One of the great attractions of studying economics is that it often resembles a mystery novel, a kind of police procedural where science, art, insight and sometimes just dogged persistence are applied to figuring out the how and why of what happened.
Economic mysteries aren’t the same as poli
ce procedurals, of course, since in most cases there isn’t a crime involved. As a result, economic mystery stories are more whatdunnits than whodunnits. Still, economic researchers are very much like detectives, looking for leads and clues about what happened, when, and where — the stuff that we ca
ll circumstantial evidence.
The Federal Reserve Bank of Cleveland recently released a study titled “Household Balance Sheets and the Recovery.” It is a very timely report and also an excellent example of how economic detectives present facts and indicate paths that might lead to answers.
The study has a lot of good information, although not enough to tell us how and when the effects of the recession will subside.
The recession hit household financials particularly hard, and many analysts believe this has slowed down our recovery. Exactly how much it might slow things down isn’t known, so there is an element of mystery in the study. While it makes sense that people’s spending is affected by their balance sheets, it is difficult to integrate that common sense into economic forecasts.
The accounting is straightforward and the math is simple, but balance sheets and income statements enjoy a relationship that is more than just arithmetic. As in many close relationships, one influences the other in ways that are sometimes difficult to understand, let alone predict.
The authors of the study, Timothy Blanco and Filippo Occhino, refer directly to the remaining elements of mystery when they write, “Also, we have documented the differing impacts of household balance sheets in different business cycles, but we haven’t examined the reasons behind those differing impacts.”
Household balance sheets first became a significant economic policy issue in the mid-1930s when, in the depth of the Depression, the classical economic theory of the Real Balance Effect clashed with the Keynesian theory that only government spending could shorten the duration of a recession.
The Real Balance Effect boils down to the relationship between net assets and spending, which is what the Cleveland Fed’s recent study is all about. In classical economic theory, a recession will lower price levels, which makes any assets worth more in terms of what they can buy.
And since households are, in many ways, spending machines — just ask any family raising kids — as their net assets rise in value in terms of what they will buy, eventually they will begin spending again.
A $5 bill in our pocket, for example, doesn’t seem like all that much these days. A cup of coffee and a doughnut would do lethal damage to it. And because the recession made us worried about future, we are less likely to spend it at all.
If a recession caused the prices of coffee and doughnuts to drop 50 percent, though, on a cold, rainy morning that $5 might start to burn a hole in our pocket, especially when we considered that we’d still keep a lot of it in change.
Instead of falling prices of consumer goods, though, this recession started with a precipitous drop in housing values. With the exception of the market price of homes, overall price levels didn’t decline very much at all and seem to be regaining quickly. The “Real Balance Effect” had no chance, then, to encourage spending.
What did change is household leverage, that is the amount of debt compared with the value of its assets. The housing price decline was a body blow to households’ net assets, or equity, which pushed our leverage way up, made us anxious about the future and encouraged us to save, not spend.
What the authors found, additionally, is that we seem to get over unemployment shocks quicker than household balance sheet shocks. And since the household savings rate has now returned to normal, they believe that this recovery may now become more robust that we had originally thought.
What the authors’ study of past recovery trajectories also suggests, although they do not get into the economic policy implications, is that the Bush and Obama administrations’ efforts to bolster the housing market were not wrongheaded, certainly not as ill-conceived as the stimulus program. It was unlikely that an economic recovery would get any traction at all until households brought their balance sheets back to a satisfactory comfort level.
As good as this research report is, of course, it hasn’t solved the mystery of exactly how household balance sheets affect economic recoveries. We’ll just have to tune in for the next episode.
James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Snohomish County Business Journal.
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