I have posted a number of posts on issues related to this subject. US has huge current account deficit and this poses huge problems for the entire global economy. For a summary of problems see this.
The source of high current account deficit is US households (HH) spending more than their incomes. In order to finance their expenditure they borrow leading to high indebtedness. The natural question to ask is what has contributed to the rising debt? In other words, how have households managed to spend more than their incomes?
This recent Federal Reserve paper seeks answers to some of these very important questions. As it is co-authored by Donald Kohn, the Vice Chairman at Fed it automatically carries a lot of weight as well. The vice chairman at Fed also does active research; it shows how much research is respected in US.
This paper is one of the most popular papers being discussed because of the consequences involved. There are 2 ways to reduce current account deficit as Feldstein has put in his paper, one let dollar depreciate and two to increase US households savings. Now, if you need to increase US household savings you need to first understand what has led to this problem.
How much is the indebtedness?
The ratio of total household debt to aggregate personal income in the United States has risen from an average of 0.6 in the 1980s to an average of 1.0 so far this decade!!
So for every $ of HH income there is a $ of debt.
What explains this rise? Let us look at possible reasons and the evidence found for the same:
1. Consuming more today and saving less for tomorrow: In other words have HH become more impatient? The paper says no, they have not become more impatient and are saving for retirement.
2.Have they become less risk averse? i.e. if you become less risk averse you might borrow.But the paper does not find any evidence of the same
3. Changing demographics: The logic is that you tend to spend more in your middle age and youth compared to old-age as your needs are more. As US baby-boomers (born between 1946 and 64 in US) have moved to mid-age, their debt-income ratos should move up. The paper suggests this has led to rising debt but not by as much.
4. Housing Prices and Financial Innovation: The paper says these two have contributed max to the rising debt.
The most important factors behind the rise in debt and the associated decline in saving out of current income have probably been the combination of increasing house prices and financial innovation. We noted a number of channels by which higher house prices can lead to higher debt. And causality probably runs to some extent in the other direction as well, especially in light of financial innovation that has reduced the cost and increased the availability of housing finance. Innovation has opened up greater opportunities for households to enter the housing market and for homeowners to liquefy their housing wealth, thereby helping them smooth consumption of all goods and services. One implication of this analysis is that a portion of the rise in debt relative to income probably reflects a shift in the level of spending that is not likely to be repeated unless house prices continue to increase as quickly as in the past and financial innovation continues to erode cost and availability constraints at a rapid pace.
So, housing prices alongwith financial innovation has led to the increasing HH debt. The consequences are even more interesting:
For one, household spending is probably more sensitive to unexpected asset-price movements than previously. A higher wealth to income ratio naturally amplifies the effects of a given percentage change in asset prices on spending.
Further, financial innovation has facilitated households’ ability to allow current consumption to be influenced by expected future asset values. When those expectations are revised, easier access to credit could well induce consumption to react more quickly and strongly than previously. In addition, to the extent that households were counting on borrowing against rising collateral value to allow them to smooth future spending, an unexpected leveling out or decline in that value could have a more marked effect on consumption by, in effect, raising the cost or reducing the availability of credit.
Another caution involves the distribution of credit and, in particular, a tendency for some households to become very highly indebted relative to income and wealth. The spending of those households is likely to be constrained by negative income or asset-price shocks as well as by households’ capacity to service their loans. Although these households represent a relatively small share of the population, in some circumstances such developments could have effects large enough to show through to the macroeconomy.
The paper tells us indirectly, why housing sector matters so much for the policymakers and why it poses a dilemma for them.
Rising housing prices along with financial innovation let HH to satisfy many of their demands which they otherwise would not have been able to meet (see last pages of this speech to see how much they have risen in various countries) .
Now, firstly policymakers have little ideas to gauge whether price rise is as per market conditions or it is a bubble. So if they do something to correct the price rise the free-marketers say let markets correct themselves, and if they do not, the natural economic cycle takes over and in case of a slowdown, the housing prices crash, and this leads to insolvencies and foreclosures (as many purchases have been financed based on house price rise) and leads to difficult economic conditions (as we see in sub-prime markets today). To mitigate losses from second situation you need effective supervision which is generally ignored when times are good.
Coming back to the paper, it is a very simple one and pretty lucid and full of interesting facts. It is a must read to fill the missing block from the global imbalance jigsaw puzzle.