Understanding Household Spending with Stocks and Flows

Household expenditure is the largest component of GDP, so understanding why and how it varies is crucial to understanding recessions.

Mainstream economics tends to look to the real interest rate and a household rate of time preference as the central explanation for such variations.  Stock flow models tend to place greater emphasis on the levels of financial stocks. 

The idea here is that household expenditure is driven by a desire to influence various ratios between financial stocks and the level of income.  Stock-flow models often describe certain target ratios, sometimes called stock-flow norms.   Household expenditure is equal to income[1] less the net acquisition of net financial assets.  If we can explain the acquisition and disposal of financial assets and liabilities in terms of a desire to move towards stock-flow norms, then we can explain why household expenditure might vary.

Looking at the UK, it is useful to divide household net financial assets into the following:

1. Pensions and life insurance

2. Other financial assets

3. Debt (i.e. liabilities of households)

The graph below shows the level of each of these relative to household disposal income.

I'll say something about each of these in turn, dealing first with pensions, then debt, then other financial assets.

Pensions

It seems likely that there should be some kind of target ratio between pension assets and income.  On the whole, people want to achieve a balance between what they can spend during their working years and what they can spend in retirement.  This means they have to save a certain amount whilst working to be run down in later life. This process is naturally going to generate a stable stock-flow ratio.

In fact, we don't need to even postulate that people have a given stock-flow ratio in mind.  Much of the time, the amount of pension contributions will be in a fixed relationship to wage levels, and amounts paid as pensions will be related to the stock level of pension funds.  Institutional arrangements including the tax system influence this.  This process will give rise to a stock-flow norm, even if no-one has such a ratio in mind.

If we look at the graph, however, we can see a clear upward trend in the ratio of pension assets to income.  There are various reasons for this.  The most important is rising life expectancy.  This has reduced the amount of pension income that a given stock of pension assets will buy.  Achieving a similar balance between working and retirement consumption therefore means building a greater stock of pension assets during the working lifetime.

The decline in the yields on government securities has a similar effect.  Pension annuities are priced off fixed income yields, so as these have come down, pension funds need to become larger.

The actual size of pension funds is also impacted by the returns on those funds including stock market gains.  So we should expect to see the actual ratio rising when the stock market is doing well.

Debt

The ratio of debt to income shows less fluctuations than the two asset classes, because it is not subject to the sort of variations in value due to market movements.

With debt levels, it also seems likely that that stock-flow ratios are important.  In particular, credit constraints will tend to limit the amount that can be borrowed relative to income.  The growth in debt levels between around 1999 and 2008 reflect a general relaxation of credit criteria. 

Maximum acceptable debt levels are often assessed by comparing the interest expense to income.  The upper bound to the debt to income ratio is therefore likely to be a function of interest rates to some extent.  At the current low level of rates, interest expense is at its lowest level of this period (see chart below), which partly explains why the debt ratio remains high despite tightening credit conditions.

Credit constraints may impose a cap on this stock-flow ratio, but that is not the same as saying this is a target ratio.  It could be that households prefer a debt ratio below that dictated by credit conditions.  However, it seems likely that credit conditions provide the binding constraint in most cases for new borrowers, and this element is a key driver of the stock-flow ratio.

Other Assets

Whilst there are good reasons for thinking that stock-flow considerations play an important role in determining accumulation of pensions and debt, it is less clear in the case of other assets.  Typical stock-flow consistent models tend to assume that there is a target ratio for holdings of other assets, but I'm not sure this is necessarily the case. 

With pensions and debt, we should be able to predict what sort of target ratios we expect to see from a knowledge of things like life patterns, the tax structures, regulatory issues and so on.  No such considerations determine the holding of other assets, so it's quite possible that any target ratio could develop over time, including in response to changes in the actual.

However, looking at the first graph, the ratio of other assets has actually changed the least over time.  Apart from an apparent slight upward trend, two factors appear to drive the variations.

1. As with pensions assets, the level of other financial assets is subject to variations in asset valuations such as stock market movements.

2. The periods of strong growth in debt levels seems to be associated with an increase in holdings of other financial assets.  There are reasons why we might expect this to be the case.  The largest part of debt is for house purchase, and an increase in debt reflects a greater volume of house purchase and/or higher house prices.  This means that those households receiving property sales proceeds and not repaying debt (otherwise overall debt levels are not increasing) are receiving greater windfalls.  This type of cash receipt, does not get spend all at once, if it gets spend at all, and it therefore adds to the accumulation  of deposits, which makes up the largest part of this catergory of assets.

Once these elements are taken into account, it does appear that there is some reversion-to-norm taking place in this stock-flow ratio.  When the actual ratio is increased or decreased by one of these factors, accumulation reacts to bring it back to a more "normal" level.  It is remains an open question, however, how stable this "normal" level is over time.

Conclusion

 

An analysis of household stock-flow ratios provides a useful insight on what drives changes in household spending.  This is particularly so when we apply a certain level of disaggregation, rather than looking at net finacial assets as a single whole.  Often, we can relate the trends to things that we know are going on.  This approach is likely to be more useful than trying to relate spending to variations in the real interest rate.

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[1] Household disposable income is usually calculated after certain pension contributions and pension income.  To align more closely with the theoretical issues, we need here to think about household income before these items.

The Net Internation Investment Position and the Trade Balance

In commenting on tariffs and the trade balance, Paul Krugman states that, in the "simple story", tariffs result in an exchange rate appreciation which leaves the trade balance unchanged. 

A critical point here (which Krugman goes on to explore) is the idea that neither tariffs nor any associated exchange rate appreciation has any impact on capital account flows (or for that matter on the net flow of investment income).  However, the simple story also contains an implicit assumption that the level of output is unchanged.  If instead tariffs are accompanied by an increase in domestic activity, demand for imports may be unchanged and there may be no change in the exchange rate.  It all depends on what else we think might be going on.

What interested me more here though was Krugman's assertion that trade deficits must eventually be replaced by surpluses (and thanks to Matias Vernengo for drawing my attention to this comment).  The idea he is appealing to is that a country cannot have a negative net international investment position (NIIP) that grows indefinitely.

In fact this comes down to an r versus g question.  g here is the rate of growth of the economy.  r is the average rate of return on the NIIP.  If r is less than g, then even with balanced trade, the NIIP will be declining as a percentage of GDP.  No trade surplus is ever needed to correct a negative NIIP.

The thing about r here is that it is an average return and the NIIP is the difference between two larger numbers.  For example the US NIIP of around negative $8 trillion is the difference between assets of $25 trillion and liabilities of $33 trillion.  This means that the average return can vary greatly and can look nothing like a normal asset return.  For example, in the US case, if the return on assets is sufficiently greater than the return on assets liabilities, the average return on the NIIP can easily be negative.

This means that, in cases where the NIIP is small relative to the gross positions, we cannot generally say anything meaningful about r and it is quite possible that a country can run a trade deficit for ever without any need for eventual surpluses.  This is not, of course, the same as saying that a country can run any level of trade deficit for ever.

Trade Measures and the Capital Account

Peter Dorman comments on Mankiew's NYT piece on the trade deficit.  This concerns the extent to which the balance of trade depends on capital flows and what this implies when thinking about the consequences for output and employment.

There are a couple of points worth emphasising here:

1. Measures aimed at improving trade performance will have no impact on the trade balance if capital account flows remain unchanged (also assuming investment income is unchanged).

2. Such measures do not actually need to change the trade balance in order to be effective.

The first point is simply an accounting statement, but it helps highlight some important mechanics.

Net trade flows can only change if capital flows change.  So in order to understand how net trade will respond to trade measures, we have to also understand how capital flows will respond.  The miracle of accounting ensures that every piece of trade will be matched by a financial flow.  But it is not only the item of trade that has to acceptable to the agents involved.  The change in balance sheets also has to be acceptable.

If it is not, something has to give.  This is probably the exchange rate and in the extreme case this would stop the trade item happening by making it no longer attractive.

Now, measures taken to improve trade performance may have consequences which impact on the preferences agents have for financial balances.  The most obvious possibility here is again movements in the exchange rate.  But, in the extreme case, where financial preferences do not respond, there can be no change in the trade balance.

However, this does not mean that trade measures can have no effect unless they change balance sheet preferences.  This brings us to the second point.  The easiest way to show this is to start with some simple identities.  We have net exports (NX) as exports (X) less imports (M):

NX = X -M

and we define the import propensity (m) as imports divided by GDP (Y)

m = M / Y

An elementary re-arrangement gives:

Y = ( X - NX ) / m

This shows that, if our concern is the impact on output and employment, then trade measures can be effective without needing to change the trade balance.  If the trade balance is in fact driven by inelastic flows on the capital account, measures that increase exports or reduce the import propensity can still raise output.

Productivity growth is about what you make, not how much.

In his Autumn Statement speech, the UK chancellor Philip Hammond talked about the UK falling behind in productivity.  He made the comment that "...it takes a German worker 4 days to produce what we make in 5".

Productivity matters because it drives what we earn.  A nation with higher productivity will be able to pay a higher real wage.

The first point to make here is that it is the average that matters.  So, nobody is claiming that for example, that  it takes a British hairdresser 25 minutes to cut one head of hair, when it only takes a German hairdresser 20 minutes.  And the average is what matters for pay.  Hairdressers in rich nations earn more than those in poor, because overall productivity in those nations is higher.  Not because they are quicker at cutting hair.

So, whilst there are some areas where productivity is the same in different nations, there are others where it will be different.  So, maybe in the car industry for example, German workers are producing more cars per day than British workers.

Now, this may be the case.  But on the whole, it is not so much about quantity as quality.  Productivity growth tends to arise not because we learn how to make more off the same stuff with less effort, but because we develop new and better products.  We have better televisions than we had 50 years ago; not simply more of the same old model.

It may not be so much that German workers produce more cars in a given period, than that they produce better cars in that period.  And in practice, being "better" simply means commanding a higher price.  (Productivity is derived from volume measures of output, which have to use estimates for the relative quality of new or improved products.  These estimates are often based on relative price.)

Therefore, what Hammond's comment means is that the output of the average German worker sells for 125% of what the average British worker's output does.  Fixing this comes not making more of the same thing per day, but from making stuff that is in higher demand and sells for more.  Positioning in international trade is a key part of this.

Devaluation and Tariffs

Chris Dillow has a post comparing devaluation and tariffs.  This raises some interesting points but misses what seem to me to be some of the most important distinctions.

First, tariffs raise revenue for the state that levies them.  This transfer from private to public sector represents a form of fiscal tightening with a potentially contractionary impact on demand.  To make a better comparison with the impact of devaluation, it is therefore useful to consider an imposition of tariffs combined with a reduction in general sales tax or value added tax, to the extent that the net tax take is unchanged.

This has the additional benefit that the overall price level for domestic sales is largely unchanged (ignoring any exchange rate movements that might result from the imposition of tariffs).  Prices of imports (or goods with high imported content) rise, but prices of domestically produced goods fall.

This is the key benefit (to the nation that levies them) of tariffs.  A devaluation raises the domestically denominated price of imported goods (generally by some fraction of the change in the exchange rate) and that of those foreign goods that compete with exports.  The rise in import prices not only has a direct impact on the general price level, but firms using domestic inputs are also able to raise their sales prices.  In the absence of any wage adjustment, this produces an immediate reduction in real wages and a drop in the wage share of national income.

What happens thereafter depends on the ability of labour to resist this erosion of the real wage.  If they are able to secure nominal wage increases then this further increases domestic based prices.  If this happens to a great enough extent, it may end up eliminating any impact of the devaluation on real price differences.  In which case, the devaluation no longer has any impact.

This is why tariffs (specifically a general tariff) may work when a devaluation does not.  It facilitates a favourable change in a nation's net export propensity without requiring a reduction in that nation's real wage level. 

In some cases, this may be the only way that particular nation can expand.  The problem is that it doesn't work if every nation imposes tariffs.  So, if some nations have to compete by having low unit labour costs, they might object to the lucky nation that gets to avoid doing so.  Particularly when it is a developed nation, with a relatively high standard of living.

However, nations often respond to a balance of payments constraint, not by devaluing, but by suppressing domestic demand, keeping the economy in a state of underemployment.  This does nobody any good and in such cases, at least in principle, a programme of tariffs may offer an improvement even for those nations that are on the wrong end of them.