Scott Sumner  

Philip Booth on Thomas Piketty

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I recently did a post where I expressed skepticism about this claim by Thomas Piketty:

In my view, there is absolutely no doubt that the increase of inequality in United States contributed to the nation's financial instability. The reason is simple: one consequence of increasing inequality was virtual stagnation of the purchasing power of the lower and middle classes in the United States, which inevitably made it more likely that modest households would take on debt.
Philip Booth has an excellent post that briefly discusses my post, and then finds an even better argument:
For reasons Sumner identifies, the quotation above is an extraordinary statement from an economist. It should be noted that Piketty says 'there is absolutely no doubt' that the trends he described contributed to the crash. Yet we would, as Sumner points out, expect the opposite trend in debt and savings if incomes stagnate. If real incomes stop rising after a period of strong growth, and are expected to be flat in the future, according to the permanent income hypothesis we would expect saving to rise. A previously lower level of saving predicated upon expectations of rising incomes would no longer be justified.

Of course, left-leaning economists keep telling us that people do not behave rationally all the time - though they should be careful not to assume that people necessarily behave irrationally all the time. And, interestingly, on this side of the Atlantic, things were rather different.

In Britain, inequality fell. Whilst in the US, there was a rise in the Gini coefficient from 0.35 to 0.38 between 1990 and 2010, in the UK there was a small fall in the Gini coefficient from 0.35 to 0.34. In the UK, not only were the incomes of the poor rising relative to those of the rich, there was good reason for individuals to expect high future economic growth in general (even if many economists were sceptical). Average annual growth was nearly 2.5 per cent from 2000-2008 and Gordon Brown famously raised the official estimate of the sustainable growth rate.

But, despite these very different circumstances, the outcome was the same. In both the UK and the US, the savings ratio fell by about two-thirds. Looking at the data over other periods makes no difference to the conclusion about income growth, savings or inequality. Indeed, there were discussions at Shadow Monetary Policy meetings around 2007 about whether the low savings rate was a concern or whether it was a natural reaction to expectations of higher income growth in accordance with permanent income hypothesis.


Booth then lists some alternative explanations that are consistent with the similar pattern of rising debt observed in both the US and UK:

There is no shortage of potential alternative explanations for the rise in household borrowing in both the UK and the US. Four that immediately come to mind are:

1. The rise in house prices led households' net wealth to increase so they believed they could borrow more or save less.

2. As mentioned by Sumner, the large rise in savings in Asia lowered world real interest rates and therefore lowered savings elsewhere.

3. As Austrian business cycle theory would suggest, loose monetary policy led to low costs of borrowing and reduced saving and/or increased borrowing.

4. There was moral hazard prevailing right through the financial system in the US which artificially reduced the risks to both borrowers and lenders.

It has to be said, that the similar experience of the US and UK in relation to debt and saving in the face of completely different experiences of income and inequality data do not provide a very firm basis for Piketty being 'absolutely certain' that inequality contributed to the crash.


PS. Alan Reynolds has an interesting critique of Piketty's wealth data. I've been traveling for the past 10 days and have fallen behind a bit in the discussion. I'd be interested in hearing any thoughts (pro or con) on Reynolds' claims.


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COMMENTS (2 to date)
Kevin Erdmann writes:

I believe there is an even larger error. Because of the peculiarities of home financing, high mortgage debt is a sign of savings.

Imagine a household with low and stagnant income. It will likely be a home renter and might have $10,000 in consumer debt.

Imagine a household with high and growing income and $50,000 in savings. It will likely be a home owner and will have a $200,000 mortgage. Not to mention likely student debt.

The unusual increase in debt was almost entirely mortgage debt, and reflected a strong and healthy middle class, partly as a result of the life cycle of baby boomers.

That this fact is used to claim a hollowed out middle class, when the overriding result was the bidding up of the nation's middle class housing stock, is pretty incredible.

http://idiosyncraticwhisk.blogspot.com/2014/04/economic-growth-was-not-fueled-by.html

Scott Sumner writes:

Kevin, Good point. That's not the whole story of the housing boom, but it's an important perspective that is often overlooked.

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