Expenditure Cascades and Savings

Robert Frank’s notion of “expenditure cascades” has an intuitive appeal — as income climbs at the top, less-affluent individuals are forced into a positional arms race that leads to overspending and indebtedness. Brad Plumer discusses new evidence on “trickle-down consumption” at Wonkblog, and Scott Winship does the same in his new National Affairs essay, “Overstating the Costs of Inequality” (a footnoted version is available here). Winship is somewhat more skeptical, and he raises a number of interesting issues:

Frank’s hypothesis is, however, supported by one additional study, conducted by economists Marianne Bertrand and Adair Morse. Bertrand and Morse find that, within states and over time, higher incomes at the top of the distribution are associated with more bankruptcies and more people saying their financial situation has worsened over the past year throughout the income distribution. Bertrand and Morse also find that, within states, a 10% rise in expenditures by households in the top fifth of the income distribution is associated with increases of 1.3% to 3.6% in expenditures by everyone else, even after accounting for increases in income below the top fifth. (The effect is smaller and not statistically meaningful for poor households.) There is some evidence, however, that part of this phenomenon is caused not by increased financial pressure on the non-rich to “keep up” with the rich, but rather by greater housing wealth and the borrowing against home equity that that increased housing wealth induces. In other words, rising inequality may increase the demand for housing among those at the top of the income scale, in turn boosting the home values of the non-rich, and then leading those newly wealthy home owners to tap into their increased home equity. [Emphasis added]

The underlying problem appears to be that many U.S. households are overleveraged. Requiring larger minimum down payments might help address this problem. Relaxing local land use regulations that restrict the supply of housing would tend to restrain growth in housing prices, as would curtailing the mortgage interest deduction, particularly for high-earners in capacity-constrained regions. These are policies that would be desirable regardless of their impact on “expenditure cascades,” and that would more directly address the problem of overleveraging than measures designed to counteract inequality as such. (It is also worth noting that young adults have been shedding debt in the post-crisis years, according to Pew. This partly reflects the fact that there has been a turn away from homeownership in younger households.)

It is also worth noting the evidence in the paper by Bertrand and Morse indicating that any effect of inequality on overconsumption is primarily about status maintenance. Among the non-rich, spending on housing and home maintenance (including on domestic services) was particularly sensitive to the spending levels of the rich, as was spending on recreation and appearance-focused categories of consumption — including clothing, jewelry, beauty services, and health clubs. Spending on education, on the other hand, was among the least responsive to expenditures at the top, as was spending on transportation.

Neither Frank’s paper nor Bertrand and Morse’s has been peer reviewed and published. Their preliminary findings, however, do suggest one way in which inequality really may affect the poor and middle class: When the rich spend more, spending apparently increases among the non-rich over and above what their income gains would dictate. [Lane] Kenworthy, too, reports that, across countries, rising inequality is associated with declines in savings. But since the incomes of the bottom and middle have increased significantly over time even after adjusting for changes in the cost of living, it is difficult to imagine that this is a story about rising hardship. Moreover, if the story Frank tells about spending is really a tale of status maintenance — as the findings by Bertrand and Morse suggest — it is hard to see how it calls out for an urgent public-policy solution. Even people sympathetic to the idea of a safety net for the poor and a role for the government in promoting mobility are unlikely to see it as the state’s responsibility to save consumers from themselves, discourage thrift, or subsidize people who live beyond their means.

Assuming that we’re dealing with an essentially cultural phenomenon, it seems at least possible that people who have overconsumed relative to income will pursue different strategies in the future, as the Pew findings on young adults suggest. But if, as Frank has suggested in the past, part of the reason middle-income households are overleveraged is because, for example, there is a drive to gain access to “above-average” school districts (which, by definition, are in limited supply), we might also consider facilitating the expansion of high-quality charter school networks and course-level instructional choice, to improve the quality of educational options across metropolitan areas, and not just in affluent pockets. 

We should also consider the possibility that overleveraging in the U.S. has at least as much to do with Chinese policies than with a “Keeping Up with the Joneses” dynamic. Consider Michael Pettis’s recent column on “The Saver’s Dilemma,” in which he offers the following explanation for differences in consumption rates across countries:

First and foremost is the share of national income that households retain. In countries like the United States, where households keep a large share of what they produce, consumption rates tend to be high relative to GDP. In countries like China and Germany, however, where businesses and the government retain a disproportionate share, household consumption rates may be correspondingly low.

The second factor is income inequality. As people become richer, their consumption grows more slowly than their wealth. As inequality rises, consumption rates generally drop and savings rates generally rise.

Note that despite high income inequality in the U.S., savings rates have been quite low in recent decades. But of course the question is whether they have been higher than they might have otherwise been in the absence of the increase in income inequality. 

Finally, there is households’ willingness to borrow to increase consumption, which is usually driven by perceptions about trends in household wealth. In Spain, for example, as the value of stocks, bonds, and real estate soared prior to 2008, Spaniards took advantage of their growing wealth to borrow to increase consumption.

This is obviously part of the U.S. story as well.

But this is not the whole story. Consumption rates can also be driven by foreign policies that affect these three factors. For example, an agreement in the late 1990’s among the German government, corporations, and labor unions, which was aimed at generating domestic employment by restraining the wage share of GDP, automatically forced up the country’s savings rate. Germany’s large trade deficits in the decade before 2000 subsequently swung to large surpluses, which were balanced by corresponding deficits in countries like Spain.

As Spain’s tradable-goods sector contracted in response to the expansion in Germany, it could respond in one of only three ways. First, Spain could refuse to accept the trade deficits, either by implementing protectionist measures or by devaluing its currency. Second, it could absorb excess German savings by letting unemployment rise as local manufacturers fired workers (because rising unemployment forces down the savings rate). Finally, Spaniards could borrow excess German savings and increase consumption and investment. [Emphasis added]

Replace “Germany” and “Spain” with “China” and “the United States” and a somewhat (we do have our own currency) familiar picture emerges. The increase in U.S. borrowing was in part a function of Chinese policies that repressed domestic consumption, subsidized capital investment, and generated substantial trade surpluses. And in turn, U.S. borrowing contributed to a housing boom that temporarily masked a dramatic employment decline in the tradable-goods sector for much of the 2000s. 

Pettis’s story is not incompatible with Bertrand and Morse’s story, but it does suggest a different policy emphasis:

Low-savings countries cannot easily adjust without an equivalent adjustment in high-savings countries, because their low savings rates may have been caused by high savings abroad. After all, savings and investment must be in balance globally, and if policy distortions cause savings in one country to rise faster than investment, the reverse must occur elsewhere in the world.

But emphasizing the importance of global rebalancing doesn’t have a clear moral valence, and so we do it less often than we should. 

Reihan Salam — Reihan Salam is executive editor of National Review and a National Review Institute policy fellow.

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