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FOMC meeting. Photo credit: Wikipedia
On June 17, the US announced further sanctions against Russia because of its support for rebels in the Ukrainian civil war. The new sanctions are widely considered to be tough. But they are also difficult to understand. The extent of their legal and practical application is by no means clear. Yet – they are very clever. However they are interpreted, they are bad news for Russia.Find out here how they should be interpreted and why they amount to financial warfare.
Falling interest rates give households the impression that they are better-off than they really are, because debt becomes more affordable. This is particularly true when there are variable interest rates. So they will borrow more even if their incomes are stagnating, because the debt is more affordable.
I don't find this a rational explanation. In fact I find it astonishing that the same people who think that temporary tax cuts are pointless because of Ricardian equivalence also think that cutting interest rates in the aftermath of a negative shock encourages higher borrowing. People are just as capable of understanding that interest rates can rise as they are of understanding that tax cuts can be reversed. And for this reason, I don't buy the frequently-used argument that household borrowing increased because of pressure from lenders or Wall Street, either. Household borrowing is a decision. In economics we assume that people make rational decisions. If households didn't perceive borrowing as being in their best interests, they wouldn't have borrowed.
So low interest rates alone won't do as an explanation. But they might be an amplifier for other effects.2. Individual expectation of higher incomes.
Booth asks: "Why would a poor individual wish to borrow if his income is not expected to increase?" But the fact that incomes were actually stagnating at that time says nothing about people's expectations. Individuals below the age of 50 tend to believe that their future income will be higher than their present one. This is a reasonable expectation, particularly for men: the incomes of prime working-age men do tend to rise as they acquire skills and experience. The picture is much less clear for women, many of whom drop down to lower income levels when they have children. Over-50s, too, tend to have declining income. And as we know - and Booth concedes - US income inequality did in fact rise during this period. So what the data actually tell us is that increasing income for some was balanced by falling income for others. The data do NOT tell us that individual incomes were stagnating, still less that individual incomes were expected to stagnate.
For individuals to borrow in expectation of future income rises is clearly rational, even if incomes in aggregate are stagnating. Indeed, it was rational for people to believe that as growth improved, so would their incomes. The problem, of course, is that for many people their rational expectations of better jobs and higher incomes have been dashed by the reality of techological change, offshoring, and since the crisis recession, stagnation and unemployment.3. Wealth effects.
Most household borrowing is against property. When house prices rise, households' net worth rises, they "feel" wealthier and are therefore more willing to borrow.
Prior to the financial crisis, there had been no housing market correction in the US since the 1930s: households had no reason to believe that house prices might fall, especially as the Fed was giving the impression that it had monetary policy sorted and there would never be another crash. It is hardly surprising that they were willing to leverage their rising net worth. Nor is it surprising that lenders were willing to help them do this: lenders also believed that house prices would never fall, or if they did, the Fed would bail everyone out. Wealth effects don't just apply to households.4. Government.
After the 9/11 shock, George Bush and others exhorted the American people to borrow and spend, claiming it was their "patriotic duty" to do so. Being a cynical Brit, I find it hard to believe that people would borrow and spend more simply because the President told them to do so. But I guess it is possible - not least because people are far more likely to do what a Government says if they think it helps the war effort. As a direct response to 9/11, the US invaded Afghanistan and later Iraq. Had there not been high household borrowing and a consumption boom during this period, the US government's borrowing would have been far higher. We could say that the tax revenue generated from the consumption boom went to finance the War on Terror.So there are four reasons why households might have chosen to borrow and spend - some more rational than others. But their decisions should be placed in the context of the decisions of two other groups in the US: the corporate sector, and the government.
"So we don't understand the causes of inflation, we don't agree about what we mean by inflation and we have no reliable means of measuring it. Yet we are absolutely terrified of it. And we want government (via its central bank) to make sure that inflation NEVER HAPPENS. How very dare government rob us of our precious savings by means of inflation!
Underlying this statement, and indeed all statements about the control of inflation, is a powerful and fundamentally irrational belief. Inflation can be prevented by government. Therefore, if inflation happens, it is because government has allowed it to. Inflation is therefore always and everywhere a POLITICAL phenomenon."