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A Review of Mian & Sufi’s House of Debt

Posted by Alex M Thomas on 31st October 2015

Lawrence Summers, a Professor of Economics at Harvard University and a Financial Times columnist, hailed Atif Mian & Amar Sufi’s book as ‘the most important economics book of the year’. The book was published in 2015 by the University of Chicago Press. This is a very readable book on issues of debt (particularly household debt in America), determination of activity levels, and on how to do good economics.

        Mian & Sufi begin by discussing the leverage ratio – ‘the ratio of total debt to total assets’ (p. 20). For the poorest homeowners, this ratio was near 80% and for the richest 20%, this ratio was only 7%. This is because the poor households borrow to purchase their assets (for example, a house). At the same time, the rich households deposit (credit) money with the banking sector to earn interest. The banking sector mediates the financial needs of the borrowers and the lenders. As Mian & Sufi write:

A poor man’s debt is a rich man’s asset. Since it is ultimately the rich who are lending to the poor through the financial system, as we move from poor home owners to rich home owners, debt declines and financial assets rise. (p. 20)

This observation immediately points to the need for looking at inequalities of income and wealth when studying debt or credit. Indeed, ‘[a] financial system that relies excessively on debt amplifies wealth inequality’ (p. 25). This is because when house prices fall, the decline in net worth for the indebted poor households will be more than proportional (p. 22-3).

       The authors rightly note that ‘the Great Recession was consumption-driven’ (p. 30) for ‘the decline in overall household spending in the third and fourth quarters of 2008 was unprecedented’ (p. 33). However, the dominant view in the US and across the world is what the authors term the ‘banking view’.

According to this view, the collapse of Lehman Brothers froze the credit system, preventing businesses from getting the loans they needed to continue operating. As a result, they were forced to cut investment and lay off workers. In this narrative, if we could have prevented Lehman Brothers from failing, our economy would have remained intact. (p. 31)

The dominant view locates the problem to be the lack of credit in the economy. And, they believe that if credit is made available at cheap rates (low rates of interest), the economy will revive. This view ignores the purpose of credit in an economy. Individual and firms demand money for consumption and investment (in a two-sector economy, aggregate demand is the sum of consumption and investment), and if aggregate demand falls so will the demand for credit. A fall in aggregate demand, as Keynes demonstrated in The General Theory, results in the reduction of activity and employment levels. This is precisely what happened during the Great Recession.

Job losses materialized because households stopped buying, not because businesses stopped investing. In fact, the evidence indicates that the decline in business investment was a reaction to the massive decline in household spending. If businesses saw no demand for their products, then of course they cut back on investment. (p. 34)

In other words, investment is not independent of consumption. This insight is of value in emerging economies like India where actual output is far below the potential output (large presence of disguised unemployment and underemployment), and political campaigns like ‘Make in India’ must be viewed with great caution. The dominant view is based on, what in growth theory is called, the supply-side growth theory. According to this theory, a growth in aggregate supply automatically generates an equivalent growth in aggregate demand. In House of Debt, the authors label this as the ‘fundamentals view’.

The basic idea behind the fundamentals view is that the total output, or GDP, of the economy is determined by its productive capacity: workers, capital, and the technology of firms. The economy is defined by what it can produce, not by what is demanded. Total production is limited only by natural barriers, like the rate at which our machines can convert various inputs into output, the number of working hours in a day per person, and the willingness of people to work versus relax. This is sometimes called the supply-side view because it emphasizes the productive capacity, or supply, of resources. (pp. 47-8)

That is, lower spending in the fundamentals view does not lead to contraction or job loss. Remember, output in the fundamentals view is determined by the productive capacity of the economy, not by demand. In response to a sharp decline in consumption, the economy in the fundamentals view has natural corrective forces that keep it operating at full capacity. These include lower interest rates and consumer prices … Obviously, however, these corrective forces weren’t able to keep the economy on track. (p. 49)

This view ignores the fundamental insight provided by Keynes in 1936. In a sense, the Say’s Law still lives on. And, in this theory, ‘[i]nvoluntary unemployment can only exist … if there are some “rigidities” that prevent wages from adjusting and workers from finding jobs’ (p. 56). These rigidities or frictions may be the following: presence of non-tradable jobs (that is, jobs which only cater to the local economy); wages do not fall; workers do not move; and the costs of reskilling if workers have to reallocate (p. 58, p. 63). For a critique and an alternative, see Thomas 2013.

       The marginal propensity to consume (MPC) varies across classes and therefore the assumption that everyone has the same MPC cannot be admitted. The MPC is high for poor households and low for rich households. ‘The larger the MPC, the more responsive the household is to the same change in wealth’ (p. 39; also p. 44). In fact, ‘the higher the leverage in the home, the more aggressively the household cuts back on spending when home values decline’ (p. 42). Therefore, debt matters. According to Mian & Sufi, ‘[t]he higher MPC out of housing wealth for highly levered households is one of the most important results from our research. It immediately implies that the distribution of wealth and debt matters’ (p. 42). Moreover, ‘[t]he MPC of households is also relevant for thinking about the effectiveness of government stimulus programs for boosting demand’ (p. 41).

       Very often, during recessions, the dominant policy response is the lowering of interest rates via monetary policy. But does the lowering of rates help? Is the problem a lack of availability of funds at cheap rates?

To help answer this, there is evidence from surveys by the National Federation of Independent Businesses (NFIB). Proponents of the bank- lending view are particularly concerned about credit to small businesses. Because small businesses rely heavily on banks for credit, they will be disproportionately affected. Large businesses, however, can rely on bonds or commercial paper markets for debt financing. The NFIB is informative because it surveys exactly the small businesses that should be most vulnerable to being cut off from bank lending. The survey asks small businesses to list their most important concern, where “poor sales,” “regulation and taxes,” and “financing and interest rates” are a few of the options. The fraction citing financing and interest rates as a main concern never rose above 5 percent throughout the financial crisis— in fact, the fraction actually went down from 2007 to 2009. It is difficult to reconcile this fact with the view that small businesses were desperate for bank financing. On the other hand, from 2007 to 2009, the fraction of small businesses citing poor sales as their top concern jumped from 10 percent to almost 35 percent. As indebted households cut back sharply on spending, businesses saw a sharp decline in sales. (p. 128)

As the survey indicated in the passage shows, the problem is a lack of aggregate demand, particularly consumption demand. ‘Companies laying off workers in these hard-hit counties were the largest businesses. This is more consistent with businesses responding to a lack of consumer demand rather than an inability to get a bank loan’ (p. 128). There is another issue here; this has to do with the effectiveness of the monetary policy mechanism. Hence, Mian & Sufi write: ‘[a]n increase in bank reserves leads to an increase in currency in circulation only if banks increase lending in response to the increase in reserves. If banks don’t lend more— or, equivalently, if borrowers don’t borrow more— an increase in bank reserves doesn’t affect money in circulation’ (p. 154) limiting the ‘effectiveness of monetary policy’ (p. 155). And there is no strict connection between interest rates and household spending; at the very least, a strong association cannot be assumed (see p. 161).

       This brings us to the end of this book review. It was noted in the introductory paragraph that this book is also about doing good economics. Mian & Sufi point to the need for have a good theory to make sense of the macroeconomic phenomena. This blog concludes with their view on the role of theory.

The ability to interpret data is especially important in macroeconomics. The aggregate U.S. economy is an unwieldy object – it contains millions of firms and households. … But unless an economist can put some structure on the data, he or she will drown in a deep ocean of numbers trying to answer these questions.

Which brings us to the importance of an economic model. Macroeconomists are defined in large part by the theoretical model they use to approach the data. A model provides the structure needed to see which data are most important, and to decide on the right course of action given the information that is available. (p. 47)

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Posted in Book reviews, Economics, Employment, Financial Economics, Government, Macroeconomics, Supply side economics, Unemployment | No Comments »

Summers, Secular Stagnation and Aggregate Demand Deficiency

Posted by Alex M Thomas on 28th February 2015

The foundations of a coherent theory of activity levels were first put forth by Kalecki and Keynes in the 1930s. Their economic theory states that an economy’s output levels are determined by aggregate demand and that there are no economic forces which ensure full employment of labour or the full utilization of capacity. In other words, aggregate supply adapts to aggregate demand. This principle was then extended to the question of economic growth, most notably by Roy Harrod. Subsequent work in this line of enquiry suggests that growth is demand led, as opposed to the mainstream/neoclassical view of economic growth as supply driven.

The idea of secular stagnation, recently articulated and advocated by Larry Summers, will be critically appraised in this blog post amidst the above backdrop. Here, we almost exclusively focus on Summers’ 2014 paper in Business Economics titled ‘U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound’. The principle (also simultaneously a policy prescription) of secular stagnation can be stated as follows: since interest rates have reached their lower bounds and aggregate activity levels are depressed, the solution is expansionary fiscal policy. Why are aggregate activity levels depressed? Secular stagnation suggests that negative fluctuations re-quilibrate the economy to a position characterised by lower output and employment levels. Moreover, ‘the amplitude of fluctuation appears large, not small’ (p. 65).

Macroeconomic equilibrium is characterised by equality between actual and potential output. According to Summers, ‘essentially all of the convergence between the economy’s level of output and its potential has been achieved not through the economy’s growth, but through downward revisions in its potential.’ (p. 66) This is because of aggregate demand insufficiency. ‘The largest part [of the downward trend in potential] is associated with reduced capital investment, followed closely by reduced labor input.’ (p. 66) To put it differently, aggregate demand deficiency leads to the unemployment (and underemployment) of labour and underutilization of capacity.

Despite Summers’ correct identification of the problem, his marginalist conceptualization forces him to connect this with the ‘equilibrium or normal real rate of interest’ which equilibrates saving and investment. As a consequence, he argues that a ‘significant shift in the natural balance between savings and investment’ (p. 69) has occurred. This post will only state that the idea of the rate of interest being sufficiently sensitive to changes in planned saving and investment is one that has been severely criticized and rightly so. [A follow-up post will examine this matter more closely.]

Towards the end of the paper, Summers makes a point which Keynes (and Kalecki) made in the 1930s: ‘We are seeing very powerfully a kind of inverse Say’s Law. Say’s Law was the proposition that supply creates its own demand. Here, we are observing that lack of demand creates its own lack of supply’ (p. 71). However, Summers states this as a contingent principle and not a general proposition as it is in Keynes (or Kalecki). This is not surprising given Summers’ economics being marginalist in nature.

Therefore, since demand creates its supply, Summers advocates public investments and vocally states the counterproductive nature of fiscal austerity. Furthermore, he hypothesises that ‘increases in demand actually reduce the long run debt-to-GDP ratio’ (p. 73). Lastly, he favours policy measures which place ‘substantial emphasis on increasing demand as a means of achieving adequate economic growth.’

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Posted in Economic Growth, Economics, Employment, Government, Keynes, Macroeconomics, Marginalist economics, Michal Kalecki, Neoclassical Economics | No Comments »

The Macroeconomics Underlying the Economic Survey of India 2013-14

Posted by Alex M Thomas on 10th November 2014

This blog post critically evaluates the first two chapters of the Economic Survey of India 2013-14 in order to get a sense of the macroeconomic theory underlying it. [This blog has assessed previous ones for the years:2012-13,2009-10;2010-11;2011-12.] What conceptual framework does the Economic Survey adhere to, implicitly and/or explicitly? This is of significance not just for those interested in theory but also for those who want to understand how economic policies are formulated. Attention will be mainly divided among the following macroeconomic themes: (1) role of investment in economic growth, (2) labour market flexibility and economic growth, (3) policies emanating from (1) and (2), and (4) the overarching aim of economic policy.


It is well-known and widely accepted that investment, be it private or public, is necessary for economic growth. By investment, we primarily refer to additions to fixed capital – machinery, tools, storage facilities, transport equipment, etc. Investment in education, health and environment should also be included, for they expand the productive capacity of the economy in the long term. Two questions may be posed now. First, what is the source of investment? Second, what ensures that the growth in productive capacity will be matched by an equivalent growth in demand?

Prior to the path-breaking work of Keynes, it was widely believed that investment is savings constrained and that saving and investment are equilibrated through variations in a sufficiently sensitive interest rate. Keynes convincingly argued that investment is not savings constrained, rather, it is finance constrained. Moreover, he demonstrated that it is activity levels (output and employment) which equilibrate saving and investment, and the causation runs from investment to saving. This is the principle of effective demand, also to be found in the work of the Polish economist Kalecki. The Economic Survey adopts the pre-Keynesian view, which, not surprisingly is still around, embedded in the neoclassical school of economics – the dominant school in economics teaching and publishing. This marginalist idea of saving-investment equilibrium is mirrored by the market equilibrium for ‘capital’ – the demand for and supply of capital is brought into equilibrium by variations in the interest rate; this is nothing but the marginal productivity theory of distribution.

Implicit in the Economic Survey is the pre-Keynesian view, an essential part of neoclassical economics. ‘…higher investment required for raising growth had to come from higher domestic savings…’ (p. 9). However on p. 11, the slowdown in investment growth is attributed to policy uncertainty, sluggish demand and high interest costs. Despite the reference to demand deficiency on the same page (on p. 13, it is acknowledged that an increase in aggregate demand has a positive impact on economic growth), the conclusion on the same page supports ‘structural reforms’ and the elimination of ‘supply-side bottlenecks’. Also, Keynes’s finance-constrained investment view is expressed when the ‘bank credit flow to industry’ is briefly discussed (p. 25); due to sluggish demand, the demand for credit was lower. [See an earlier post on the determinants of investment.]

Income earners make saving decisions (commonly referred to as households or wage earners) whereas it is the firms and entrepreneurs who make investment decisions in a decentralized economy as India. Firms also make use of their retained earnings for purposes of investment (p. 14). The intermediation of saving and investment is carried out via the banking and financial system – the suppliers of credit, so to speak. The point I wish to highlight is this: abundant savings or a low rate of interest is not sufficient for (physical) investment. There should be demand for the commodities and services produced. Also, there are no mechanisms which ensure that supply will create its own demand, famously known as the Say’s Law. At various points, it appears that the architects of the Economic Survey believe in the Say’s Law. In other words, they do believe that a growth in productive capacity will engender an equivalent growth in demand.

Policy uncertainty & investment

Policy uncertainty emanates from ‘difficulties in land acquisition, delayed environmental clearances, infrastructure bottlenecks, problems in coal linkages, ban on mining in selected areas, etc.’ (p. 11; also see p. 33). This particular statement is reflective of a view which does not take common property resources, ecosystems and environmental sustainability seriously and with caution. The uncertainty in policy vanishes when the government is clear, transparent and committed to socio-economic and environmental justice. Policy uncertainty arises from vague, untimely and arbitrary policy decisions. In fact, this approach to securing higher economic growth is inconsistent with the position adopted in the Economic Survey on sustainable development and climate change which, on paper, appears committed to environmental justice and inter-generational equity. And it is such inconsistencies which cause confusion and policy uncertainties for firms wishing to invest in India.


The marginalist growth theory (Solow’s growth model being the exemplar) makes use of the marginal productivity theory of distribution. Put simply, a growth in the factors of production (or factor endowments) is sufficient for economic growth. And, supply creates its own demand. According to this view, widely taught in macroeconomics courses, growth is supply-side. The impediments to growth then become imperfections in the factor markets, particular labour markets. Consequently, policy is supposed to make labour markets flexible/free/perfect so that the economy can gravitate towards the full-employment position. But, this theoretical view has been shown to be unsatisfactory given the logical problems associated with the marginal productivity theory of distribution. In addition, the creation of a just society must necessarily ensure a minimum wage for all workers sufficient for a decent living, the scope of which ought to widen as societies progress.

According to the Economic Survey, ‘[t]he inflexibility of labour markets have prevented high job creation’ (p. 30). For those brought up in the marginalist tradition, the usual culprit is the labour market. Of course, labour laws, like any other law, should be just and provide opportunities for workers to support each other given that the employers are more powerful than the workers. Also, working conditions, social security, equal opportunity across gender, caste and class and so on must be provided to the workers. This is the responsibility of institution builders – the government together with the civil society. Yes, labour market reforms are necessary: ‘changes in the legal and regulatory environment for factor markets’ (p. 31).

Reforms, unfortunately, have come to possess a single meaning in economics and politics. Reforms have come to refer to policies which make markets more free. There is no reason why reforms need to be thought of in this manner. Politics is about possibilities, and economics suggests some ways of engineering these possibilities in order to provide a decent life to all. There is nothing intrinsically good in any economic or political sense about reforms. The efficacy and goodness of reforms lies in its details.

‘Factor markets such as those for labour, land, and capital, however, remained largely unreformed. This has proved to be a constraint for growth and employment generation’ (p. 48). This statement also is very marginalist or neoclassical in nature. Moreover, one has to be cautious for the three factors of production are very different from one another. Capital refers to produced means of production – commodities and services. Barriers to entry and exit need to be reduced and firms need to operate in a competitive environment. Land is a resource which needs to be treated very carefully and on a case-by-case basis; it has immediate impacts on livelihood as well as on the natural environment. Labour market constitutes people, and there should be strong social security for workers and good working conditions.


Policy prescriptions include primarily supply-side measures. This is not surprising owing to the Economic Survey being fundamentally neoclassical. Investment, a component of aggregate demand, is rightly considered crucial. But, public investment is not much favoured. Investment, as noted in section I, will be revived if supply bottlenecks are removed – that is, projects get easily cleared. Policies are targeted at boosting productivity. Provision of physical and social infrastructure is of utmost importance. A market for food (reducing distortionary interventions in agriculture) needs to be created. Manufacturing must be improved.


What is the central aim of these economic policies? Repeatedly, in these two chapters, the objective is to create a ‘well-functioning market economy’ (p. 29; also 26, 46). This is much needed, but the ‘reforms’ need to be socially and environmentally sensitive. Also, just as with reforms, many different configurations of a market economy are possible. This must not be forgotten, and nor should social, economic and environmental justice be overlooked. To conclude, I would add a few words to the first sentence in chapter 2: ‘The defining challenge in India today is that of generating employment and growth’ (p. 29) which is economically, socially and environmentally inclusive. These additional words make all the difference, both in terms of economics and politics.

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Posted in Economics, Employment, Government, India, Macroeconomics, Marginalist economics, Neoclassical Economics, Supply side economics | No Comments »

Principles of Banking: A Review of a Review of Adamati & Hellwig’s The Bankers’ New Clothes

Posted by Alex M Thomas on 7th September 2014

The capacity of an economy to grow is dependent on the nature of financial institutions besides other factors. Financial institutions, particularly banks, channelise savings (via deposits) into investment (via loans for economic activity). That is, they play a vital societal function. Hence, Roger Myerson, the author of the review essay, writes: ‘So there is an essential role for public regulation of banks: to maintain stable trust in channels of credit that are vital to our society’ (p. 197). This blog post is a review of a review essay of Admati and Hellwig’s The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It by R. Myerson in the Journal of Economic Literature.

Banks are unlike other economic entities. Manufacturing firms do not require public trust to carry out their daily operations in the same way as banks do. If the public find the banks to be untrustworthy, no deposits will be made and nor will anyone borrow. This affects the saving-investment intermediation and consequently other ‘real’ economic activities (agriculture, manufacturing and services) are affected. What happens in the banking system does not stay within it but it both directly and indirectly impacts other parts of the economy – a financial contagion, as it is called. Thus, banks need to be publicly regulated. And, as Myerson points out, ‘the reliability of any regulatory system must depend on broad public monitoring of the regulatory process itself’ due to the vast wealth involved in the business of banking (p. 198). This is not all. According to Myerson, ‘any meaningful financial regulatory reform must include a clear explanation of its principles to millions of informed citizens and investors’ (p. 198).

For Amati & Hellwig, the problem is that bank owners have lost the incentive to keep their banks afloat. Why is this so? First, the owners’ stake in the bank’s investments has dwindled. In other words, banks possess less equity. Equity is the difference between the value of assets or investment the bank owns and all the debt liabilities the bank owes to its depositors and other creditors (p. 198). From about 25 percent equity capital in early 20th century, it fell to about 3 percent or less in 2008 (pp. 198-9). A large value of equity capital signals to the depositors that their deposits will be safe. This provides reassurance due to two reasons – (1) ‘the probability of investment losses large enough to affect the depositors become smaller when the bank has more equity’ and (2) ‘the owners who control the bank have more incentive to avoid risks of such large losses’ (p. 199). The second reason for a decline in bankers’ incentive is the ‘creation of government deposit insurance programmes in America and elsewhere’. Now, the risks of the owners of the banks get transferred to the government and therefore to the tax-paying public. Hence, as Myerson writes:

…when creditors are publicly insured, bank default risk becomes a public problem. Thus, the requirement that banks should have adequate equity has become a responsibility of public regulators. (p. 199)

Given the wider economic function banks play and the contagion effects, it is important that banks are not allowed to fail. Admati & Hellwig recommend banks’ equity levels to be 20-30 percent of their total assets (p. 209).

A firm can finance its investment by issuing debt or equity. The proportion of equity to total liabilities (sum of equity and debt capital) matters because the risks are borne by different groups. Government deposit insurance enables banks ‘to borrow at low rates that do not properly respond to the greater risks that their creditors must pay when the bank has less equity’ (p. 200).  Also, financial fragility intensifies if tax laws encourage financial institutions to use more debt than equity in financing investments (p. 201).

When short on cash, the banks go to the Central Bank, the lender of last resort, for assistance. It lends only to solvent banks. An assessment of solvency requires the Central Bank to be able to assess the assets of the bank – whether its collateral is ‘good’ and whether it has positive equity (p. 202). This also points to the importance of capital regulation for banks as it is ‘fundamental to liquidity’. A slight digression is in order here. Owing to the fundamental role of liquidity in all economic processes, the provider of liquidity ought to be publicly controlled. In fact, as Myerson rightly states:

…the role of monitor and lender of last resort should be recognized as a vital natural monopoly, maintain costly expertise to provide public information, but with monopoly power that should be publicly controlled. (p. 203)

The lender of last resort is therefore consequent on the central banks’ ability to monitor the equity of banks. Thus, measurement (financial accounting, imputing values, risk weighting and so on) assumes great importance (pp. 203-9).

To conclude, banks perform a fundamental socio-economic function in channelling savings into productive investment. The ability of banks to conduct their business depends on public trust. Public trust in turn depends on the proportion of equity capital to total liabilities which is deemed acceptable by the financial regulator. This acceptable ratio is computed by private experts who do not fully take into account the social cost of a low ratio. Given the high possibility of moral hazard in banking and the threat of financial contagion, it is imperative that there is public regulation of banks with the principles made transparent to the tax-paying public who have a direct stake as savers and an indirect stake as contributors to the deposit insurance.

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Posted in Economics, Government, Macroeconomics, Monetary Economics | No Comments »