Home > Economics, Monetary Policy > [Insert Here] Causes Aggregate Demand Crises

[Insert Here] Causes Aggregate Demand Crises

I’ve got a new theory to try out.  Here it is:

If households accumulate too much wealth, an aggregate demand crisis must inevitably follow.  There is a simple causation: when households become very rich, they slow down their spending.  Because one household’s spending is another’s income, aggregate spending (income) will then subsequently fall.

My theory is perfectly consistent with the UK data, in which the 2008 recession directly followed an unprecedented rise in total household net wealth to £6.8tn in 2007 (Source: ONS Blue Book), a doubling of wealth in just ten years.  If you owned £6.8tn would you carry on working?  No, you’re not stupid.  And UK householders are not stupid either – you don’t get to own £6.8tn of wealth by being stupid.

The recession was not good for UK households, with their total wealth falling by a cool £1tn in 2008.  UK householders were not happy.  By 2009, they had resolved to step up and get back to spending more money so they could build up their wealth again.

By 2011, the recession was long gone, and UK households had built up their total wealth to a staggering £7tn.  Can you guess what happened next?  Yup, that’s right.  Boom.  Another recession.  The data are clear.  If aggregate UK household wealth rises to around £7tn, the people of the UK kick back and stop spending as much.

Yes, that is a pretty silly theory.  But this type of theory is what got me interested in macro.  If you replace “assets” with “debt” in my story… does it make more sense?  Or is it a confusion of correlation with causation?   And if debt in the UK (and US) caused an AD crisis, why is Australia different?  What if debt merely correlates with the level of nominal spending, and does not cause it?

This post is a roundabout way of saying that Nick Rowe’s post on who controls the size of the Sun is one of the most enlightening things I’ve read this year.  If you’ve not read it, I recommend it to you very highly indeed.

Categories: Economics, Monetary Policy
  1. August 24, 2012 at 13:30

    ‘What if debt merely correlates with the level of nominal spending, and does not cause it?’

    As an aggregate causation is probably from spending to debt – with assets in the form of govt bonds and bank loans created as its counterparts. But probably more important is in which sector(s) the debt accumulates, and whether the holders of that debt can repay it or roll it over if expectations are not realised. If they can’t repay that sector’s expansion is then limited; if they can’t roll over there will be balance sheet damage elsewhere.

    If changes to nominal values matter, and they surely do, it’s important not to assume the consequences are reversible.

  2. Bill le Breton
    August 24, 2012 at 15:49

    May I “insert here” the role of early adopters and early sellers of the latest fad-asset in creating inflexion points in AD.

    The astute get into a developing asset bubble earlier than the herd and leave it earlier. But are these not the ‘butterflies’ whose individual wing beats Chaos Theory predicts will produce subsequent violent storms?

    I recall in 2007, astute people getting into cash; deleveraging. Later entrants kept on leveraging. I met some who were getting calls from their bankers very late on asking whether they had a project on the shelf and could use another £50m that the caller needed to place to hit their target.

    These latter types were more ‘established’ with impeccable backgrounds, the kind that the regional Agents of the Bank of England meet in breakfast meetings and on golf courses.

    Earlier entrants are often seen by this ‘establishment’ as spivs. They are also often part of the darker side of the economy or have their origins there. As such they tend to be quicker through the gears and the gearing.

    Had those Agents talked to these ‘guys’ in 2007 they would have known that it was time to be ready to loosen monetary policy to offset the destruction of money that their move into cash was initiating and which would inevitably determine the coming ‘depression in the weather pattern/AD’.

    I realise that this is all very Minsky, but perhaps the idea of the roots of the inflexions in the black economy is more original.

  3. August 24, 2012 at 22:40

    ‘What if debt merely correlates with the level of nominal spending, and does not cause it?’

    The correlation is incredibly tight and debt moves first, which suggests the causation goes from debt to spending.

    That and the underlying mechanics of banking – supported by evidence – that go along with it.

    • August 24, 2012 at 23:59

      UE, neither the tightness of the correlation nor the observable order of outcomes preclude a common cause elsewhere; such as that the expected path of nominal income is what determines both debt and current spending.

      • August 25, 2012 at 11:42

        The invocation of expectations as the primary causal mechanism just seems to lead to an infinite regress. What if I suggested that expectations of future debt burdens were the cause?

        If we have a banking sector in which the creation of credit adds to purchasing power, the Keen(ian?) story seems to have another data point to back it up.

  4. August 25, 2012 at 12:14

    ‘…the expected path of nominal income is what determines both debt and current spending.’

    Bidirectional causation surely? But with many ‘animal spirits’ on the way! At an aggregate level an increased ‘intention to spend’ must precede any increase in aggregate debt. But the former is not an easily observed variable – and the observed sequence will depend on the type of loans. A credit transfer precedes spending. Drawing down of an overdraft is contemporaneous. (This supports UE’s observation.)

    Since an increase in aggregate debt is associated automatically with an increase in aggregate assets, there shouldn’t be any consistent aggregate impact. But if this were out of line with expected income fundamentals, it would be expected to increase fragility and perceived fragility.

    However, as Chris Dillow nicely points out the equal spread of financial wealth ‘is a fantasy of representative agent economics more than of socialists’. At the level of the individual agent their own current level of debt will interact with their own current asset value, and their own income expectations. How this all impacts on the aggregate numbers is probably anyone’s guess.


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