic cycle is different to previous post-war cycles, and why a full recovery could be delayed.

Early last century, economists such as Ludwig von Mises and Friedrich Hayek argued that, if interest rates were held below their “natural rate” (at which the supply of saving from households equals the demand for investment funds by firms), credit and investment will rise too rapidly and consumers will not save enough.

Sound familiar? America displayed many of those features in the late 1990s. Faster productivity growth raised the natural rate of interest, but because inflation was low (and because Austrian economics had long been out of fashion) the Fed failed to lift interest rates by enough. Investment and borrowing boomed.

Strict Austrian-school disciples would argue that, because America's recent downturn was due to overinvestment and overborrowing, slashing interest rates to encourage yet more borrowing was wrong because it delayed the need for households to save more. Central banks can postpone a downturn only by injecting more and more credit. The inevitable downturn is then deeper or longer.

But having made the mistake of allowing a bubble to inflate and then burst, the Fed now faces a difficult balancing act: trying to prevent deflation, while at the same time avoiding a credit bubble which may burst even more painfully. Joachim Fels, an economist at Morgan Stanley, accuses the Fed of being a serial bubble blower. Slashing interest rates and pumping out liquidity every time a bubble bursts—from the Asian and Russian crises to the stockmarket bubble—creates yet another. America's latest bubble is in house prices and mortgage financing. By rescuing investors from their folly each time, central banks encourage increased risk-taking. On this view, the Fed will eventually run out of soap and the last bubble will burst.

Posted by DeLong at November 8, 2003 06:32 PM | TrackBack


I don't get the step about rising productivity raising the "natural" rate of interest. Wouldn't rising productivity mean as a first approximation higher profits and lower prices, thus increasing the availability of retained earnings investment funds and the ability of consumers to absorb further output? Also doesn't the notion of a "natural" rate of interest tout court miss the positive feedback effects of low interest rates, as they will encourage consumption over savings, but increased consumption demand plus low interest rates will stimulate investment, which will generate increased employment and income, further raising demand and the income to finance debt? To be sure this dynamic must top out as full employment and capacity utilisation kick in, but insofar as there is long-term trend productivity improvement due to technical improvement in capital stock, would not this point tend to get kicked forward in time? Though it seems to me there is a such thing as real overinvestment qua real overaccumulation of capital stock, whether in aggregate or intersectorally, which would amount to losses that need time to be cleared out and readjust, and, though low interest rates may cover a multitude of sins, there are still sins needing coverage.

The focus in the article on U.S. domestic savings misses the astonishing ability of the U.S.A. to import savings/investment thus far, but how long could this continue? I have not seen much commentary in these comments on the fact that we now have in the U.S.A. both an apparently large, if misdirected fiscal stimulus and a very loose expansionary monetary policy at the same time. What are the effects of this? Would not one of the main results of the Bush tax cuts plus low interest rates be to shift the composition of GDP toward private investment and do we really need this right now? I would appreciate any enlightenment anyone has to offer on this.

Posted by: john c. halasz on November 8, 2003 05:48 PM


Unfortunately, I can't read premium content, but re: interest rates and productivity, if increased productivity DOES lead to increased profits (I don't see any reason why it must, but I suppose it could), then I'd think that that might lead to higher interest rates. After all, if stocks are, in at least some sense, a substitute for saving (It really isn't, you say? Where would you put your money if the bank offered 15% interest rates and was as secure as banks now, and stocks grew by an average of 1% a year while retaining their current risk?), then an increase in profits would lead to higher "natural" interest rates, by the logic of competition between the stock market and other bits of the financial system for money. At least, that's what I'd think.

Posted by: Julian Elson on November 8, 2003 06:56 PM


The trade-off is job creation in China against purchase of American treasury notes by China. China finances a significant part of our national saving deficit in return for American consumption of Chinese products. Japan and other Asian countries are in a similar setting.

Well, you would think there is a limit to this sort of arrangement but the limit might be years away. Years away, can seem forever. The problem with a lack of national saving seems more important when you consider that American households will own less and less of our own production and wealth over time. We need to save more, but there is no perceived urgency and why should Asia worry?

Posted by: anne on November 9, 2003 09:42 AM


Important corporate analysts who worry about the interest rate and currency effects of too little American saving are Stephen Roach and Bill Gross. Several EPINET economists worry about the wealth effects. Paul Krugman and Alan Greenspan worry about the Social Security, Medicare and Medicaid effects of deficits or lack of natioanl saving as America ages.

Posted by: anne on November 9, 2003 09:52 AM


The tax reduction on capital gains has undoubtedly helped to buoy the stock market, and in fact has not even been totally factored into market prices for dividend-paying stocks. So there is undoubtedly a wealth effect that is supporting spending, as Team Bush intended but never discussed. But all this of course is a one shot affair, sustainable growth and earnings have to underpin the markets from now on.

Posted by: BobNJ on November 9, 2003 11:12 AM


"Sustainable growth and earnings have to underpin the markets from now on."

Sure, but given productivity growth there is every reason to expect earnings will hold for quite a while. Earnings have indeed been fine through the year. Stocks are pricy but bonds are pricier. So, where is the worry for now? Why not just ride the index, and think of buying an attractive dividend now and again? This is a world wide bull market, involving almost all sectors of the American market. About the only weak market is the Dutch. Though I like to worry, I am having trouble worrying in the near term.

The tax cut will be an economic problem in time, but "in time" is not what an investor should worry about just now.

Posted by: anne on November 9, 2003 11:26 AM


OK so the problem is too much private debt. The solution is to raise interest rates? Doesn't that just put the net debtors further in the hole.

That has always been my problem with Austrian business cycle theory. It sure sounds to me like the problem that ends expansion is that the economy builds capacity to produce mass market goods for middle and low income consumers and then when a shock leads to temporary softness in labor markets they lack the purchasing power to keep pace and the economy collapses. Surely the sensible response is to redistribute wealth and income to bring it in line with productive capacity.

Isn't that what Clinton did? Bush I had an economy strangled by consumer (and public) debt. Clinton used both direct (raising top bracket and EITC) and indirect (targeting deficit to lower interest rates) methods to shift income and wealth to net debtors and the economy took off.

Isn't that what BushII has shown? The economy shows a spark of life when they hand out rebates or when an interest rate drop allows a new round of refinancing and then peters out when that bit of oxygen is used up and rising health care costs, declining wages and tax shifts further starve consumers for purchasing power.

Posted by: Dave Richardson on November 9, 2003 02:19 PM


The Austrian School was more concerned with 'malinvestment' than 'overinvestment.' The idea is that the uneveness of the inflation process distorts relative price signals as well as the intertemporal price of capital, leading to a misallocation of resources that is subsequently corrected.

Posted by: Stephen Kirchner on November 9, 2003 03:38 PM


I don't get it. Does the Economist think that investment in the USA is too high or too low ?

I am going to consider the business cycle to be unemployment or some indicator of the output gap (maybe capacity utilization or employment growth minus trend but certainly not GNP).
Let's imagine that the USA is a closed economy and imagine that Americans don't save enough. I can see how this would lead to slow GNP growth, but I don't see why that should lead to persistent high unemployment, low capacity utilization or low employment growth.

Another way to put it is that the reason that interest rates would rise is increased investment. Why shouldn't the US have reduced consumption if/when investment kicks in ? I mean it seems to me that demand should be a continuous function of (among other things) the interest rate. I don't see how incrased investment demand could force the FED to increase interest rates up to a point that total demand decreased.

Or another question is does the economist think Americans consume too much or too little (no bets on that it's too much). So why doesn't that make increased consumer debt and debt service a good thing which will force Americans to consume less ? It seems to me the story is Americans are consuming too much, to allow investment without huge(r) CA deficits, the FED is going to increase interest rates so much that the recovery stops. Seems to me they assume the FED will panic. That doesn't sound like the current FED.

Notice that in most of the above, I completely ignored the possibility that the USA might run huge current account deficits (you know like it has since I can remember) just make things easier for the Austrians.

Strange but true, I don't agree with Julian Elson (there's a first time for everything). I don't think high productivity growth must imply high returns on Stocks. That would happen if productivity growth is higher than expected. This is silly, but consider an immediately recognised break in the trend of productivity growth (say to higher). That should cause stock prices to jump up implying huge returns the instant the trend broke (and this was instantly recognised). After that expected returns could be higher or lower than before. I guess this is a quibble. The thing which should have lead to high stock returns and therefore (maybe) to high real interest rates in the 90s was a long long series of pleasant productivity growth surprises. If people had been quicker to believe that there was a true increase in trend productivity growth, the period high returns on stocks should have lasted less. Same if they had not gone irrationally exuberant towards the end.

Posted by: Robert on November 9, 2003 04:01 PM


I think it was the wish of the tutelary deity of this wesite, Prof. Delong, that we comment on Austrian theory and its possible current applicability. I may have started things of on the wrong foot by asking some unrelated questions.

Julian Elson's comment does not answer my question, as far as I can see, since I took the "natural rate of interest" to be a theoretical construct, equal to something like the costs of capital in relation to the supply of savings. So, leaving aside the diffences between stock and bond markets as forms of savings/investment and their interrelations, if a company has a high stock value, it could simply issue more stock to raise investment funds.

Robert Kirchner comments that the Austrians were more concerned with what I called intersectoral over-accumulation and he called mal-investment. And this, in turn, was to be related to the efficacy of price signals with respect to differential inflation rates and the "intertemporal price of capital". Now I take it that the problem of the intertemporal "price" of capital has to do with the differences in the technical quality of various capital stocks deployed at different times and their comparative valuation and the returns due to such different stocks. And differences in the rates of inflation between various productive sectors in the long run reflect differences in the rates of productivity improvement between the various sectors. But I fail to see how a distortion of price signals, which otherwise would be the holy grail for the Austrians, enters in here. Were they simply obsessed with the distortive effects of the German/Austrian hyperinflation of the Weimar period? For investment in technically improved capital in some sectors will mean that older capital stocks in that sector will be relatively devalued, that some degree of liquidation of those older stocks will occur, that the relative prices in other sectors will increase as lower per-unit costs increase the supply in improved sectors relative to aggregate demand, and that thus some redeployment of idled resources to other sectors will have to occur. But isn't that precisely what the market price system is intended to achieve?

Now the coordination of interdependent productive sectors is a core problem of an industrial capitalist system. In classical political economy, based on an analysis assuming long period equilibrium, which factored out temporary fluctuations of supply and demand to get at the "values" based on the costs of production underlying the price system, an equalization of the rates of profit between the various sectors was supposed to ensure the optimal allocation of productive resources. Leaving aside the empirical question of exactly what period a long period is, and the fact that such an assumption was far more plausible at a time when both the rate of technical change and the degree of penetration of industrial processes into the economy as a whole were vastly less that it is today, we all know some of the reasons such an equalization of rates of profit does not obtain, ranging from degrees of competition or monopolization and thus market power prevailing in a sector to differences in the capital to labor ratio to exposure to volatility or cyclical dependencies. But such a approach does allow us to consider something of the "real" economy vs. the economy in monetary terms. In these terms, savings/investment means the forgoing of consumption of some portion of the total surplus product in favor of dedicating it to the production of further capital goods. Something of this will always have to occur, obviously, to replace worn out capital stocks and such production and deployment will continue to be profitable until the point where diminishing returns to diminishing capacity utilization will cause the liquidation of extant capital stocks, barring any technical improvements to the productivity of capital stock. (That classical political economists thought that this point approached sooner than later and that they did not fully consider the possible scope of technical capital improvement, gave to their writings their underlying pessimistic tone, which caused Carlyle to coin the phrase "the dismal science".) Beyond this there are two considerations. 1) Technical improvements are economic to the extent that they lead to a net gain in productive capacity vs. the liquidation of extant capital stock. 2) The total surplus product will be distributed, in simplified form, between the returns to capital, profits, and the returns to labor, wages. Prescinding from exactly what determines this distribution and ceteris paribus, it can be stated that a high rate of profit and thus a low wage rate, in monetary terms, will mean a high valorization of capital and of output, i.e. high prices relative to wages, and vice versa; since there is a finite limit to how much any person or group can actually consume, no matter how extravagent, (as opposed to appearing on a "Fortune Magazine" list for the market valuation of the assets one owns), returns to capital are mostly savings/investments and returns to wage labor are mostly consumption demand. Thus an excessively high rate of profit will lead to underconsumption and thus, in the end an overaccumulation and devalorization of capital, whereas an excessively high wage rate will lead to overconsumption and deficient savings/investment. And it is a fair guess that technical improvements, which can neither be guaranteed, nor predicted in advance, are more likely to occur and be promulgated at economic rates at higher levels of capacity utilization. Finding the "correct" or optimal equilibrium betweens these three in the distributions between productive sectors and the cross-implicated distributions between profits and wages is at the "real" core of the prospects for economic growth. The interest rate amounts to a confidence or "prediction" that growth will occur ( or, least, that monetary inflation will permit the repayment of debts, assuming that debtors, like gambling-addicted aristocrats of yore, are not simply consuming their inherited wealth). Low interest rates, when prospects for growth are diminished, if not negative, stimulate both consumption and investment; high interest rates, when prospects for growth are high, prevent confidence from outrunning the reality of diminishing returns. But I don't see the point of "natural" interest rates, (as opposed to real/nominal interest rates), here. If productivity-enhancing technical improvement in capital goods in some sectors, which is the source of real long-term economic growth, are more likely to be developed and promulgated at higher levels of capital capacity utilization, when interest rates are trending upward, and this leads to a need for sectoral readjustment, redeploying labor and capital resources to other sectors, would not this be best facilitated by lower interest rates, reducing the cost of capital for the redeploying sectors and maintaining consumption demand for their higher relative prices?

Posted by: john c. halasz on November 9, 2003 11:09 PM


I would also like to re-iterate my last question, should anyone choose to reply. There are three functionally equivalent response to an economic downturn: fiscal stimulus through increased public spending with a deficit, fiscal stimulus through tax cuts with a deficit, and monetary stimulus through lower interest rates at the behest of the Fed. The "New Keysian" doctrine, which I take it Prof. Delong adheres to, as once did Mr. Mankiw, is that monetary stimulus is the preferred option, presumably because it is more timely and because it avoids problems with the deficit. But with the Bush administration, we now have some sort of application of all three, the two fiscal ones through the tax cuts combined with increased expenditures for defense and pandering, and the Fed policy that presumably reacts to accomodate the situation, whether it approves or not. Now though functionally equivalent in terms of increasing aggregate demand, the three have different effects on the composition of GDP: government spending increases the share of government production/consumption, tax cuts increase the share of private consumption, and monetary loosening increases the share of private investment. So my question is this: doesn't current policy, given the distribution of the tax cuts and the nature of extra spending, plus the miniscule interest rate, amount to one of increasing private investment in the face of rising unemployment, stagnant demand and increasing consumer indebtedness? And what sense would that make?

Posted by: john c. halasz on November 10, 2003 12:20 AM


"given the distribution of the tax cuts and the nature of extra spending, plus the miniscule interest rate, amount to one of increasing private investment in the face of rising unemployment, stagnant demand and increasing consumer indebtedness? And what sense would that make?"

Two things.....

1- Doesn't the increase in government debt cancel out the tax cut? Since no spending was actually cut here, extra dollars which appear in accounts of investors are matched by the increase in gov't securities, so possibly the spread with corporates declines, but the overall pressure on interest rates and the economy should be close to zero from that particular aspect of cutting taxes on the class of investors which don't spend it (although there are plenty of reasons to believe some portion will be spent by them or by charities)

2- I don't believe increasing private investment in the face of rising unemployment is a bad thing. You are right that lower interest rates lead to a combination of spending and private investment, and you cannot control which as I suppose this is a matter of public taste. While both increase current economic activity, the investment spending has the effect of increasing output and possibly reducing the workers needed.

This is where Austrians have it wrong. Rather than being a situation that calls for liquidation, this is quite a wonderful situation, as the population is wealthier than they think they are. Once the increase in private investment ends, you run the auction again at a lower rate (or by some other means of easing). Either there is another round of investment, or there is finally an increase in end consumption. So there is this competition, the longer end consumption holds out, the better a deal it gets in the long run (by lower rates on debt), and the longer investment holds out compared to consumers, the better that side does in the long run (by higher rates of return). The Austrians seem to want to impose this "natural" interest rate on the situation rather than accept that the market rate will move around based on what the needs of the population are. As far as I'm concerned, if nobody wants to spend, return on investment should fall until the choice is between spending your money and losing it. This is where zero interest rates get in the way though. BDL has called for a 4% inflation rate for this reason, and I'm in agreement with him on that.

Posted by: snsterling on November 10, 2003 08:48 AM


Post a comment