Posted on February 13, 2021 by Florian Buschek
…is a new paper by Atif Mian, Ludwig Straub and Amir Sufi, a phenomenal paper.
We propose a theory of indebted demand, capturing the idea that large debt burdens lower aggregate demand, and thus the natural rate of interest. At the core of the theory is the simple yet under-appreciated observation that borrowers and savers differ in their marginal propensities to save out of permanent income. Embedding this insight in a two-agent perpetual youth model, we find that recent trends in income inequality and financial deregulation lead to indebted household demand, pushing down the natural rate of interest. Moreover, popular expansionary policies—such as accommodative monetary policy—generate a debt-financed short-run boom at the expense of indebted demand in the future. When demand is sufficiently indebted, the economy gets stuck in a debt-driven liquidity trap, or debt trap. Escaping a debt trap requires consideration of less conventional macroeconomic policies, such as those focused on redistribution or those reducing the structural sources of high inequality.
They construct a model to simulate different policies and the effect of inequality on the economy in terms of debt, interest rates etc.
A key insight is that growing inequality lowers interest rates and increases household debt. As higher net worth individuals consume less than they save in a relative sense, asset prices are bid up and income in form of GDP is depressed. The government can intervene of course. According to their model, government spending, if financed by taxes, as well as redistribution policies can not only lower household debt (increase household net worth) and raise interest rates, but also increase GDP growth. In other words, by distributing the pie more equally, the pie actually grows faster. A wealth tax would do the job in their specific model while consumption taxes would have detrimental effects. Similarly debt jubilees would have essentially no long run impact as the economy would revert back to its old state if no further redistribution policies are employed.
Interestingly they also make the case for fixed rate, long duration debt. The reason is that if the natural rate of interest changes, this kind of debt with long duration adjusts quickly in magnitude (if rates rise the value of fixed rate liabilities erodes), thus balancing the economy faster.
There is also a feedback loop in place. If businesses don’t have prospects for higher consumer demand for their products, they will invest less regardless of interest rates. As investment is also part of GDP, this lowers GDP growth even more. This is what we have seen. Business investment in fixed assets has not done well in a relative sense. The money went instead to buybacks and the reason is simply that businesses see their own stock as a higher returning investment than capital expenditure.