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© Frank


The Saving Glut of the Rich

by Ludwig Straub
September 22, 2020

This interview with Ludwig Straub, assistant professor at Harvard, was conducted and condensed by franknews. 

Ludwig | I started working on inequality and debt related issues during my Ph.D, and since then I have been fascinated by how the distribution of resources across households can have macroeconomic impacts. Inequality and debt are just two examples of how these distributional aspects matter to the economy.

frank | To begin, what is the general economic understanding of the role debt plays in financial crises?

Debt is an important contributor to, and sometimes the cause of, economic crises.

Obviously, it does not cause all economic crises, as we have seen with the COVID crisis, but we have fantastic evidence as to the role that debt plays -- like that from my coauthors Atif Mian and Amir Sufi as well as Moritz Schularick and Alan M. Taylor -- who find that household debt run-ups for multiple years often culminate in a large, subsequent economic crisis.

We also see that debt can make financial crises, meaning the crises in which banks lose a lot of their equity, worse. Studies show that financial crises that occur after such household debt run-ups are much worse than other types of financial crises. 

Why is a household holding debt dangerous to the economy? 

Typically there's some kind of a saving glut – meaning there is a large amount of saving in the economy. This can be a global saving glut, or a domestic savings glut, like the savings glut of the rich that we write about.

Once that saving glut enters an economy, its financial system needs to digest it. In practice, this means the financial intermediaries, such as banks, who are holding the funds, will look for investment opportunities. They might increase lending to businesses and households. If there's not enough demand for those funds from businesses, the funds will flow to households and we will start to see households being offered lower and lower interest rates. We will see households get increased advertisements for using debt to finance all sorts of purchases, even those for every day goods such as furniture or appliances. That sort of thing becomes more and more prevalent the more desperate the financial system is to invest -- in other words, lend -- the funds originating from the saving glut.

One very natural thing that happens here is that people will be more likely to buy a house or a larger house, using mortgage debt. This demand raises house prices, and will ultimately start feeding on itself: if you have five, six, or seven years of steady house price growth, at some point, people irrationally believe that house prices will continue to grow forever. If that is your belief, then anyone’s best response is to go out and invest in housing, raising the price of housing even more. We call this a housing bubble. And all of it is financed by debt.

The problem is that at some point the bubble will burst, and households will see that they have accumulated a large amount of debt and that their investments are not doing so well anymore. As a result, they start cutting back on their spending. What's very important to understand here is that these are often middle-class people, people with high marginal propensities to consume. When they get worried about the depreciating value of their home, or about losing their job, they're going to respond with a dramatic cut in spending.

This is a key distinction between bubbles that happen in the housing market compared to bubbles that happen in the stock market. The majority of the stock market wealth is held by the top few percent of the wealth distribution. The wealthy typically have a low marginal propensity to consume. If they lose wealth in the stock market, they're not going to cut back their spending in a significant way. 

That distinction explains why housing bubbles have much stronger effects on the real economy.

When normal people cut back on their spending, people lose their jobs, and the standard Keynesian cycle of increased unemployment and lower spending is set into motion. It leads us straight into a recession. 

Is that a widely accepted view of debt and crises, specifically in the 2008 crisis?  

There are two broad views on the 2008 crisis, and they each have their own set of supporters. Nearly everybody agrees that household debt and the housing bubble in the early 2000s played a role in the crisis and that we did have a crisis in the financial sector. The two camps just differ on how much weight they put on either factor.

Is the saving glut always tied to inequality?

A savings glut can happen in many different ways. I'll give you a few examples. 

For the global savings glut of the early two-thousands, we need to look at what happened in 1997. After the East Asian financial crisis in 1997, central banks in East Asia feared they might run out of foreign reserves again, so they began and have continued to purchase massive amounts of U.S. treasuries. U.S. treasures are the go-to asset for central banks wanting to accumulate reserves outside of their country. Another well-studied source of a saving glut is an aging population. As people get older, there are more wealthy, older households compared to less wealthy, younger households. That is a phenomenon that is very pronounced in Italy and Japan, for example.

In our research, we focus on the saving glut that has emanated from rising inequality. The key idea is quite intuitive. 

When the rich become richer, they are not going to go out and spend the additional money they make. Instead, they are going to save it. That naturally generates the saving glut of the rich, as we call it.

When you speak to the idea that more saving means more lending to households, what does that decision-making process look like? 

That is something we don't have a definitive answer to yet. For instance, one of the big surprises that we found in our work is that when presented with that strong increase in saving, the financial system did not successfully channel those funds into businesses.

One of the most well-known relationships in macroeconomics is that saving is equal to investment. If there are more savings, typically the lending rate will go down, and businesses invest more. The thought is that we will have more investment overall and stronger growth; everybody will be better off no matter where the saving is coming from, whether it is from abroad or from the rich. 

We uncovered that additional saving does not seem to hit businesses, it seems to flow back into the household sector. It does not increase investment, it just reduces the saving of the not-so-rich. It increases the debt they take on.  

Quite frankly that surprised us. It goes against the standard logic macroeconomists grow up with.

More research is needed to understand whether the fact that the funds did not flow to businesses is because businesses didn't seem to want the investment, or if banks had preferences against lending to businesses and instead preferred to lend to households. I don't know the answer to that question, but I'm very interested in doing more work on it.

Are there policy solutions to look towards?

There are a number of solutions. 

One possible solution is to have governments invest more. If businesses are not investing, why don't governments take advantage of low lending rates and invest, for instance, in infrastructure? Public investment has never been so low, and it has been falling over the past few decades. That could be one way to substitute for some of the missing private investment. 

Another solution is redistribution, away from richer savers towards less rich spenders. And that is important for several reasons. One is that a heavily indebted population reduces demand.  Whenever an economy generates less demand, central bankers cut their interest rates in order to stimulate the economy as much as they can. Currently, we are at zero percent interest rates, which means that one of the big steering wheels we used to navigate past crises is out the window. We are up against a constraint – we can’t go lower with interest rates than the zero lower bound. That is a major challenge that is coming about from too much borrowing in the bottom rungs of the wealth distribution. 

How do you see the role of debt in the crisis we are in now?

The precise role remains to be seen, but there are already a few indicators as to what the role might be.

So far, household debt seems relatively stable, but since the extra unemployment insurance benefits in the Cares Act have not been extended, it might be the case that households need to begin to borrow more to make ends meet. That will have all of the macroeconomic implications related to debt that we spoke about earlier. So that is something to watch.

I think that the two types of debt that are going to be most affected are corporate debt and government debt.

For corporate debt, one key issue is going to be something called debt overhang. Consider a restaurant in New York City. After the pandemic, the restaurant's debt payments may be two or three times higher than before because the owners had to borrow in order to stay in business. This level of debt can make them less willing or able to invest in new locations.

Even if it is a good investment, most of the revenue would be going towards paying back the debts incurred during the pandemic. 

That's the debt overhang problem, and that will put an additional drag on corporate investment in the coming years. That, I think, is another factor we need to watch.

For government debt, the risk that many economists think about is that there might be a loss in confidence in the dollar as the world’s reserve currency if we don't manage to get deficits under control. I don't think this is a risk that will materialize in the next 10 years. There's still ample room to go before that risk starts to become threatening, but at some point, if there is no sign of willingness to bring deficits under control, it may certainly become a threat. In that case, we would potentially see foreign central banks turning to other assets as opposed to U.S. treasuries, like Chinese or European bonds. But to emphasize, I think this is one is, luckily for us, more of a long term problem.