Monday, March 10, 2008

Variations On A Theme

In today's post I will revisit the theme of too much debt vs. earned income.

Are you familiar with Bach? Unlike most composers, if you play his piano music separately for each hand you will likely just hear random notes, frequently dissonant instead of harmonic. But put both hands together and his genius becomes apparent. Two, three and sometimes even four distinct voices are intertwined for your listening pleasure - assuming you are not tone deaf, of course.

Well, it is quite obvious that many economists and policy makers are, in fact, tone deaf to the multiple voices of the economy. And no matter that piano is scored for both hands*, they keep trying to make music by playing only the "right" hand notes: Lower interest rates, more liquidity injections, tax rebates to boost consumption. For some reason they continue to ignore the more fundamental "left" hand: earned income - which is, after all, the entire support mechanism for asset prices and credit quality.

Below is part of the score in chart form - think of it as sheet music: The top blue line (equivalent to the right hand) is household debt growth, directly related to asset prices, interest rates and liquidity. The bottom red line (the left hand) is growth in earned income. They each provide a very different tune and, just like with Bach, you need both to get the proper music going.

Annual growth in household debt (blue) and hourly earnings (red)

It is no surprise, therefore, that after repeated attempts at right-hand only concerts the economy's self-styled virtuosos (Fed and Treasury), are failing to please the audience (markets). Many previously devoted fans are increasingly perplexed and some are even looking anxiously towards the exits. The music critics in the popular media are starting to take notice.

But enough with the Bach divertimento - back to the economy.

Earned income growth trailed debt badly for 15 years, with the divergence becoming very pronounced after 1999. The economic recovery after 2001 was, thus, largely a mirage produced by debt: people did not spend money they earned, but money they borrowed. What we are experiencing now - the credit crisis - is the expected result: borrowers are swamped by debt payments they cannot possibly meet.

The shortfall between income and debt service requirements is leading to the rapid abandonment of leveraged assets, including homes, automobiles, LBOs and all manner of structured finance schemes. As assets are cast away their prices drop, leading to generalized markdowns.

Where the leverage was very high - and it was very high in many instances - a vicious cycle ensues where lower prices result in margin calls and forced liquidations, i.e. a self-reinforcing negative feedback loop: lower prices create more supply. This is the opposite of what we expect from classical "invisible hand" supply-demand curves. It is also the reason why such a virulent crisis could result in a systemic meltdown, if left to continue without proper intervention.

It is essential to realize that assets being upside-down versus their loans (negative equity) is not a cause of the credit crisis, but a result.

The root cause of the credit crisis is that many loans are
too large versus the present value of the income streams of the borrowers, after living expenses.

An important corollary from this observation is that keeping wage increases low - as many economists frequently advise - further weakens this negative balance, ensuring continued pressure on asset prices in the future.

It is quite clear from the above that if a generalized crisis is to be avoided policy must be directed immediately towards enhancing the earned income of working people, i.e. increasing their after-tax wages and salaries. Some may object on the grounds that such actions will create demand-driven structural inflation. However, given the parlous state of household finances, I believe the risk of such a development is very small. With the personal saving rate at an unsustainable zero/negative range and given the proper inducements, people will elect to rebuild savings instead of spending the extra income.


(*) For you piano buffs, there are a few lovely pieces written exclusively for the left hand. To me, the most beautiful are Scriabin's Prelude and Nocturne. Click below for the Nocturne. Ignore the cheezy balloon decor, the performance is excellent.


  1. Thanks for the video link - the hand is a very strange thing.

  2. Hell, remember the tragedy of the commons. Nothing is more unfair than govenment intervening to assure equality of outcomes/results, because of course it cannot.

    Focus on everyone playing by the same rules. You will have much more success.

  3. Does removing government oversight keep the tragedy of the commons from occurring?

    It could exasperate the tragedy but then again a limit on grazing and a maintenance tax my have prevented the tragedy.

  4. Anon, that is exactly my point! If government focuses on limiting grazing, it will have done its job. But if it decides to play favorites with who has the right to graze, it will fail.

    Hell's solution is to let those who want to overgraze do so on another plot of common ground when the real issue is people need to reduce their grazing.

  5. We should have allowed tragedy to proceed after the tragedy of the dot com pasture. Now we have ruined yet another pasture and we want to move on and hope the oversight works the next time.

    In the meantime many people are hoping for someone to come up with a more durable, fast growing grass seed.

  6. I'm sure you're well aware that wage increases are not going to happen due to the global wage arbitrage, not when Chinese counterparts are making 68c/day to slave away in factories. The delta is much too large to ever bridge in a conventional sense, short of a massive Wiemar-style get-paid-to-not-work program.

    More likely will be a massive standard of living readjustment, as the average American wakes up one day to suddenly find himself quite poor, with not enough to eat. The truth is, he's been poor for quite some time, he just didn't know it.

    This credit crises will be followed by a depopulation crises, imho.

  7. thai, re: "overgrazing"

    You have got me quite wrong.

    The main problem is unequal distribution of grass. And don't forget I am all for a SUSTAINABLE economy, not an overgrazing one.

    This is not equivalent to letting the weak die off, however.


  8. Hell, that is why I admire you (I see your heart is in the right place), and yet know you are arguing with the structure of the universe (much like those who argue evolution does not exist). This is why I suggest you read up a little more on evolutionary psychology and econophysics before you get suggest moral solutions to our economic ills.

    I see your concern for others, I really do (Kudos), yet the problem is you do not see inequality as a fundamental property of social networks (whish it is). This inequality is unalterable no matter what you do. But the illusion that those on the top are the best off is also just an illusion.

    Even if the wealthiest paid 99% of their income in taxes, still we would see a similar distribution over time (which is why we see wide disparity today even though taxes on wealth are at the high end on a historical time scale). Grass inequality is simply a fact of the universe. It will always be.

    But that does not mean people need to 'die off'-- a does not equal b here. I do not see why people always get so draconian and release their inner nazi when this toic comes up. There is a lot of grey between absolute black and absolute white.

    Ask yourself the question: "what is wealth?" in the first place.

  9. *"What is wealth?"-I once read an interview with some non-economist (baseball player? artist?)and when asked about their fortune they demurely answered that they could cover their daily expenses for many days. Of course you want to scream that they don't know what expenses will be for the future days (inflation/deflation/stagflation/toppled governments/plagues), but it is still a fairly nice framework for determining wealth.

    *I used to be in lending and can attest that its appalling what debt-to-income ratios people were voluntarily getting themselves into (even using minimum credit card payments, no daycare or utilities, etc.). And no assets. They were borrowing today's daily expenses from future days. Like most here (I assume) the price of wheat or gas doesn't cause any change in our lifestyle, but its easy to forget we're not the majority (nationally or globally).

    *Thai- I don't want to be draconian, but I have to admit that the word "inequality" is pretty loaded. Any question of it is a cultural taboo pretty much. Cortisol levels rise as flashes of guillotines (sp?) race through our minds. Any options besides Darth Toll's depopulation would be of interest.

  10. I might give another definition of wealth-- information. Give me good information over money ANY day of the week. It is much more valuable.

    Dink... fair enough. But unless people are allowed to discuss this in a safe way, I do not see us moving from our current predicament. I am simply writing what we all know as truth. Nothing has ever eliminated inequality-- because it cannot be eliminated.

    As for 'what do we do'?-- how about I put it this way: I would love to visit outer sapce, but in reality I know I never will-- I will need to live vicariously through those that did (which is what every engineer at NASA has always done)-- heck, I haven't even ever flown first class on an airplane. But I won't burn society down over this 'inequality'. I can live with inequality (we all do every night we go to bed). I may not like it, but I can live with it.

    What is an issue: how we spend and invest our resources.

    If the spending behavior of the wealthy is gluttonous, I am not 'feeling the love' towards them. If they are good stewards of resources, especially in ways that benefit us all over the long term (and don't tell me bigger homes create jobs-- I am talking about things like R&D, drug development, etc...) I will be thriled to call them 'fellow citizen'. I have never heard anyone complain about Jonas Salk's wealth, ever.

    That is one reasons 'living beyond our means' is so socially destructive (look at Michael Jackson, gross), it is not hard to see why trust breaks down quickly in a society where even our rich can't live within their means. If they can't, why should the poor?

    We can and should shame people a little more )we need to shame BOTH rich and poor, it is not OK to treat one differently than another. We are all equals in this world). It is just like junk food-- I can eat as much as I wan't, but why would I?

    Thirft, savings, investment need to become admired behaviors again-- we need to end our gluttonous culture of spending.

    I really believe this is why gluttony is one of the 'seven deadly sins'. It destroys societal trust.
    I am not religious, but I see where the ideas around this sin originated.

  11. Hell:

    Thanks for re-introducing the notion that income is a key component of the solution to the U.S.' economic imbalances. Darth Toll's remarks about labor cost arbitrage are the pivot point around which the U.S. economy is re-directing itself.

    Also, Thai's question of "what is wealth, anyway?" is timely, because necessity will require us to redefine "wealth" according to what is possible, rather than what used to be.

    Is that a big deal? Only if we get stuck in first or second gear:

    1st gear: Recognize the problem
    2nd gear: Accept it as reality
    3rd gear: Generate alternatives
    4th gear: Pick the best alt
    5th gear: Implement and adapt if it doesn't work

    Who is moving us out of denial (1st and 2nd) and into 3rd? I prefer to go fast.

    Thai, have you come across anything in your cognitive psych stuff that addresses the characteristics/ethos of societies that waste little time in denial, and deliver the goods on the high ranges of the perf spectrum?

    Finally, I think the elite's overgrazing of the commons is a different topic than income distribution. The over-grazing is a crisis problem - I agree. But the lack of earning power of the middle class needs to be laid squarely on the shoulders of the middle class. We (I am lower mid-class, at best) don't invest in ourselves (retraining, information, situational awareness, development of strategic thinking skills) as necessary in order to maintain earning power in a rapidly changing (leveling) environment.

  12. The tragedy of the commons was not that the resource was overexploited and abused(usage of common land in medieval society was carefully controlled), but that they were enclosed so that only a very few benefited from the wealth that they produced. Sounds all too familiar

  13. outerbeltway... no, not really. But I am not an expert in this field-- just an amature reader. It is a vast field and it is probably 38 years old at best.

  14. Thai:

    My favorite person to argue with here.

    Re: Inequality as a fundamental property of social networks

    It sounds a lot like you are saying that inequality is not only "natural" to the macroeconomy, but is a good thing. But certainly at some point that disparity of wealth and income (when we talk about wealth, the two terms are often intertwined and confused) become destructive to social cohesiveness.

    I believe we are at that place now.

    What is often assumed by "free marketeers" is that all wealth is achieved by proper means. I can assure you that this is not true. I have seen incidents ranging from passive exploitation of someone's ignorance to outright criminal fraud to acquire massive amounts of money "one dollar at a time."

    It is this sinister element that requires the law to make "value judgments" (morality, if you will) in regard to human behavior and interaction. Just because it may be natural doesn't mean it is just.

    It is not enough that there be equality of opportunity (I think it is patently obvious that large disparities of wealth and income weakens this equality because it results in disparities in bargaining power.); there must be some aspect of equality of results, too.

  15. Okielawyer, I do not think it is a good thing at all, as I do see it as very destructive to social cohesion. But it is what it is... I do not know how to download papers to this blog or I would-- there is a research evidence suggesting people are genetically programmed to try and reduce inequality. Remember, the majority of our evolution on the savannah was in small bands.

    The problem is that try as you will, inequality is a fundamental property of social networks. You can eliminate income disparity, but you will just substituting one form of wealth (easily measured) for another (less easily measured). Every attempt to elimate inequality just harms trust that much more, since someone who did play by the rules will be harmed.

    And your point is actually my point, the research on the tragedy of the commons shows that where people have successfully resolved this problem, there are certain common elements to the solution. Most importantly, everyone playing by the same rules is one critical component. We spend far too muc energy on equality of results, and far too little on everyone playing by the same rule. That people get away with sleeze as you see in your law world just further proves my point.

    You cannot guarantee equality of results so don't even try, it just destroys trust, even if the intent is to do the opposite.

    Focus on system fairness--everyone playing by the same rules.

    And that is most decidedly what Hell is not doing with his recommendation, even if he does not see it himself.

  16. well, heck, poker has a set of rules but if you and I sit down to play but I 'happen' to have, say, 20 or 30 times more than you, most likely I will walk away with all you had.

    supposing I desired to do this to lesser degree but in ongoing fashion, I might build some enclosures in order to prevent you from reproducing yourself as you had but, instead, force you to sell your sole remaining commodity, your labor-power. I might force you to become a wage laborer and work for either myself or one of my brethern since only by doing this would I be able to appropriate from you while hiding this behind the wage relation.

    All in all a very neat deal especially since my primary goal is capital accumulation and profit.

    The rules are straightforward: a legal-political regime of private property; my ownership of the means of production and your exchange of labor-power for a wage which covers your cost of reproduction which, not so accidentally, happens to be less than the total value which you create, so providing me with a surplus value that can be realized as profit and further accumulation. At least until such point that I have overaccumulated, see my profit rate falling and demand that you work harder for less.

    But then this hightens the contradiction between production and consumption and we begin to experience more problems though mine are quite a bit less significant, especially so long as you are able to borrow from others.

  17. So the countless iterations that our genes experienced, on the savannah in groups no larger than 150, resulted in bodies housing minds that are predisposed to certain tendencies. Evolutionary psychology is in the process of identifying these tendencies, figuring why they came about, and theorizing what we are doing with these tendencies in today's circumstances. Knowing what our genes are trying to manipulate us into thinking/behaving will help us quit (assuming our minds can determine a more logical course of action).

    So we've got the Tragedy of the Commons as a framework to consider the situation we're in as a global population. We have to make rules, which may or may not please our genetic tendencies, and then all cooperate with them. Many people won't cooperate (the same ones not cooperating under our current economic system) so we have to have a form of accepted "mutual coercion". Perception of fairness is a requirement, there is no way to override that genetic impulse (not that I would want to). Fairness will not be defined as equality of results, though there have to be certain boundaries to keep social cohesion.

    The free market, supported by a political system protecting individual rights, worked very well in the circumstance with a small global population and plenty of resources. Perception of fairness was pretty easy when most members had 1) enough resources to subsist, and 2) the belief that they could have what their rich neighbor had if they felt like putting time and effort into it. In a circumstance of overpopulation where some members do not have 1 or 2 I don't think a free market will be able to be perceived as fair and society could get ugly.

    Sooo.... how do we make the rules and how much mutual coercion can we stand? I'm not religious which opens me up to some ideas about birth control and criminal justice that may offend some. We have technoligical possibilities that could be amazing. Feel safe in discussing this and putting your ideas out; I won't yell and even if I did you'll enjoy internet anonymity.

  18. Dink, discussions like this are a little too 'social darwinist' for my taste. As I have said in the past, while I believe strongly in evolution, I am not a social darwinist.

  19. Well I certainly didn't like social darwinism as explained in Wikipedia. I am no "eugenecist". There could never be any mutually accepted way to have a goverment tell one person they couldn't have any children and tell another they could have unlimited children. But perhaps there could be a way to tell each person they could only have one child (if it was mutually accepted that they Earth had a max capacity of 4 billion). I like humans and only suggest global birth control to prevent their suffering. I sincerely hope I didn't give any impression to the contrary.

    Whistling in the dark,

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