A Cycle to Watch Out For

Greg Hannsgen | February 27, 2012

Perhaps we’re back to our old ways. For many moons, the household savings rate has again been falling, though it is still above the levels reached in the years leading up to the home loan crisis of 2007–2009. There are even some signs of a resurgence of the mortgage-backed securities industry. Could the economy be riding a merry-go-round familiar to students of economic history, as concerns about financial fragility, risky borrowing, and small nest eggs ebb and flow with the headlines of the day?

There is an economic term for this type of historical pattern that has not been prominent in recent debates. In loose terms, an epistemic cycle is an economic cycle of learning, knowing about, or understanding certain issues or facts; for example, the dangers of reckless consumer borrowing. The late Hyman Minsky of our Institute wrote authoritatively about the tendency of financial risk-taking to build up over time in the years following a crisis, as people gradually let their guard down after a fight to save the financial system. Eventually such trends would bring on a crisis and a subsequent return to more cautious behavior, especially on the part of banks and regulators.

This leads to the question of whether policymakers can reduce the danger that risky levels and types of borrowing will return over the coming years, as people begin to put the financial turmoil of the past few years into perspective. Economists of all stripes tend to be pessimistic about such issues, ironically in many cases because of a belief that human behavior is generally rational in one way or another.

One concept that often comes up in discussions of policies for dealing with the aftermath of the crisis is moral hazard, which was the subject of an interesting essay in yesterday’s New York Times. In the context of finance, this is the risk that bankers, borrowers, etc. will not fulfill their responsibilities because they know that losses that they incur will be covered by insurance, bailouts, and the like. As the Times notes, many have argued against further government assistance for the financial industry or for financially stressed homeowners on the grounds that such programs could exacerbate the moral hazard problem, i.e., that people and corporations might take advantage of forgiveness.

But how about policies designed to reduce the frequency of situations in which the government and the people are in the position of having decide whether to forgive? For example, the Dodd-Frank financial legislation of 2010 was intended in part to strengthen rules against conduct and practices that allowed and in some cases encouraged consumers to get too far into debt. The country might do well to use this opportunity to work in advance to discourage people from acting on their more reckless tendencies and impulses when they make financial decisions.

As an example of the issues at stake, many recall concerns about the aggressive marketing of credit cards to students, unrealistically low minimum monthly payments, and the like. The rules involved are among the institutions that have shaped economic behavior, contributing for example to high rates of bankruptcy and low savings rates in the United States compared to other countries.  (“Medical bankruptcies,” and similar phenomena, as well as fraud, are of course also crucial.) The academic literature indicates that rules about consumer lending often have a big impact on borrowing decisions. Some excellent coverage of these issues is available at the Credit Slips blog, and, of course, these Ford-Levy projects have been working on financial re-regulation issues in general. Senior Scholar Ed Wolff documented the seriousness of ongoing problems with the distribution and level of household savings and debt in this working paper last fall.

The details of many of the new rules are still being worked out by various regulatory agencies. (For some recent news on overdraft fee regulation, see this NYT editorial.) Further legislation is inevitable, while, on the other hand, some in Congress seek to repeal Dodd-Frank altogether. This is a key area of policy concern for people worried about macroeconomic and financial stability. Work and discussion along these lines would hopefully be less divisive than emphasizing questions about who should pay the costs associated with the bad loans of, say, 2000 to 2006, when checks on excessive or unwise lending had already become very lax.

Perhaps the cycle of financial folly can be tamed to a great degree with some careful analysis and legislation.

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5 Responses to “A Cycle to Watch Out For”

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  1. Comment by TylerFebruary 27, 2012 at 1:12 pm   Reply

    Can policymakers reduce the danger that risky levels and types of borrowing will return over the coming years, as people begin to put the financial turmoil of the past few years into perspective?

    Yes, by raising interest rates higher than they were in the 1990s, right?

    • Comment by Greg Hannsgen — February 27, 2012 at 3:50 pm   Reply

      I do not think the low rates of recent years have themselves been a leading cause of excessive borrowing. They cannot be said to be responsible for lending that should not have taken place at any conceivable interest rate–for example, certain “payment-option” mortgages that allowed payments to be deferred in the first years after the loan was originated, loans to borrowers who were not required to document their incomes, etc. Raising interest rates instead of preventing such unfortunate practices would only impose unnecessary costs on the business of making sound loans to creditworthy borrowers, unless macroeconomic circumstances call for higher rates. I say this especially because of the need to get the economy, and especially the housing market, moving again. Another issue to keep in mind is that in many cases, borrowers at the retail level pay fairly high interest rates even when the federal funds rate and other Fed-controlled rates are near zero.

  2. Comment by TylerFebruary 28, 2012 at 9:05 am   Reply

    Are we sure that low interest rates get the economy moving again? Interest rates were high in the early 1960s, when John Kennedy got the economy moving again. The probable reason: High rates cause the federal government to pay more interest into the economy.

    • Comment by Greg Hannsgen — February 28, 2012 at 10:32 am   Reply

      The income effect of higher interest rates on government securities is indeed a stimulative one. It may be far more important than some of the effects mentioned in most economics textbooks, such as a general effect on corporate investment. The latter effect has proven to be rather small in most empirical studies. On the other hand, interest rates do have a very important and large impact specifically on the housing market (and often the automobile industry, as well). The housing industry is currently among the most moribund in the U.S. economy, and the auto industry is just getting back on its feet after the recent bailouts. Thus, while interest rates are not always crucial, they are macroeconomically important at the present moment.

      Another point about interest rates is that while interest payments on government debt are net payments from the public sector to the private and foreign sectors, interest on private debt has to be paid by private-sector borrowers, who tend to be less well off than lenders. Hence, high interest payments on such debt tend to redistribute income and wealth toward people with high net worth. This redistributive effect tends to reduce aggregate demand, since those with higher incomes usually save a larger percentage of their incomes.

      On the other hand, as you imply, monetary policy by itself cannot possibly bring strong economic growth or full employment.

      • Comment by TylerFebruary 28, 2012 at 11:56 am   Reply

        We can eliminate the FICA tax and let the Bush tax cuts expire only for incomes over $100k to offset the upward redistributive effect of high interest rates.

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