...against fictions and other tall tales

Friday, 18 March 2011

Was the rise in household indebtedness caused by low interest rates?

One of the most frequently cited explanations for the increased indebtedness in the US prior to the financial crisis has been the easing of monetary policy by the US Federal Reserve following the bursting of the dot.com bubble. Take, for instance, the following comments made by economist John B. Taylor in 2009:
The classic explanation of financial crises is that they are caused by excesses -- frequently monetary excesses -- which lead to a boom and an inevitable bust. This crisis was no different: A housing boom followed by a bust led to defaults, the implosion of mortgages and mortgage-related securities at financial institutions, and resulting financial turmoil. Monetary excesses were the main cause of the boom. The Fed held its target interest rate, especially in 2003-2005, well below known monetary guidelines that say what good policy should be based on historical experience. Keeping interest rates on the track that worked well in the past two decades, rather than keeping rates so low, would have prevented the boom and the bust. (my emphasis)
This explanation makes for a simple, plausible story. However, it completely disregards the fact that the rise in household indebtedness started well before the Fed adopted an easy stance on policy following the bursting of the dot.com bubble. The chart below makes that very clear. As you can see, the level of household financial obligations as a percent of personal disposable income (green line) started its upward trend in the mid-1990s, well before the steady decline in the fed funds rate (blue line) following the 2000-2001 recession.

If anything, it could be argued that the low interest rates actually helped to offset the rising household debt burden and reduce its rate of growth during those years (notice the indebtedness indicator remains fairly stable between 2001 and 2004 when the rate is low). In other words, there is a strong case to be made that, contrary to what mainstream economists have been saying, higher rates would have actually accelerated the increase in the debt burden of households rather than act as a disciplining influence on household spending behavior. Such an outcome would have been much more likely. In fact, this is exactly what occured when the Fed sharply raised its rate starting in 2004 in an attempt to restrict borrowing. As you can see from the chart, the debt burden resumed its upward trajectory following the rate hike. The rise in the debt burden only reversed course once the crisis hit.

A much better explanation for the rise in US household indebtedness is found in this article by economists Reuven Glick and Kevin Lansing of the Federal Reserve Bank of San Francisco. According to Glick and Lansing, it was primarily supply-side factors such as "the greater availability of credit cards and home equity loans, the growth of subprime lending, the spread of exotic mortgage products and other changes that over time served to relax consumer borrowing constraints" rather than low interest rates and other demand-side factors that caused the uptrend in household leverage (p. 3). The authors base their conclusion on the strong correlation between the increase in credit availability and the rise in household debt in the US since the 1960s.*

This explanation appears much more adequate because it enables us to understand why a similar uptrend in household leverage was also noticeable in countries such as Canada where the monetary authorities did not pursue rates as low as the US Fed in the first half of the last decade.

All that being said, the low interest rate environment did present the monetary authorities with a challenge in terms of how best to address the problem of increased household indebtedness. On the one hand, raising interest rates entailed the possibility of increasing the debt burden even more (which is what happened). On the other hand, central bankers' ideological aversion toward regulating the banking industry led to a situation in which the monetary authorities chose to overlook one of the most (if not the most) sensible solution to the problem of rising household indebtedness: establishing more stringent loan standards.

NB: Although they are outside of the direct purview of the monetary authorities, the other policy options available to governments to address the problem of indebtedness in the private sector are to pursue fiscal policy measures aimed at sustaining growth and employment, as well as to make substantial improvement in net export demand (by depreciating the currency or otherwise). For more on these policy options, I recommend the following article by Dimitri Papadimitriou et al: "Is Personal Debt Sustainable", Levy Institute, November 2002.

*The last four paragraphs of this entry were added on March 20, 2011.


  1. Excellent piece. You are right on. I have only one precision: you intimate in your column

    central bankers' ideological aversion toward regulating the banking industry led to a situation in which the monetary authorities chose to overlook one of the most (if not the most) sensible solution to the problem of rising household indebtedness: establishing more stringent loan standards.

    Please refer to the continuing efforts of an insightful, serious and pragmatic public servant against difficult hurdles: Edward Gramlich. A very good mind indeed, and among the best of bankers the Fed has had in the decades since Volker.


  2. Thanks Jorge. You caught me unfairly lumping all central bankers together. Absolutely, Ned Gramlich definitely saw it coming. And there were others as well. Unfortunately, their views did not sit too well with the majority of Fed Board members or, for that matter, with the rest of the economic policy establishment in D.C. at the time.

    In my opinion, Gramlich was victim of the powerful organizational phenomenon known as 'groupthink', the triumph of concurrence and authority over good judgement, common sense and expertise. I'll definitely come back to the idea in a future entry given that it presents such a huge challenge to sensible policymaking, especially in the field of economic policy.

    Robert Shiller was another Fed actor who felt the potency of groupthink. He discussed his experience at the Fed during the run-up to the subprime crisis in the following NYT article: http://www.nytimes.com/2008/11/02/business/02view.html

    A must read for anyone interested in knowing some of the challenges that smart and well-intentioned minds face in the field of public policy.

  3. Very well done. I enjoy your blog. Glad there's a Canadian someone who addresses Canadian issues, and does it very well.