Scott Sumner produced an excellent blog post on Piketty recently. It begins by quoting Piketty:
‘In my view, there is absolutely no doubt that the increase of inequality in United States contributed to the nation’s financial instability. The reason is simple: one consequence of increasing inequality was virtual stagnation of the purchasing power of the lower and middle classes in the United States, which inevitably made it more likely that modest households would take on debt.’
Sumner’s blog really should be read in full as it reveals other factual inaccuracies in Piketty’s book that are then used as the basis for his economic judgements. Those factual inaccuracies all seem to suggest a particular set of political prejudices that then colour normative judgements.
For reasons Sumner identifies, the quotation above is an extraordinary statement from an economist. It should be noted that Piketty says ‘there is absolutely no doubt’ that the trends he described contributed to the crash. Yet we would, as Sumner points out, expect the opposite trend in debt and savings if incomes stagnate. If real incomes stop rising after a period of strong growth, and are expected to be flat in the future, according to the permanent income hypothesis we would expect saving to rise. A previously lower level of saving predicated upon expectations of rising incomes would no longer be justified.
Of course, left-leaning economists keep telling us that people do not behave rationally all the time – though they should be careful not to assume that people necessarily behave irrationally all the time. And, interestingly, on this side of the Atlantic, things were rather different.
In Britain, inequality fell. Whilst in the US, there was a rise in the Gini coefficient from 0.35 to 0.38 between 1990 and 2010, in the UK there was a small fall in the Gini coefficient from 0.35 to 0.34. In the UK, not only were the incomes of the poor rising relative to those of the rich, there was good reason for individuals to expect high future economic growth in general (even if many economists were sceptical). Average annual growth was nearly 2.5 per cent from 2000-2008 and Gordon Brown famously raised the official estimate of the sustainable growth rate.
But, despite these very different circumstances, the outcome was the same. In both the UK and the US, the savings ratio fell by about two-thirds. Looking at the data over other periods makes no difference to the conclusion about income growth, savings or inequality. Indeed, there were discussions at Shadow Monetary Policy meetings around 2007 about whether the low savings rate was a concern or whether it was a natural reaction to expectations of higher income growth in accordance with permanent income hypothesis.
There is no shortage of potential alternative explanations for the rise in household borrowing in both the UK and the US. Four that immediately come to mind are:
1. The rise in house prices led households’ net wealth to increase so they believed they could borrow more or save less.
2. As mentioned by Sumner, the large rise in savings in Asia lowered world real interest rates and therefore lowered savings elsewhere.
3. As Austrian business cycle theory would suggest, loose monetary policy led to low costs of borrowing and reduced saving and/or increased borrowing.
4. There was moral hazard prevailing right through the financial system in the US which artificially reduced the risks to both borrowers and lenders.
It has to be said, that the similar experience of the US and UK in relation to debt and saving in the face of completely different experiences of income and inequality data do not provide a very firm basis for Piketty being ‘absolutely certain’ that inequality contributed to the crash. If Piketty were not a respected economist, one might assume that he held a prior left-leaning view around which he is trying (not very successfully) to fit to the evidence.
A further comment on this issue has come from Frances Coppola, and her points do need to be addressed. She suggested – in elaborating on Piketty’s own explanation and attacking Sumner - that the increase in inequality in the US led to a large pool of private savings held by the rich and by corporate entities that was then used to fund borrowing by those whose incomes had stagnated. Coppola argues that, in boom times, savers prefer not to buy real assets but to lend more to individuals because they become less risk averse and individuals pay higher interest rates. However, this does not address the fundamental point. If a rich individual is lending to a poorer individual, that poorer individual must want to borrow. But, why would poor individual wish to borrow if his income is not expected to increase? And why were the savings of the rich not invested abroad? Coppola argues that Piketty (and Coppola) are taking a sector balance approach to the problem rather than focusing on individual behaviour. But to take such an approach is not economics: sector balances are not handed down from heaven but depend on individual behaviour (and the behaviour of the government and the corporate sector). Coppola argues that the excess savings of the rich had to be invested at home because the US had a trade deficit and therefore could not be a net accumulator of overseas assets. However, the trade deficit is a function of the supply of and demand for goods, services and capital and, if the supply of US capital to overseas borrowers increases, the exchange rate will fall and the balance of trade adjust in the other direction. The US trade deficit is not some kind of fixed constant around which everything else must vary.
For all the problems of the neo-classical/new-Keynesian synthesis, old-fashioned hydraulic Keynesianism, which simply takes economic variables as given when the causes of changes in those variables are the very subject of economic science, is no replacement.
Update: Scott Sumner responds to Philip Booth's post here.