by Karl Smith
Mike Konczal posts a summary of a working paper by Mason and Jayadev. The leader:
Changes in debt-income ratios can be attributed to primary borrowing, interest rates, growth, and inflation. In a new working paper, we apply such a decomposition to the evolution of U.S. household debt. This shows that changes in borrowing behavior has played a smaller role in the growth of household leverage than is widely believed. Rather, most of the increase can be explained in terms of “Fisher dynamics” — the mechanical result of higher interest rates and lower inflation after 1980. Bringing leverage back down will similarly require contributions from factors other than reduced borrowing.
Having read over the post I would say there is both more and less here than meets the eye. I think the authors are essentially correct – declines in inflation are the key driver behind high household indebtedness.
What they are not as explicit about is that indebtedness is fundamentally a nominal phenomenon. It's always difficult for me to lucidly explain this even to myself but these two graphs should help.
First, look at how household debt has grown:
An almost inexorable rise since the early 1980s. Even now we are barely back to 2005 levels.
Now compare that to debt service payments;
Though by 1995 the level of debt-to-income had gone up by about 50%, debt service payments were almost as low as in the 1980s.
And today, while debt-to-income is just shy of 200% of early 1980s levels, debt service payment is not that far off the bottom.
This is because inflation causes your debt-to-income ratio to fall faster, but it does this by requiring a higher payment at any given level of debt. So even though debt-to-income was much lower in 1985, for example, debt payments were higher.
One of the things I think these means – but I haven’t worked it out – is that low inflation creates a fundamentally more precarious economy, even without thinking about the zero lower bound.
In short when a lot of your payment is interest then the “price of debt” is less sticky. When lots of your payment is principal then the “price of debt” is very sticky.
The current recession has a weird extra stickiness because the falling price of land now means that lots of folks can’t refinance or sell out.