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Overspent?

By Karl Smith

This post from Alison Schrager is beautiful in that its opening paragraph is so absolutely and perfectly wrong.


AMERICANS, to a large extent, have only themselves to blame for the state of the economy. They consumed a lot that they did not want to or could not pay for. Cheap capital from abroad and easy mortgages fueled veracious consumption habits. Americans can blame China or Wall Street for offering loose credit in the first place. But in the end they, too, played a role. If anything undermines America’s economic future, it is the belief that its residents are entitled to more than they can afford.

There are few ways to explain this but perhaps this is the most clear and obvious: When people try to buy too much the market responds by raising prices and forcing them to buy less. There are various prices that are relevant in Schrager’s analysis: mortgage rates, the consumer price index, the price of imports and conversely the value of the dollar.

At the peak of this crisis, every single one of those prices was falling. Mortgage rates were falling. Government interest rates were falling. Foreigners were desperate to lend us more money, not less. The dollar was rising and hence our foreign purchasing power was increasing. The consumer price index was declining, not spiraling out of control.

Most importantly, American-made goods were piling up in warehouses and on car lots. We were producing more than people were willing to buy. Could we really be living beyond our means when our factories were pumping out more cars than we were taking home? Were we living beyond our means when our construction workers were building more houses than we were living in?

How can you be over-consuming when people are being laid off because there is so much stuff sitting around that no one is going to consume? In short, over-consuming should mean that we run out of stuff, not that we have too much.

The confusion arises because Shrager is thinking in terms of money. For a household, the amount of money it takes in is a fair proxy for how much it produces, and the amount of money it lays out it is a fair proxy for how much it consumes. Thus a shortage of money means that you have consumed more than you produced.

Countries, however, don’t work this way.

In a country, when one person spends money, another person receives it. In a country, when one person borrows, another person lends. In a country, when one person consumes, another person produces.

The observation that we “ran out” of money is correct. However, for a country, that means that the central bank – in our case the Federal Reserve -- isn’t printing enough. Once we realize that, the circle squares.

Now, it should make sense that inflation would fall, because inflation rises when the Federal Reserve prints a lot of money. It should also make sense that the dollar would rise, because the dollar falls when the Federal Reserve prints a lot of money.

A lack of money was the problem, but for a country, that doesn’t mean overspending, it means underprinting.

Note, I am not suggesting that the Federal Reserve actively caused the crisis. In a later post, hopefully, I can get to how the banking system creates private money and how a collapse of some major banks meant that hundreds of billions of dollars in privately created money was destroyed in a matter of weeks.

Karl Smith is an assistant professor of economics and government at the University of North Carolina and a blogger at ModeledBehavior.com.

By Karl Smith  | November 4, 2010; 3:05 PM ET
Categories:  Economics, Economy, Federal Reserve, Financial Crisis  
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Comments

I hope you will develop this further, as you promise, because it's not easy to follow.

What do you mean by "at the peak of crisis?"

Posted by: Hopeful9 | November 4, 2010 3:20 PM | Report abuse

Im not sure that your post is explaining this very well, most people will be adverse to the idea that the feds should just print more money.
When I read the clipped paragaph it seemed to me that he was talking about the run up to the crisis and not during the crisis. Before the crash is when people drunk on cheap money and refinancing spend more then they had...
Any thoughts???
TJP

Posted by: tjproferes | November 4, 2010 3:25 PM | Report abuse

"easy mortgages fueled veracious consumption habits"

I find this hard to believe given the American public's general distaste for the truth.

I don't think you can refute Schrager's argument by citing figures during the crisis. He is obviously talking about before the crisis. You know the period where Americans had a negative savings rate?

However, that doesn't mean I agree with him. I don't see how it is the borrower's responsibility to not take bad loans. Why search for another suspect when we already have the culprit (the banks)?

Posted by: awcarr | November 4, 2010 3:27 PM | Report abuse

Schrager said:
"They consumed a lot that they did not want to or could not pay for. Cheap capital from abroad and easy mortgages fueled veracious consumption habits."

Karl said:
"At the peak of this crisis, every single one of those prices was falling. Mortgage rates were falling. Government interest rates were falling."

I think Karl misses the point. So what if RATES were falling. RATES do not equal the PRICE people were paying. Let me illustrate....

The problem were ARM's. More specifically, ARM's with severe jumps in rates. A person making $50,000 a year would buy a $250,000 house, and finance 95%-100% of the purchase price with an ARM sporting an initial rate of, say, 2.9%. Monthly payment...let's say $1,200/mo.

So even though overall rates were 'falling', two years later this poor sap saw their 2.9% teaser rate jump to 7%. The monthly payment suddenly went from $1,200 to $1,500. The person still only made $50,000/yr, and whaddya-know...all a sudden they had a hard time making their payment! Six-to-twelve months later, here comes foreclosure...

There's two conclusions here
1) RISING prices (i.e., effective rates paid by borrowers, regardless of macro-economic rates) were a major player in the foreclosure crisis.
2) if a $400-$500 increase in monthly expenses meant losing your house, then Schrager is right: many were consuming things THAT WERE MORE EXPENSIVE THAN WHAT THEY COULD PAY FOR.

Posted by: dbw1 | November 4, 2010 3:39 PM | Report abuse

Say you visit a car showroom today. The car you want has a sticker price of $25,000. But good news...the salesman says they are offering a $5,000 rebate, so the car would cost $20,000.

You go home to think about it, and next day you go back to buy the car. When you walk in you see the sticker price now shows $24,000. You are excited that the 'price' has dropped. But the salesman says there is no longer any rebate available.

Question: has the price of the car increased, or decreased, since yesterday?

Apparantly Karl Smith would say the price has decreased, even though anyone with common-sense and sans an economics degree would know that the effective price is higher.

Posted by: dbw1 | November 4, 2010 3:46 PM | Report abuse

I'm fairly neutral on this debate.

A lot of people don't accept the idea that our ecnoomy is now based on consumption rather than production. We are in some ways trying to turn that around by throwing our currency down the toilet and pushing exports. However for that to be fully succesful, would require that other leading nations, not notice, and do nothing about their own currencies.

On the brighter side, if you have been buying commodities on the dips, you are very, very, happy indeed today as the dollar sails away and oil hits $86.69

Posted by: 54465446 | November 4, 2010 4:03 PM | Report abuse

I'm still scratching my head over whether Karl just didn't understand what Schrager was saying, or if he's on the bandwagon of leftists who continue in their attempt to exempt people from personal responsibility.

See, in the old days people were taught to think for themselves. You would take your last paycheck, figure out what that translated to in "income" for each month, and write that number at the top of a page. You would then list your monthly bills...utility, car payment, cable, insurance, daycare, groceries.....whatever was left, you knew you needed to save some of it, and the rest was what you could afford for 'housing'. If you didn't have enough money saved to buy a house, you rented.

The problem came about when we started walking into banks with nothing more than our W-2's in hand, and asked the banker how big a loan we could get...and then bought the biggest house the bank would give us.

Now, you can blame the banks for that (a good Fannie/Freddie analysis is in order, though...), but myself and Schrager tend to put the first layer of fault on the individual. I don't expect people to know the intricacies of monetary policy and currency fluctuations. But I do expect people to be able to do simple addition and subtraction.

But as I've found with most progressives like Ezra, simple math is not their forte...

Posted by: dbw1 | November 4, 2010 4:13 PM | Report abuse

Dbw1 I am a leftist?

Moreover, what you are pointing out is why some particular people faced a crisis where they were over extended.

That does not explain why the whole US economy and indeed the world, went into recession.

If they were making payments weren't they making them to SOMEONE.

Even if person X couldn't afford to buy anymore, shouldn't his payment's to person Y have made person Y able to buy even more.


This is why its critical that a country is not simply a giant household.

Posted by: karlsmith | November 4, 2010 4:37 PM | Report abuse

One other factor that neither Karl Smith nor Alison Schrager mentions that played a huge role in the collapse of the economy was the loans that banks were giving out.

They were selling a bad product that they knew was a bad product and the collapse of the big banks was the catalyst for the recession. Without all of the junk mortgages, we have a regular recession because of the things Mr. Smith mentions. Mr. Smith explains the why we ended up giving loans to GM and Chrysler but not the TARP. The issues resulting in the TARP were the real cause behind our economic issues not overspending.

Posted by: furrinersblogspot | November 4, 2010 5:21 PM | Report abuse

I feel like Karl and Allison are talking about different points here. Allison is looking more at the individual, Karl is looking at the country as a whole. Both are right.

Reading Allison's whole blog, I have to agree with her point: Americans aren't taking any responsibility for what happened, or showing any willingness to learn. They bought houses they couldn't afford, cars they couldn't afford, dinners they couldn't afford, and put it all on a credit card they didn't pay off. And now, they are blaming all of this on Obama, or Wall Street, or the Fed, or Republicans, or Democrats. They have never looked at their own role (greed, irresponsibility) in the economic collapse. It is true for entitlements, as well. Americans don't want higher taxes, and they want to balance the budget, but they don't want to cut Medicare or Social Security. Which obviously is a logical impossibility. They want, want, want but don't want to give. There will be a day of reckoning for this, no matter who is in the White House, or what the Fed does. A person can't spend more than he/she makes, and Americans realize that, the economy will be endlessly boom/bust.

Karl is making more of a monetary argument - Sure, when people are spending or charging, someone is making that money. And eventually, products went unpurchased when demand went down. But I don't agree that price had any affect - Yes, when people buy, price goes up. But look at what happened in this crisis: Housing prices were way too high, but people were still buying, because credit was so cheaply and readily available. You could be a busboy and get the money for an $800,000 house .. so at that point, "price" is a relative term. It didn't affect anyone's habits for the very reason Allison is saying - Americans never admitted or accepted they couldn't really afford anything on earth, no matter how expensive. The problem is, this thinking hasn't gone away - And as long as Americans continue to blame everyone but themselves, I don't see how the economy will ever be on solid footing again.

Posted by: workmonkey | November 4, 2010 5:22 PM | Report abuse

In addition the continued economic troubles are a result of consumer confidence. Businesses have plenty of money to spend to hire new people to make new products but they won't do that until people start buying the products.

Long term debt is offset by inflation unfortunately the lack of consumer confidence has also had the effect of drying up inflation which compounds the problem.

Posted by: furrinersblogspot | November 4, 2010 5:28 PM | Report abuse

"Even if person X couldn't afford to buy anymore, shouldn't his payment's to person Y have made person Y able to buy even more."

Here is how I see it:

Easy credit increases the demand for homes. Prices rise, particularly in areas without a lot of available space for new homes. Of course, construction also ramps up on increased demand.

Since homes are part consumption and part investment goods, rising prices don't have the same disincentive effect as they do on, say, apples or Ford F-150s.

The ability to buy more house than you can afford, and then refinance after the home appreciates later, gets people who can't afford homes into the market. Investors are lured in too. These new entrants increase the demand for homes, further driving construction/sales/prices.

Construction all the while is driving other activity related to it - furniture stores, retail (Lowes, Home Depots especially, but also other strip mall & big box stores and sales at them), not to mention business for real estate agents, banks, law firms, etc. Patterns of trade develop based on the housing boom.

At some point, the pool of new investors/homeowners is tapped out, and prices cease their parabolic rise. This has the secondary effect of blowing up some of the people who either couldn't afford their house or who bought with ARM products. Prices start to fall.

At the end of the day, we produced too many houses. New home production needed to fall, and its not going to return to the 2005/2006 peak for a long, long time. Overall home sales fell too, and won't return to peak levels for a long, long time.

All that activity based on elevated levels of homebuilding/sales is now no longer needed, and won't be needed for a long time. Furniture stores close, best buy sees lower sales, real estate agents go bust, lawyers are laid off.

As real estate prices fall, people realize that their wealth hadn't gone up as they thought (after all, their real wealth was unchanged - the real wealth was the house itself, not the dollar price on it). Feeling less wealthy, and seeing some of the damage set in, they cut back.

This all is exacerbated by the financial crisis (level of perceived wealth lower, reduced access to credit, psychological shock, lower sales).

Increasing demand can do something to offset part of this, particularly the secondary nominal shock.

However, no amount of demand boosting we can comtemplate will lift home production back to 2005 levels. Likewise, the parts of the economy structured to meet that demand need to downsize to more appropriate levels. Some real estate agents, lawyers, construction workers, etc are going to have to find new lines of work - specialized work they haven't trained for and have no experience in.

To the extent disinflation has accidentally increased real wages, and the decline nominal demand reduced sales below trend, more demand can in theory help. But it is only a partial solution.

Posted by: justin84 | November 4, 2010 6:40 PM | Report abuse

The author, after presenting an X-Y scenario, writes that "This is why its critical that a country is not simply a giant household."

I'm really looking forward to see that conclusion supported by logic. X's and Y's are fun and those two variables, without others, should be enough to prove or disprove the conclusion.

Some might argue that a democratic economy must be a giant household, except when it trades with other giant households. In fact, some might even argue (and be able to prove) that a government which does not behave as a giant household will fail in a demonstrable, repeatable manner.

Posted by: rmgregory | November 4, 2010 7:05 PM | Report abuse

Wow, this is one of the stupidest columns ever. Schrager's quote is 100% on the money. Smith makes awful logical errors. It's truly a grade school rationalization.

"How can you be over-consuming when people are being laid off because there is so much stuff sitting around that no one is going to consume? "
Because you were investing (in housing) on the margin, and then the price dropped and you can't sell the asset because you can't pay back the principal.

This Smith guy has really confused himself.

Posted by: staticvars | November 4, 2010 11:04 PM | Report abuse

"Countries, however, don’t work this way.

In a country, when one person spends money, another person receives it. In a country, when one person borrows, another person lends. In a country, when one person consumes, another person produces.

The observation that we “ran out” of money is correct. However, for a country, that means that the central bank – in our case the Federal Reserve -- isn’t printing enough. Once we realize that, the circle squares. "

I see a huge gap in this argument. In a market, not just a country, one person spends money and the other receives it. Those in China saved and produced, and those in America spent and consumed. It is clear that the money that Americans spent in the 90s and 2000s did not stay in the country. What is the responsibility of one country's central bank in a global market?

Also, A.S. is Allison Schrager (correct spelling) and is a "she," not a "he."

Posted by: christinemccorkle | November 5, 2010 9:32 AM | Report abuse

Americans bought houses, cars, etc... at a time when they were gainfully employed. They applied for loans and were told by lenders that their income was sufficient to support the debt. They believed the lenders.

What the people are guilty of is not knowing that in the future they would lose their jobs. The people did not know that in the future their income would not match their debt.

The people are also guilty of not predicting the crash of the real estate market. The people believed that if they lost their wages they could always sell their house. They didn't know they would be unable to sell their home to reduce their debt.

Hindsight is 20-20 and now it's fairly easy to convince ourselves that the problem is as simple as the people purchased beyond their means. At the time of purchase they actually did purchase within their means. What changed was really "the means" to pay. When jobs were lost they lost wages. When they lost wages and couldn't sell their home they were buried in debt.

So, in all fairness it's a bit harsh to call this a case of greed on the part of the people. The truth is people were simply trying to make a living, provide a home for their families based on the income they had from their employment at the time and they did this with the assurance of the lender that they were acting within their means. Most people genuinely believed that they would not receive a loan or mortgage if they did not qualify financially.

Posted by: deborahjbrown | November 5, 2010 11:16 AM | Report abuse

I agree that the difference between a country and a household needs to be illuminated, however, even if we treat them as much the same, there are ways to make sense of deficit spending, at least if the tool is borrowing rather than strictly printing money. If you lose your job and your whole area of expertise becomes useless, who will you are stupid to borrow money to learn a new career, or to get a car so you can go further to a more distant job.

While it takes judgement, and judgement isn't infallible, spending borrowed money to create a new opportunity for making money can't be dismissed out of hand. A good example would be the cancelled rail tunnel between NJ and NY. If anything like to projections of doubling mass transit capacity between NJ and NY is true, the cancellation wrong if not downright crazy. It means fewer people working NY jobs will live in the NY suburbs. It may well mean a smaller work force for the whole region, and many NY jobs going to London or elsewhere.

I've said more about this at http://eisenhowersocialist.blogspot.com/2010/10/what-is-stimulus-or-keynesian-economics.html

P.S. someone in this discussion said "I don't see how it is the borrower's responsibility to not take bad loans."

I can't agree with this, but it is also the bank's responsibility. One way we confuse ourselves when thinking about responsibility is to see it as "either/or" or zero-sum. Also, people used to see the lender as having interests somewhat aligned with the borrower. When that becomes drastically wrong, I believe it is time for some sort of action. Does "buyer beware" have to apply in every area? No, there are some relationships where it is accepted that the person you deal with is either on your side, as advertised, or acting unethically. Lawyers, stock brokers, doctors all come to mind. 12 years ago that was said to be true of mortgage brokers, and I went to one and was not disappointed. Obviously many people had a different experience.

Posted by: HalMorris | November 5, 2010 12:15 PM | Report abuse

I believe there's a second flaw in this argument -- in our current economy, anybody can put money into circulation or take it out. There is the money that the Federal Reserve puts into circulation, but anybody who has a few dollars can put it into a bank account, which pays negligible interest and isn't actively used to make loans. This takes the money out of circulation as certainly as burning the paper. Similarly, buying on credit is a form of creation since the money to pay the bill doesn't exist yet. It may come out of the bank account, which in effect balances the removal, but in many cases credit is a way of spending money that won't be available until some time in the future. Thisn is a form of increasing the current money supply without going through the printing presses.

Posted by: su10 | November 5, 2010 1:04 PM | Report abuse

Can we all just agree that the taxpayer, through Fannie, Freddie and Ginnie should not be buying 3.5% down mortgages? Still. As they are today? Or do you believe that the market couldn't drop 5%? (...thus making a short sale condition when people have to move or sell because of job loss or change.)

"but anybody who has a few dollars can put it into a bank account, which pays negligible interest and isn't actively used to make loans."

You mean you keep lots of extra cash in a checking account? A savings account is used to make loans.

Credit is a key bubble ingredient, getting the amount right is key, and the Fed did an awful job of this in the Bush years (in hindsight).

Posted by: staticvars | November 5, 2010 1:52 PM | Report abuse

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