peak debt

Peak Debt and Income

Philip Brewer — Tue, 15 Mar 2011 12:00:09 +0000

The big argument in the debate on the stimulus packages was between two groups. The demand-side folks wanted to make sure that the money got into the hands of the poor, because they'd spend the money, boosting the economy. The supply-side folks wanted to keep money in the hands of the well-off, because they'd invest it, providing increased productive capacity to boost the economy. (See also: 5 Creative Ways to Invest During a Weak Market)

If you're interested in looking into the issue a bit more deeply than the economic pundits in the mainstream media usually do, check out Peak Debt and Income (PDF), a new paper by Ronald M. Laszewski. (I linked to his previous paper in my Peak Debt article.)

There are two threads to Laszewski's argument.

Maximizing Household Assets

Laszewski creates a simple model of the economy as a tool for investigating the question of how to get household balance sheets back in order after suffering the problems diagnosed in the earlier Peak Debt paper:

At the time it appeared that a peak in consumer purchasing power had already been reached, and that it was likely that there would be a long period of economic decline to follow. Three ways in which the consequences of the large over-hang of debt might be ameliorated were examined: (1) a significant growth in real personal income, (2) a default on outstanding debt, and (3) a central bank induced hyper-inflation.

The earlier paper had gone on to demonstrate that options two and three would probably have little effect in boosting future economic activity. Option one, on the other hand, could be effective.

The result of Laszewski's further analysis is that growth in GDP is strongly dependent on how total income in the economy is divided up.

Consumption by Income Group

From the end of World War II until the early 1980s, the top 10% got about 34% of total income. In recent years the share taken by the top 10% has grown sharply; they now get almost 50%. If the income fraction received by the top 10% was returned to its historic value, the current incomes of the other 90% of households could be increased by 30%.

As the demand-side analysts have been pointing out, the rich spend much less of their income. The poorest folks spend almost 100% of their income, average folks spend about 90%, and the top 10% spend only a little more than 50% of their income.

Putting these facts together, Laszewski calculates the effect on the economy if the income distribution were returned to something like its post-war norms. If the richest 10% only got 34% of the national income (instead of the 50% they're currently receiving), the increased spending on consumption would boost GDP by 4.2%. Other assumptions about how the money might be redistributed could add as much as 10.5%.

The math in this paper isn't as complex as in the previous paper. So, if you're interested, take a look at Laszewski's Peak Debt and Income paper (PDF).

Key Takeaways

The supply-side folks are wrong. At this time, additional business investment will produce very little additional growth in GDP.

The demand-side folks are right. Getting extra money into the hands of the bottom 90% of the population would produce substantial growth in GDP.

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

A champion of savings over spending

Philip Brewer — Fri, 20 Feb 2009 14:36:32 +0000

We're subjected to constant barrage of unhelpful advice to the effect that what the economy needs is more spending. (The stimulus program is one piece of this.) It's kind of understandable: A recession is all about the downward spiral of people buying less, forcing businesses to shrink, putting people out of work, so that they spend even less. The cure, though, is not just a bunch of extra spending. The cure is to get the economy to the right size.

The right size, of course, is the size where the spending for consumption leaves a surplus that exactly matches the economy's need for investment. For decades it has been the wrong size in one direction--Americans have been spending at unsustainably high levels, saving too little to make the necessary investment in future production. The recession has caused spending to plummet, meaning that current levels of spending may well be below the long-term "right size" for the economy--the current stimulus program is an effort to get spending back up. Personally, I'm not hopeful.

For one thing, that "right size" is impossible to know. Economists try to estimate the right size by looking at shifts in the demand for money, changes in interest rates, and so on. Those sort of analyses can be useful as steps toward understanding the economy, but it's hopeless for coming up with the right answer. That's why a market economy is so much more productive than a planned economy: The analysis is simply impossible--data isn't timely or complete enough, production technology and consumer preferences are constantly changing, and planners aren't smart enough even to know all the things they ought to be planning, let alone how they all interrelate in the real world.

Fortunately, this is the area where markets work really well, if you let them. Let investors allocate resources, let consumers decide what to buy; you'll get very close to optimal resource allocations. You'll also, in the long run, get close to optimal saving and investment. Sadly, as we've seen recently, in the medium run you can get really bad levels of saving and investment.

There are a lot of bad solutions for this. In particular, having the government decide what investment is worth making is a bad solution--although maybe not as bad as what we've seen over the past 25 years or so. A much better solution is educating people to make smarter decisions. One group that's trying to do that is Choose to Save.

I just learned about Choose to Save in a segment on last night's NewsHour on PBS. They showed clips from some hilarious public service announcements with Savingsman, a comic book hero out to rescue people from bad financial decisions. The PSA spots are available on their website, along with brochures, calculators, tips, and so on.

The NewsHour segment has a great interview with Dallas Salsbury, the founder of Choose to Save. One of the main themes of the interview was about whether it's really appropriate to chose saving over spending right now, with the economy in the shape it's in.

Fortunately, Salsbury is a great advocate for saving as a necessary step in restoring individual balance sheets to sound levels. He had some stuff to say that most people will probably find pretty tough to hear: That we probably need to spend the next decade or more deleveraging--paying off debts, building up savings, and making investments. That's how we can build the foundation to once again find some prosperity. The interview is well worth listening to.

The current stimulus program is an attempt to pull up the dip in spending between now and when individual balance sheets are at sustainable levels--to keep things from getting as bad as they might until we're back on a sound basis. The problem is the vast gulf between here and there. Unless something amazing happen with income levels, we're at least a decade away from having things cleaned up enough that we can start thinking about finding a new normal. As I've written before, debt levels are just too high.

So, don't worry that being frugal will hurt the economy. In the long run, the best thing people can do for the economy is to get their own debt levels down and saving levels up to where their personal financial situation is secure. Until then, choosing saving over spending is the right choice.

Like this article? Pin it!

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Peak Debt

Philip Brewer — Fri, 19 Sep 2008 09:13:01 +0000

Is there a limit to how much Americans can spend? Clearly there is: All they earn, minus savings and service on their existing debt, plus new borrowing. Since the Bureau of Economic Analysis puts numbers on those very items, it's possible to see just how close we are to the edge. In a fascinating paper, Ron Laszewski does exactly that. The results are rather depressing.

Laszewski has kindly let me post his peak debt paper itself on my personal website, so you can read it yourself. What follows here is a quick look at his conclusions (with just a glimpse of the math that's in the paper).

Quick overview of the analysis

Basically, what Laszewski does is turn that simple statement of the limit to spending--all you earn, minus saving and debt service, plus new debt--into an equation. Then, he fits that equation to the historical data from the Bureau of Economic Analysis.

Since income has been flat since the 1970s, increases in spending since then have had to come from somewhere else. They came first from a decline in saving, and then from an increase in borrowing. (Not surprisingly, these changes went hand-in-hand with a decline in interest rates. If there's scarcely any return to savings, why save? If there's scarcely any cost to borrowing, why not borrow?)

In about 2005, though, the "new borrowing" term hit its maximum. According to the data, Americans as a group had, by then, reached the peak in the rate at which they could take on new debt. Unable to take on new debt at an increasing rate, growth in spending would have to shrink--and that is exactly what the data show.

What does it mean?

The depressing results that I mentioned at the beginning go beyond just a decline in the growth of consumer spending. Under any plausible scenario, consumer spending actually drops--and, in fact, drops by quite a bit.

Since consumer spending is a large fraction of the economy, a drop in consumer spending inevitably means a recession. The analysis in this paper suggests a rather severe one.

Alternatives

When I read an early draft of the paper, I suggested that things wouldn't really go along this path--people wouldn't just let the enormous debt load grind them down. Instead, we'd see a mixture of ways to eradicate the debt without paying it off (some combination of inflation and defaults of various kinds--restructurings, bankruptcies, debt holidays, etc.).

Assuming that this little model reflects reality, it turns out that none of these things really make much difference. Under every scenario that we've been able to think of, consumer spending declines sharply--and remains depressed for decades.

A model

It's important to note that what Laszewski has created is a model. It's a little toy version of the economy that you can make changes to and set to run and see what the economy might look like. The actual economy is a real thing. Whether the model reflects reality remains to be seen.

However, after doing his initial analysis, Laszewski found some data on residential mortgage debt between 1913 and 1940, which let him do a similar analysis for that period. Fitting the curves to that data shows that America hit peak debt in 1925, with the great depression setting in about 5 years later. The equations fit the data very nicely--one piece of evidence that the model may well reflect reality. (Laszewski's analysis is in Appendix A in the paper.)

People who are familiar with the model of "peak oil" will see certain parallels here--because the data turns out to fit a logistic curve (as does growth oil production)--a fact that Laszewski notes in the text:

The shape of the rise in total debt shown is also very well fit by the logistic growth equation. The rate-of-change in the logistic growth curve implies that new borrowing probably reached its peak in 2005 and is now in decline. We will refer to the peak in the rate of accumulation of new debt as Peak Debt, in conformity with the popular use of the designation “Peak Oil” to refer to the maximum in the rate of petroleum production.

What to do?

As far as what to do in managing your affairs, I'm afraid I don't have much in the way of new suggestions. Certainly, avoid running up new debt of your own. Be concerned that many other people's debt is not all going to be paid back, and let that fact guide your decisions about where to invest.

Arranging your life so that a sharp and long-lasting decline in consumer spending won't destroy both your job and your investments at the same time is a most excellent idea--I wish I were in a position to give you some more specific suggestions about just how to do that.

If you're at all interested in the math, I strongly suggest that you read the peak debt paper, rather than relying on my analysis.

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread: