Brookings: Experts - Karen Dynan

Better Ways to Promote Saving through the Tax System

Karen Dynan — Tue, 26 Feb 2013 08:00:00 -0500

In this policy proposal — part of The Hamilton Project's 15 Ways to Rethink the Federal Budget — Karen Dynan examines the design of government incentives for personal savings, outlining how reforms to these programs would improve saving and economic security for low-income households and reduce expensive and ineffective federal subsidies for high-income households.

IMPACT

Deficit Reduction (10-year): $40 billion

Broader Benefits: Improves saving and economic security for low-income households; reduces expensive and ineffective federal subsidies for high-income households.

INTRODUCTION

The U.S. personal saving rate has declined dramatically over the past several decades and is currently very low by historical standards. Americans saved about 4 percent of after-tax personal income in 2012, down from average saving rates of 5.5 percent in the 1990s, 8.6 percent in the 1980s, and 9.6 percent in the 1970s (figure 6-1).

Increasing personal saving in the United States is a desirable policy goal. To be sure, over the near future there would be a downside to households saving more because that means they would be spending less, and, in turn, the economic recovery would not be as strong as it otherwise would be. But, over the longer run, higher personal saving would lead to stronger economic growth. The correlation between a country’s saving rate and its investment rate remains large and significant despite the globalization of international capital markets (Obstfeld and Rogoff, 2000). Hence, higher personal saving in the United States should increase investment in this country, which, in turn, should raise our capital stock and our productive capacity.

In addition to promoting higher personal saving in the aggregate, policy also should encourage higher saving among individual households. Households need savings in order to cope with unforeseen disruptions to their income and unanticipated consumption needs. Having such reserves is even more important now than it was in the past because household income volatility has trended upward amid ever-more-competitive and dynamic labor markets: recent research has found that the share of households experiencing a 50 percent plunge in income over a two-year period climbed from about 7 percent in 1971 to 10 percent in 2008 (Dynan, Elmendorf, and Sichel 2012). Moreover, as policymakers look for ways to reduce growing budget deficits, they may cut social programs so that the need for households to have precautionary reserves may be even higher in the future.

Saving also provides households with opportunities. Funds accumulated through saving can be used to pay for college tuition and to purchase big-ticket items such as cars and homes. Saving is likely even more important to attaining homeownership than it was in the past, given the greatly reduced availability of low-down-payment mortgages in the wake of the recent mortgage crisis. In addition, saving puts some households in a better position to establish businesses.

Finally, higher saving is important to households because it means that they will enjoy a better standard of living in retirement. Although most people can expect to receive social security benefits when older and many will receive regular payouts from defined benefit pensions, these sources of income are generally not sufficient to make up for the step down in earnings that occurs at retirement. As a result, many older households will need to supplement pension income with accumulated wealth if they wish to maintain the consumption levels they had when younger. Encouraging adequate retirement savings among lower-income households is particularly important given the available evidence suggesting that these households are much more likely than other households to experience a material drop in their consumption at retirement (Hurst 2008). The possibility of austerity-driven cuts to programs that help older Americans makes the issue even more pressing.

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Authors

Karen Dynan

Publication: The Hamilton Project

Want a Stronger Economic Recovery? Encourage More Home Refinancing

Karen Dynan — Wed, 20 Feb 2013 13:53:00 -0500

In last week’s State of the Union address, President Obama urged Congress to pass legislation that would help more homeowners refinance. Much of the policy focus in this area has been on proposals that would modify the government’s Home Affordable Refinance Program, which helps borrowers with loans insured by Fannie Mae or Freddie Mac. However, other proposals would go further, such as one that is reportedly being developed to facilitate the refinancing of mortgage loans that are not backed by the government.

Finding ways to encourage refinancing is good policy. The Federal Reserve has done its part: Its asset purchase programs have helped to lower long-term interest rates to historically low levels. The interest rate on new 30-year fixed-rate mortgages is now around 3.5 percent, down from more than 6 percent prior to the financial crisis. Yet, many homeowners appear to have been blocked from refinancing into lower-rate mortgages. Indeed, data from the Commerce Department suggest that the average home mortgage has an interest rate of around 5 percent right now—much higher than the rate available on new loans.

One reason to promote refinancing is that the families that would be helped would tend to be among those less-advantaged and harder hit by the economic slump. Many of the proposals target “under water” homeowners (those with mortgages that are larger than the value of their homes) that are still current on their loans, because these people have had particular difficulty refinancing their mortgages. Based on the 2010 Survey of Consumer Finances, I calculate that median financial assets and median liquid financial assets in this group were only about half as high as the medians for all homeowners. A greater share had experienced job loss over the preceding year (22 percent versus 15 percent), and the median ratio of required debt service payments to before-tax income for this group, at 0.31, was close to double that for the broader homeowner group.

A second reason to support such proposals is that more refinancing would be good for the economic recovery. A family with a $150,000 30-year mortgage with a fixed interest rate of 6 percent that refinances into a new loan with an interest rate of 4 percent will lower its mortgage payments by $180 a month or $2200 a year. The weak retail sales report we saw in the wake of the recent expiration of the payroll tax cut suggests that the spending of many families is very sensitive to the ups and downs in their discretionary monthly cash flow. Thus, we should expect that the interest savings from refinancing will translate into stronger consumer spending and, in turn, promote more hiring and a stronger economic recovery.

It is true that the individuals and institutions that provided the funding for mortgages would lose out if refinancing picks up because they would receive lower interest income. However, these investors lent money for mortgages knowing that borrowers had an option to refinance, and, so far, they have seen much smaller losses than would be the case if it were not unusually difficult for many borrowers to refinance. Moreover, the net effect on the economic recovery should still be positive, as the spending of this group is unlikely to be as sensitive to their losses as the spending of refinancing borrowers is to their gains.

A third reason that proposals to facilitate refinancing make good sense is that, if designed right, they need not impose significant costs on the government. An oft-heard worry is that the programs will expose the government to yet more risk in the housing area. But, for mortgages already insured by the government, lowering mortgage payment burdens would reduce the probability of default. For other mortgages, where proposals typically involve a government entity purchasing the loans before issuing new ones, the risks can be mitigated by limiting the program to homeowners that are in good standing with their mortgages and trying to set the prices paid for the old loans and the interest rates on the new loans to reflect any greater credit risk associated with these borrowers.

Refinancing proposals are not a magic bullet for the economy. Reports vary on how many mortgage borrowers will be helped, but even under generous assumptions—that 10 million borrowers with high spending propensities would achieve interest savings of a couple thousand dollars a year—the programs might raise GDP growth by only ¼ percentage point or so. But, with the enormous burden associated with the still-high rate of joblessness and most economists expecting only tepid economic growth over the coming year, it seems like we should be doing all we can.

Authors

Karen Dynan

Publication: Yahoo! Finance

American Households and the Continuing Economic Recovery

Karen Dynan and Mark S. Sniderman — Thu, 24 Jan 2013 00:00:00 -0500

On November 9, 2012, Mark Sniderman, the Cleveland Federal Reserve Bank's executive vice president and chief policy officer, spoke with Karen Dynan, focusing on the critical role of American households in keeping the country's economic recovery on track.

Sniderman: I want to start by asking you a little bit about being an economist. When did you first know that it was the career for you and, along the way, what have you learned about the profession?

Dynan: I discovered the field of economics in college. I’d always been good in math and sciences and statistics, but I really wanted to do something to help people. When I took my first economics class I knew it was right for me because it gave me a chance to use my skills, but also it provided a wonderful way to help people by affecting public policy. That was really what whetted my appetite.

Later, after college, I went on to become a research assistant at the Federal Reserve Board, working on monetary policy, and that was just such a wonderful experience, being able to learn about monetary policy, understand the ways in which it affects the economy. So that is when I decided to go to graduate school to become an economist.

Now, in terms of what I’ve learned along the way—and I’m still learning—the number one lesson is that economics is really hard. The world is a complicated place and when you’re given your formal training, you’re often told to describe the world using these very simple and stylized models. The entire Federal Reserve System might be described by the letter p for prices and m for money. But you know, as I’ve gone on to work in policy and particularly as we lived through this financial crisis and tried to use policy to respond to the crisis, I’ve learned that the world is far more complicated. There are constraints and incentives that people and businesses and financial institutions face that are far more complicated than any economic model will tell you. You have to think about all these things as you are setting policy.

Sniderman: Your having answered that question that way makes me nervous to ask you the next one, because I’m giving you just a few minutes to deliver a very complex analysis. Coming through the worst financial crisis since the Great Depression, what do you think we have learned and should have learned? And what are the lessons for public policy and for economics?

Dynan: It was a period when some pretty big mistakes were made and there’s lots of blame to go around. The roots of the financial crisis were in the fact that too much risk was being taken. Too much risk was being taken by households. Too much risk was being taken in the financial system by financial institutions—banks, investors. Regulation didn’t do what it was supposed to do. It didn’t recognize the risks as they were building up.

Things might have worked out okay if the housing bubble hadn’t burst, but in fact it did burst. And that caused a lot of these risks to come home to roost. People suddenly found themselves with mortgages they couldn’t sustain. Financial institutions found themselves exposed to losses that they didn’t expect because they didn’t understand how much risk they had been taking.

Sniderman: What’s your take on the way that we as a nation have responded to the crisis legislatively?

Dynan: I think that it’s pretty clear what direction we needed to move in. We needed to move in a direction that put in place a regulatory system that was better able to protect people and protect financial institutions from excessively risky behavior. We’ve redesigned regulations and, yes, the laws are complicated. That’s not surprising—the financial system is very, very complicated. Nobody wants unnecessary and burdensome regulations. I think the regulatory community understands that. But the challenge is going to be how to get the right amount of regulation, given how complicated things are. A lot of it is still being worked out. They’re still studying exactly how we should implement these laws. And I think that’s very appropriate, given how hard the problem is.

What you’re looking for is a balance. You’re looking for the right amount of regulation, such that credit can still flow and people and businesses can still enjoy the benefits of credit while being protected against the worst abuses associated with credit and reducing the exposure of the system to the kind of meltdown we saw during the financial crisis. That is going to be a hard balance to achieve. And I think regulators need to study the problem, they need to try to work out the solution, but they also—after we’ve put in place the solution—they need to continue to study the problem. They need to see whether we’ve gone too far. They need to be ready to be responsive to that.

The roots of the financial crisis were in the fact that too much risk was being taken. Too much risk was being taken by households. Too much risk was being taken in the financial system by financial institutions—banks, investors.

Sniderman: Are there aspects of all the regulations that have been put in place that even today you would look at and say, gee, maybe we’ve imposed too much red tape or too many complications?

The roots of the financial crisis were in the fact that too much risk was being taken. Too much risk was being taken by households. Too much risk was being taken in the financial system by financial institutions—banks, investors.

Dynan: I think in many senses it’s too early to know. What we do know is that, if you think of credit supply as a pendulum, we had swung way too far in one direction, in the direction of easy credit during the lead-up to the financial crisis. And now we’ve swung way too far in the other direction. Credit is still very hard to get and that’s holding back the economy.

Now, we don’t know exactly why. We don’t know if lenders don’t want to lend because of the normal caution that comes with a weak economy or whether it has something to do with the new regulations. That’s something that we’re going to have to study over time. There’s also the whole issue of the uncertainty about future regulation. The Dodd–Frank law is still being implemented and there are parts of it that still require the details to be written down. I think it’s very hard for financial institutions to design their lending strategy until that’s all worked out.

Sniderman: There are differences of opinion among some economists about how to think about regulation. There are some who—to paint the extremes here—say that all we need for markets to work effectively is transparency and disclosure; you want to provide good instruction manuals and provide warnings and tell people how to use these products, but after that it’s caveat emptor. You don’t get into this nanny state with consumers. Other people have the view that people in certain instances are just going to make bad choices. You should prohibit certain products, you should prevent people from harming themselves by outlawing and regulating. Have you formed any views about that tradeoff?

Dynan: One important lesson that we’ve drawn from the financial crisis is that there are real limits to people’s capacity to process information. The fact of the matter is that managing one’s finances is really complicated. It’s complicated even for people like me with training in economics, and I’m married to an economist [Douglas Elmendorf, director of the Congressional Budget Office]. I know how complicated these decisions are. I think it’s been a real lesson that we shouldn’t just be emphasizing providing information.

During the run-up to the financial crisis, people signed on for mortgage products that I’m sure had ample paperwork describing what the payment would be and how the payments might adjust as, say, interest rates moved. But I think we’ve seen evidence that many people didn’t really understand that that’s what they were signing up for. What this tells me is that it’s not just about providing a lot of information; it’s the type of information you provide.

So we really need to think about designing simple, low-cost products that are easily understood by a wide range of the population. I also think we can learn from behavioral economics. Oftentimes when people don’t have the time or ability to understand a complicated financial situation, they take cues from their peers, or from their employment, or even from what they’re seeing on TV. That’s taught us that it’s very important how you set up the defaults of any kind of situation. We need to think harder about what the baseline offering is, because I think people will take that as a piece of advice that, yes, this is a good financial product.

Sniderman: One of the other things that has come up in the aftermath of the financial crisis is a rethinking of housing finance. With the government-sponsored enterprises Fannie Mae and Freddie Mac scaling down, I wonder how you think about what we should be doing with housing policy?

Dynan: Let me start with Fannie and Freddie. The financial crisis illustrated that our pre-crisis housing finance system—which was dominated by Fannie Mae and Freddie Mac—really had severe deficiencies that ended up leading to too much risk in the financial system. In thinking about how we should reform these entities, three principles come to mind.

First of all, I think we need explicit and limited government guarantees for mortgage loans. In the old system, the guarantees were implicit and essentially provided a subsidy to Fannie and Freddie that incentivized them to take on too much risk. So I think we need to move towards guarantees on loans that are explicit and priced to correctly reflect the risk of the underlying loan.

The second principle that I think we need to keep in mind is that securitization really needs to move back into the private sector. Fannie and Freddie have been in conservatorship since 2008, which essentially means that the government has been doing all of their activities, both securitizing the loans and guaranteeing the loans. While I think the government should continue to be a guarantor of certain loans, the securitization activity really should move back into the private sector because the private sector is going to be more efficient at it and is more likely to innovate in ways that save money. And when it moves back, we need to move it back in such a way that there’s not just one or two institutions dominating the whole market, because in that situation you would end up with entities that were too big to fail, which would lead to excessive risk-taking.

Sniderman: The status quo.

Dynan: Right. The third principle is that we need to get a plan in place as soon as we can. Not that we need to move to the new housing system as soon as we can—the housing market is still in a lot of trouble and maybe it’s right for the government to have such a large role right now. But we need to get the plan in place, because right now the situation we’re in is kind of housing finance limbo. It’s very difficult for lenders to go about their activities making mortgage loans when they don’t know what the future mortgage finance environment is going to be. It makes it very hard for them to make loans today, and it makes it hard for them to strategize about the future.

Sniderman: I think we’ve seen in other realms, as with the Basel accords, when they set these new standards, they typically give these long phase-in periods. I think you’re saying, let’s give people a flight path to where we’re headed and a time frame.

Dynan: Yes. I think it would make it easier for everyone to plan, to know where we’re headed.

Sniderman: What are your thoughts about the scale of this? You said we should let securitization become private, but the guarantee system could remain public. Would there be more limited types of guarantees to all forms of owner-occupied housing?

Dynan: One question that’s still under debate is whether we need these guarantees in order to have 30-year, fixed-rate mortgages. If you look across countries, for example, the 30-year, fixed-rate mortgage mostly is a product that’s seen in the United States. Some people would argue that is because we have these guarantees on mortgages. So maybe that’s an argument for having guarantees. More importantly, we need to have the capacity to do enough guaranteeing so that we can keep credit flowing if the mortgage market seizes up again.

I also think the guarantees should be limited. One of the biggest problems we had was that the risk wasn’t priced correctly in the run-up to the crisis. Pricing risk is very hard. If you want to price risk correctly, you need to keep the situation as simple as you can. I think we’re going to want to limit these guarantees to simple, transparent mortgage products with clearly defined parameters.

I think it’s very tough to know what the right level of homeownership is for our country. The experience of the past few years suggested that there are certainly limits to how far you want to push it. At the same time, I think there are clear benefits of homeownership.

Sniderman: It’s commonplace for people to say that we had too much emphasis on owner-occupied housing leading up to the crisis and now we should support a more balanced housing system between rental and owner-occupied. Is that sensible or not?

Dynan: I think it’s very tough to know what the right level of homeownership is for our country. The experience of the past few years suggested that there are certainly limits to how far you want to push it. At the same time, I think there are clear benefits of homeownership. The evidence suggests that putting down roots in a community can benefit the whole neighborhood. On top of that, a benefit of homeownership is that homes still represent a form through which consumers can build assets. I want to qualify that very carefully. In the period leading up to the financial crisis, the mistake was that people thought they could build assets effortlessly by just waiting for their homes to appreciate. We learned that that was a very bad assumption.

But I do think homeownership can help a household build assets through a more traditional financing model, where you have to make a down payment and where you have to make payments that pay off principal, so that you’re building equity in your home. The equity is not locked off, you can still get at it through a refinancing transaction, but it takes some work to get at it. I think that actually could be very useful for households that have trouble saving because they have trouble planning or they have self-control problems.

Over the longer run, I think that means we need a system that not only emphasizes homeownership but also puts weight on creating good rental housing for households for which homeownership is not the right choice.

Sniderman: Recently you’ve looked at this deleveraging process that’s under way. I wonder if you can talk about that a little bit. How far along in the deleveraging process might households be?

Dynan: We have seen considerable deleveraging for the nation as a whole. If you look at household debt for the entire economy, relative to income for the entire economy, you can see that that ratio has fallen back to its level as of 2003. So it sounds pretty good, but I think it’s very important to look beneath that aggregate figure and see what’s going on for different types of households. As it turns out, the deleveraging has been concentrated in certain groups.

One group would be the people who defaulted on their mortgages. They had loans that proved unsustainable and they defaulted on those loans so they no longer have that debt any more. Those households have managed to do quite a lot of deleveraging. There’s a sense in which those households are in a better financial position today as a result. They don’t have the burdensome debt obligations that they were finding so hard to sustain. That’s probably a plus for their situation. That’s not to say that they came by it costlessly. In many cases, they lost a home, they were displaced from their community, and, going forward they’re going to have limited access to credit, which is going to make it hard for them to get through periods when their income is temporarily disrupted. But, when all is said and done, these households did deleverage very dramatically.

Another portion of the decline in household debt in the nation as a whole has to do with reduced new borrowing—people just not taking out loans that they otherwise would’ve taken out. There are probably two things contributing to this. One is that people don’t want to borrow much when the economy is weak because they don’t want to spend much when the economy is weak. So some part of it has been by choice. But another part of it has been forced upon households. Lenders are being super-cautious right now. We can look and see they are requiring higher credit scores and better documentation of income than they did prior to the financial crisis.

For many of those households, consumption is below what it otherwise would be. But the good news is that as credit conditions ease, we’ll probably see households’ consumption rise, which would be a good thing for the economic recovery in this country.

The last group of households I think about are those highly leveraged households that didn’t default. Those are the people that ran up a lot of debt prior to the financial crisis and so have high debt obligations. On top of that, many have seen their home prices fall dramatically, which has put many of them underwater with their mortgages. I’ve researched this group of households and it looks to me that unless you defaulted, you probably haven’t made a lot of progress deleveraging. You just haven’t found a way to really pay off that debt very aggressively, such that the distribution of leverage for the highly leveraged households is pretty similar to where it was a couple of years ago. These households have spending that is very constrained by their situation. And that’s the group of households that we need to worry about and we need to think about what we can do to help.

Sniderman: If you go back to the earliest part of the financial crisis, knowing what you know now, are there things we might have done differently, or is it still pretty elusive and difficult to think about solving?

Dynan: The government put certain programs in place to try to prevent foreclosures and also to mitigate the costs of foreclosures. Those programs have helped many households. At the same time, we’ve still seen millions of foreclosures and many households that are under severe strain trying to make their mortgage payments. That’s creating hardship for them and hardship for their communities. I think the policy response didn’t meet expectations in terms of how much it would help get us through the housing crisis.

Sniderman: In the earlier days of the crisis, there were some voices calling for much more expansive and innovative kinds of programs. Do you think those things would’ve worked? There were sensible things for people to talk about but they were not done.

Dynan: Of course, it’s hard to say for sure but there are some things we do know. Some programs, at least in their early form, had flaws. It turned out that mortgage servicers faced constraints that people who designed loan modification policies didn’t really understand. That really limited the degree to which they could modify mortgages to make them more sustainable for borrowers. I also think that the earliest forms of the program were limited in their scope. Much of the thinking that went into the government’s largest mortgage modification effort occurred before we saw labor markets deteriorate. Those programs helped people in certain situations, but they actually were not targeted towards people who needed a very large amount of help over a short period, as a homeowner who has lost her job might. So the programs fell short in that way.

Sniderman: Looking ahead, we have some demographic changes: Our population is getting older. Most studies say households are not very well prepared for their older years. It seems to be difficult to figure out, from a financial education point of view, how to get households to do better financial planning and increase their savings. Do you have any insights about that?

Dynan: The issue of saving is really important. We know that for the nation as a whole, personal saving is up from where it was prior to the crisis. But again, it’s a question of how that is spread out. Is that increase just a few households doing a lot more saving, or is it broadly spread across the population? We don’t have the kind of data at the household level to answer that question because the data sources you would use are usually released with a lag, so we can’t look at them yet.

But if you look at earlier studies and you think about the anecdotal evidence that’s out there, it’s clear that a lot of households don’t have the savings they need to live as comfortably in retirement as they would like to, or simply the savings they would need to buffer disruptions to income, to allow them to sustain spending if suddenly their income drops. So I think there’s good reason to be concerned about parts of the population not saving enough.

What you do about it from a policy perspective is a hard question. Financial education is tricky. There is not great evidence about what you can do to really move the needle to get people to prepare adequately for retirement and to make sure that they have enough savings so that they’re financially secure. But I’m actually a fan of programs like the automatic IRA idea, which is that you would require businesses of a certain size that don’t have a retirement plan to automatically create a retirement account for their employees, unless the employee opts out. So the employee doesn’t have to participate, but the company is creating a default and effectively providing some advice to its employees about what would be good from the point of view of their financial security. I’m a fan of that.

For the lowest-income households, I am very intrigued by programs that provide some sort of match to incentivize saving. If households do a certain amount of saving, either the government or some other source will match their saving in order to incentivize them to do yet more saving. I think those ideas are very interesting and we should be piloting and studying these sorts of programs.

They need fiscal policy to play a role as well. The challenge there has been designing steps that will support the economy over the short run but contain debt and deficits in the longer run.

Sniderman: Is it just that society has changed or is there something different about the saving habit?

Dynan: The issue of a cultural shift is a really interesting one, and people love to tell the story that our grandparents lived through the Great Depression and were enormously thrifty ever after. We haven’t seen that kind of thriftiness in today’s generation. We see people much more focused on keeping up with the Joneses. That said, we don’t have great evidence as to whether a cultural shift might be occurring. Certainly a lot of people are now asking whether, having lived through what we lived through over the past few years, we’ll see renewed interest in thriftiness for the folks that faced a lot of hardship.

Sniderman: Speaking of our nation’s ability—or inability—to plan ahead, what are your thoughts about the fiscal crisis? What should we be thinking about there?

They need fiscal policy to play a role as well. The challenge there has been designing steps that will support the economy over the short run but contain debt and deficits in the longer run.

Dynan: One thing that’s been a source of frustration for monetary policymakers is that the steps they’ve taken have been constructive for the economy, but they’re by nature limited. They can’t support the economic recovery by themselves. They need fiscal policy to play a role as well. The challenge there has been designing steps that will support the economy over the short run but contain debt and deficits in the longer run; if you take the first part and not the second part, you create a lot of uncertainty about what the future holds, which will hold back the economic recovery. I think we’ve seen a lot of dysfunction in Washington that’s stood in the way of making smart fiscal choices. I hope that we’ll be able to overcome that.

Sniderman: Part of your career was working for an economic policymaking organization [the Fed] and you had a career partly as an academic, and now you’re at what’s popularly called a think tank. How does working as an economist differ in these different settings, and what kind of satisfaction do you get and what challenges do you find in these places?

Dynan: Universities are the traditional career choice of economists, and I think they are a great place to engage with students and to pursue research in an incredibly intellectually rigorous environment. But I do think that anyone who is very interested in policy should consider working for a government agency or for the Federal Reserve System. Besides the generally rewarding aspect of public service, these institutions are places where you really can have a direct influence on the policy leaders who are making important decisions, and that can be very rewarding. That’s certainly what I found when I was working for the Federal Reserve Board just after I left graduate school.

I would say that think tanks also play an incredibly important role in the policy sphere. You don’t have the direct connection with policymakers, or as much of a direct connection, as you would at a government agency or the Fed. But the activities and the research that is done at think tanks are incredibly important.

One big difference for me now is that I come into contact with a far broader range of people as I do my research. I spend time talking to business leaders, to people who work at consumer groups, and to people who work at international agencies, and also I spend time with the general public. I think this kind of exposure has led me to understand far more about how the world really works than I had previously. That’s been very good for my research. It means that my research offers a perspective to policymakers that they’re not necessarily going to get from inside their institutions.

Authors

Karen Dynan
Mark S. Sniderman

Publication: The Federal Reserve Bank of Cleveland

Image Source: © Norbert von der Groeben / Reuters

The Evolution of Household Income Volatility

Karen Dynan, Douglas Elmendorf and Daniel Sichel — Sun, 20 Jan 2013 00:00:00 -0500

Editor's Note: The full version of this paper is available at the website for the B.E. Journal of Economic Policy and Analysis. An earlier working version of the paper can be directly downloaded above.

Abstract

Using a representative longitudinal survey of U.S. households, we find that household income became noticeably more volatile between the early 1970s and the late 2000s despite the moderation seen in aggregate economic activity during this period. We estimate that the standard deviation of percent changes in household income rose about 30 percent between 1971 and 2008. This widening in the distribution of percent changes was concentrated in the tails of the distribution. The share of households experiencing a 50 percent plunge in income over a two-year period climbed from about 7 percent in the early 1970s to more than 12 percent in the early 2000s before retreating to 10 percent in the run-up to the Great Recession. Households’ labor earnings and transfer payments have both become more volatile over time. As best we can tell, the rise in the volatility of men’s earnings appears to owe both to greater volatility in earnings per hour and in hours worked.

1. Introduction

Researchers have found it relatively straightforward to document changes in the volatility of the U.S. economy as a whole over the last several decades. The aggregate U.S. economy entered a period of relative stability known as the Great Moderation in the mid-1980s and, much more recently, has been in dramatic flux since the onset of the financial crisis and Great Recession in 2007 and 2008. However, aggregate trends do not necessarily translate into trends in the experiences of individual households. For example, the Great Moderation is generally thought to be a period over which the economy became more dynamic, with globalization, deregulation, and technological change increasing the competitive pressures and risks faced by workers. Given these developments, it is not clear that the economic environment facing individual households was in fact more stable during this period. Thus, to the extent that one is interested in household economic security, one is compelled to consider micro data. Accordingly, a large literature has developed that directly examines the volatility of earnings and income at the household level. While income volatility is not the same thing as the risk or uncertainty faced by households, changes in volatility are likely to be associated with changes in risk and uncertainty.

To date, this literature has been inconclusive. Starting with the seminal work of Gottschalk and Moffitt (1994), many studies have found that individual earnings and household income have become more volatile during the past few decades. That said, there are some notable exceptions, which find no increase or a decline in the volatility of earnings and total household income (such as CBO, 2008, and Dahl, DeLeire, and Schwabish, 2011).

This paper examines household income volatility using data from the Panel Study of Income Dynamics (PSID). As the longest-running representative survey of U.S. households, the PSID is an ideal vehicle for considering how the household economic environment has changed. In contrast to much of the early literature in this area, we focus on the volatility of overall household income as opposed to the volatility of labor earnings. To be sure, the evidence on labor earnings provides important insights into labor market dynamics. We believe, however, that the broader concept of household income brings an important additional element to the table for two reasons. First, some important questions of economic welfare hinge more on the resources available to households (and the volatility of that stream of resources) rather than on the labor earnings of a single member of that household. Moreover, for macroeconomists interested in understanding the micro foundations of aggregate household-sector behavior, household income provides the natural starting point. Although a few other studies have looked at the volatility of household income in the PSID, we are the first (to our knowledge) to incorporate survey results through the late 2000s.

To make the analysis as transparent as possible, we do not estimate a formal model of income dynamics but rather document changes over time in the cross-sectional distribution of income changes. We carefully investigate, and correct for, measurement problems in the data. We also explore the evolving volatility and correlations of movements in various components of income (including earnings) and the evolving volatility of related characteristics such as hours worked and earnings per hour.

To summarize our results, we estimate that the volatility of household income—as measured by the standard deviation of two-year percent changes in income—increased about 30 percent between the early 1970s and the late 2000s. The rise in volatility did not occur in a single period but represented an upward trend throughout the past several decades; it occurred within each major education and age group as well. Yet, the run-up in volatility was concentrated in one important sense: It stemmed primarily from an increasing frequency of very large income changes rather than larger changes throughout the distribution of income changes.

Turning to the components of income, we estimate notable increases in the volatility of labor earnings and transfer income and a small increase in the volatility of capital income. Household labor earnings (combining earnings of heads and spouses before estimating volatility at the household level) became more volatile even though the volatility of individual earnings (heads and spouses taken as individual observations) edged down. The explanation is that women’s earnings became less volatile while men’s earnings became more volatile, and the latter matters more for household earnings because men earn more than women on average. We show that rising volatility in men’s earnings owes both to rising volatility in earnings per hour and in hours worked, though our interpretation could be affected by changes in PSID methodology. And we demonstrate that earnings shifts between household members, as well as shifts in market income and transfer income, provide only small offsets to each other.

The limitations of our analysis bear emphasis. First, an increase in the volatility of household income does not imply a corresponding increase in risk or uncertainty. Our calculations distinguish only slightly between voluntary and involuntary changes in income, they do not include shocks to desired spending, and they do not account for adjustments to saving and borrowing that can buffer income shifts. Second, our findings are based on a particular methodology applied to a single dataset. Given the wide range of findings across studies that use different techniques and different data sets, further research is needed to reconcile the various results before economists can have a high degree of confidence in the facts about household income volatility. Moreover, our analysis ends in 2008 and therefore precedes much of the recent turmoil; once the relevant data become available, researchers undoubtedly have much work to do to establish how income dynamics changed following the Great Recession.

The next section of the paper discusses how we measure volatility using PSID data. Subsequent sections present our results on the evolution of volatility of individual labor earnings, of the components of household income, of household income, and of hours worked and earnings per hour. We then discuss how our results fit in with the broader literature. A final section concludes.

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The Evolution of Household Income Volatility

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Karen Dynan
Douglas Elmendorf
Daniel Sichel

Publication: The B.E. Journal of Economic Analysis & Policy

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The American Consumer Is Holding Up

Karen Dynan — Fri, 21 Dec 2012 00:00:00 -0500

Despite elevated joblessness, Superstorm Sandy and the fiscal cliff, American consumers seem to be spending and that’s good for the economy. Holiday shopping is always a focus this time of year; the real question is where the demand is coming from – are people using savings or just shifting their purchases around.

The downside to the outsized role of consumer spending is that it means less saving and investment, which makes our economy less productive. We need to focus on exports – getting consumers abroad to spend on our products.

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The American Consumer Is Holding Up

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The American Consumer Is Holding Up

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Karen Dynan

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The Future of Homeownership in the United States Featuring Bank of America CEO Brian Moynihan

Fri, 14 Dec 2012 10:00:00 -0500

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December 14, 2012
10:00 AM - 11:30 AM EST

Falk Auditorium
Brookings Institution
1775 Massachusetts Avenue NW
Washington, DC 20036

Homeownership has long been synonymous with achieving the “American Dream.” Yet the collapse several years ago of the housing market calls for homeowners, lenders, and the federal government to re-evaluate their expectations and roles to meet the goal of long-term stability, soundness, and fairness in homeownership.

On December 14, the Economic Studies program at Brookings hosted a discussion with Bank of America CEO Brian Moynihan, followed by a panel discussion of industry and policy experts. The discussion focused on the benefits and costs of homeownership and the appropriate role of lenders, investors and government policies, such as tax incentives and housing finance subsidies, to achieve this goal.

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Internet Everywhere: Broadband as a Catalyst for the Digital Economy

Tue, 27 Nov 2012 13:00:00 -0500

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November 27, 2012
1:00 PM - 2:30 PM EST

Falk Auditorium
Brookings Institution
1775 Massachusetts Avenue NW
Washington, DC 20036

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Broadband technologies power the country’s digital infrastructure and have become essential platforms for 21st century communications and commerce. One of the most important economic and policy issues facing the new administration is whether U.S. regulation of broadband platforms will help or hinder the kind of innovation, investment, competition and economic growth the country needs to climb out of the economic decline it has been experiencing in the last few years.

On November 27, the Economic Studies program at Brookings hosted a forum to discuss how a well-crafted regulatory paradigm can work to foster investment, continue innovation, and increase consumer welfare. Former Brookings Senior Fellow Robert Litan and co-author Hal Singer, managing director and principal at Navigant Economics, presented policy recommendations from their soon-to-be-published e-book, The Need for Speed: A New Framework for Telecommunications Policy for the 21st Century (Brookings Press, 2013). Darrell West, vice president and director of Governance Studies, moderated a panel of industry and academic experts on the current and future economic potential of broadband platforms for bringing the Internet everywhere, and catalyzing the digital economy.

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Internet Everywhere: Broadband as a Catalyst for the Digital Economy

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The U.S. Household Debt Overhang

Karen Dynan — Thu, 25 Oct 2012 00:00:00 -0400

Editor's Note: Speaking before the annual research conference of the Dutch central bank, Karen Dynan summarized her BPEA Spring 2012 paper (PDF) on how the consumer debt overhang and the uncertain state of households' finances are related to the weak U.S. economic recovery.

Thank you for inviting me to speak today. I would like to start by commending the organizers for putting together this conference. The past few years have really highlighted just how much we do not know about household finances. Dramatic balance sheet developments have created tremendous hardships for individual households and have wreaked havoc with the financial system as well as the broader economy. Research like that featured in this conference should yield important lessons about how, going forward, we can foster household economic security and reduce the likelihood of financial crises.

I am going to talk about the U.S. household debt overhang and how it is related to the weak U.S. economic recovery. I will draw off my own research and that of others, as well as what I have learned engaging with people from policy agencies, financial institutions, and consumer groups over the past few years.

Slide 2 shows a cartoon that summarizes the popular interpretation of what has been going on. We see the consumer trying to move forward and fill his shopping cart. But, he cannot do so because his leg is chained to something that is holding him back. That something is a charming little house. The message is that purchases of homes, and, in particular, the debt taken on to do so, have now become a terrible drag. Americans cannot move forward and consume.

I will turn now to how well this characterization captures the actual situation.

First (slide 3), let me define what I mean by “household debt overhang” since I will be using that term a lot throughout my talk. I am specifically referring to the extremely high levels of leverage—meaning debt relative to assets—experienced by many U.S. households in the wake of the plunge in home prices that occurred between late 2006 and early 2009. The pattern is particularly striking for mortgage leverage. As you can see in the chart, the ratio of aggregate U.S. mortgage debt to the aggregate value of homes jumped up during the housing bust—denoted by the shaded area—and has remained extremely elevated since then.

The Causes of the Household Debt Overhang (slide 4)

To understand how the United States ended up with this household debt overhang, one needs to go back about a decade (slide 5). In the early 2000s, strong U.S. housing demand arose from the combination of solid economic fundamentals, low interest rates, and the increased prevalence of so-called “affordable” mortgage products that made homeownership possible for households with little savings and limited ability to make mortgage payments. In turn, housing construction boomed, prices started to rise rapidly, and mortgage borrowing picked up.

And, as time went on, the boom became self-reinforcing—the more prices rose, the more eager homeowners were to buy, the more willing lenders were to lend, and the more willing investors were to supply funds. Neither regulators nor market discipline put a check on the cycle, partly because of complex mortgage funding arrangements that obscured the risk associated with many loans. In addition, the widely held views in the United States that increasing homeownership was highly desirable and that financial innovation generally made for more efficient and less risky financial markets probably also contributed to the environment of lax regulation.

To shed more light on what was going on, I used the Panel Study of Income Dynamics to look more closely at the households that took on a lot of debt during this period (slide 6)[1]. By way of background, the PSID a longitudinal survey of U.S. households that was launched in 1968. The survey is currently done once every two years; the most recently released full wave contains information from about 8,000 interviews conducted in 2009. The full data set offers a fairly rich set of information about households, including data about their demographics, income, employment, housing situations, spending, and balance sheets. In addition, preliminary balance sheet data from the 2011 wave of the PSID was released earlier this year.

A few key concepts from my paper are as follows. First, I define highly leveraged homeowners as those in top quintile of mortgage leverage as of 2007 (that would be the PSID wave that was closest to the peak of the U.S. housing and mortgage boom). Second, I define “housing boom states” as those in the top quartile of home price appreciation between 2000 and 2006; of course, most U.S. states saw considerable home price appreciation over this period, but, for the purposes of identification, I separate out the ones where market conditions were especially frenzied. Finally, my consumption measure excludes housing because it would confound the analysis to include something so closely related to housing wealth as an outcome variable.

The most striking results from this part of my study concerned just how important a role home prices played in the buildup of risk during this period. In this slide (slide 7) I compare the experience of highly leveraged homeowners in housing boom states with that of highly leveraged homeowners in other states. As can be seen, as of 2007, mortgage debt relative to income among highly leveraged homeowners in the housing boom states (the dark blue bars) was much higher than that of their counterparts in the other states (the light blue bars). Debt service payments relative to income were also higher. In addition, consumption relative to income was higher for the highly leveraged homeowners in the housing boom states. So, the results are certainly consistent with the view that some households were significantly tapping into their housing capital gains to finance higher consumption.

Many people have pointed out that policymakers would have better anticipated the mortgage crisis if they had had better data. I agree with this point. As this group well knows, household surveys, like that used for these charts, are of limited use for monitoring household financial risk in real time because they are released with a significant lag, sometimes a several year lag. Mortgage records and credit bureau data can provide more timely information about indebtedness at the household level, but these proprietary sources were not being widely used for policy purposes prior to the financial crisis because they are very expensive and sometimes difficult to use.

However, foreseeing the crisis was not just a matter of having the right data; it was also a matter of how one interpreted the information. Despite the indications of risk building up among highly leveraged homeowners like that in this slide, the same data source yields other information that could be read as indicating these households were in very solid financial positions. In particular, although highly leveraged homeowners in housing boom states saw large increases in mortgage debt between 2005 and 2007, their median net worth actually rose by 13 percent of income over this period because of rapid home price appreciation. Also thanks to home price appreciation, their mortgage leverage—the median ratio of their mortgage balance to home value—stood at a less-than-alarming 0.84 in 2007.

A key implication is that, even with the right micro data, one’s precrisis assessment of U.S. household financial conditions depended critically on whether one thought that the run-up in home prices might reverse (slide 8). This chart, which is again from my research, drives the point home. The bubbles in the panel at left correspond to different states and are sized to reflect each state’s population. In this panel I have plotted actual mortgage leverage at the 90^th percentile against the home price appreciation the state saw during the housing boom. As you can see, if anything, actual mortgage leverage was lower for states with more home price appreciation. But, the panel at the right shows what mortgage leverage at the 90^th percentile would look like if mortgage debt stayed the same but home prices reverted to the level they would be at if they had risen at just the rate of consumer inflation during the housing boom. Under this counterfactual scenario, highly leveraged homeowners in the housing boom states very clearly appear to be in a precarious situation.

The point is that correctly assessing the riskiness of U.S. household balance sheets in the precrisis period required not only the right data but the right perspective on home prices. There is a fascinating literature that documents the widespread reluctance of economists and others, including financial market analysts, to recognize the housing bubble. Gerardi, Foote, and Willen (2010) speculate that it goes against the basic training of economists to believe that assets can be substantially over- or under-valued.[2]

In any event, home prices did peak in 2006 and fell by close to one-third over the next 2½ years. As a result, mortgage leverage spiked and many homeowners were left “under water,” meaning that their mortgage loans exceeded the value of their homes. These highly leveraged households faced severe financial strains for several reasons. First, they no longer had home equity that they could tap into to support their spending. Second, although mortgage rates fell, they had difficulty refinancing into lower-rate loans in order to lower their monthly payment obligations. Third, they would have to take a loss if they tried to sell their homes in the face of job losses or other developments that impaired their ability to make mortgage payments.

Many homeowners defaulted under these circumstances, and we have seen millions of foreclosures in the United States. But, many others were simply left with extremely high levels of leverage. To give you an idea of the aggregate size of this problem, according to Corelogic, the share of mortgages that are under water has been running between one-quarter and one-fifth for the last several years, with the amount of negative mortgage equity currently totaling close to $700 billion.[3]

Let me turn now to how this debt overhang affected household spending and broader economic activity (slide 9).

The Effects of High Household Leverage on the U.S. Economy

It is clear that the areas of the United States that suffered more pronounced housing busts—and, in turn, larger increases in household leverage—generally saw deeper recessions (slide 10). This slide plots the change in unemployment rate (trough to peak) against the change in home prices (peak to trough) by state. The negative relationship implies that that states that experienced larger home price declines also saw larger contractions in economic activity. Of course, correlation does not establish causality, but in a paper that corrected for possible endogeneity, Mian and Sufi (2011) found that shocks to household balance sheets account for a very large share of the jobs lost in the United States between March 2007 and March 2009. In a different paper, coauthored with Rao (2011), these authors found that consumption declined much more in regions with larger home price declines.[4]

But, does this mean that high household leverage in and of itself leads to depressed economic activity? No. A plunge in home prices affects household balance sheets in two distinct ways—it causes both an increase in leverage and a decline in overall wealth. Findings like those of Mian and Sufi could simply be the result of the latter change, particularly given the abundance of empirical support for wealth effects in the consumption literature.

Basic economic theory does not offer a lot of guidance about the possible role of leverage (slide 11). According to the simplest models, a household’s consumption is determined by its income, wealth, the return it earns on savings, and preferences. In slightly more refined models, the uncertainty faced by a household plays a role, as does its ability to borrow. But, debt and leverage do not typically enter these simple models, nor the empirical specifications derived from them.

That said, we can think of several reasons why high debt and leverage might matter for consumption. First, some households may be uncomfortable with having leverage beyond a certain level; such households might reduce consumption in order to pay down debt when faced with a shock that increases leverage. Second, financial institutions may be less willing to lend to more highly leveraged households. As a result, the rise in leverage may have impeded some households from borrowing more to finance consumption and prevented others from raising their discretionary cash flow by refinancing into lower-rate mortgages. Similarly, the burden associated with debt service obligations might matter for the willingness or the ability of households to borrow.

Unfortunately, it is really hard to look for such effects using our standard macro empirical models. The challenge with putting debt-related variables into such models is that debt is often used to finance spending spurred by an unrelated development, such as good news about future income. It is generally difficult to disentangle this positive (and endogenous) relationship between household debt and consumer spending from any negative effect stemming from excessive indebtedness.

Hence, one again needs to look at household-level data. In my research, I started by simply looking at the change in consumption from 2007 to 2009, comparing homeowners with high leverage as of 2007 with other homeowners (slide 12). This chart shows results for housing boom states, where one might expect the effects to be most pronounced.

As you can see, highly leveraged homeowners in housing boom states—those captured by the dark blue bar—experienced a median percent decline in consumption that was nearly twice as large as that of other homeowners—captured by the light blue bar. Now, the highly leverage households did see a slightly larger decline in income. But, turning to the left panel on this next slide (slide 13), even if one scales consumption by income, one sees a considerably larger decline in consumption for highly leveraged households. And, this is not because highly leveraged homeowners experienced a larger decline in wealth—in fact, as you can see on the right, they experienced a smaller decline in wealth. So, these various charts suggest that the increase in leverage associated with the decline in home prices had an important depressing effect on the consumption of some households that goes beyond any wealth effects associated with the decline.

The next step was to test the hypothesis more formally using regression analysis (slide 14). Again, we are seeking to answer whether consumption has shown more weakness because of high leverage than would be expected given the movements in its other fundamental determinants, including the loss in wealth and weak income. This logic suggests estimating the following equation:

where the dependent variable is the change in the non-housing consumption of household i between 2007 and 2009, and the independent variables are the change in its wealth, the change in its income, its 2007 leverage and a vector of other variables that might also influence household consumption growth (such as the interest rate, economic conditions in the state, and demographic factors).

I use ex ante (2007) leverage in this equation because ex post (2009) leverage might be endogenous, although I also tried a specification where I instrumented ex post leverage. I focus on mortgage leverage only because of incomplete information about non-mortgage debt. In addition, I follow a long tradition in the empirical literature on household-level consumption and finances by using a transformation that downweights large values; in particular, I take the inverse hyperbolic sine of consumption, income, and wealth; the first differences can then be interpreted much like percent changes.

This table (slide 15) shows my results under some of the different specifications that I tried. The estimated coefficients on leverage—shown in the bolded row—were not very precise, most being statistically different from zero at between 5 and 10 percent levels of significance. The point estimates for the subsamples associated with different degrees of housing boom differ in the ways that one would expect, but, otherwise my point estimates were fairly similar across different specifications. At face value, a point estimate of -6.1 suggests that the effect of leverage on consumption could be material—an increase in a household’s mortgage loan-to-value ratio from 1.0 to 1.1 would have reduced its consumption growth by 0.6 percentage point over this 2-year period, or 0.3 percentage point per year.

Implications for the U.S. Economy

One big question, of course, is how important these effects are from a macroeconomic point of view (slide 16). I did not feel comfortable extrapolating from the data in the PSID alone because it is a small noisy survey and people have raised questions about its representativeness. But (slide 17), based on the aggregate mortgage leverage ratio I showed you earlier, we can say that the average homeowner has a mortgage leverage ratio that is running about 0.2 above its precrisis level. Applying my estimates—and taking into account the fact that about two-thirds of Americans own homes—one concludes that high leverage could be dampening aggregate consumption growth by ¼ to ½ percentage point per year.

But, this conclusion comes with a lot of caveats. First, the PSID, like most household surveys, contains a great deal of measurement error. Also, there might be important nonlinearities in the relationship that my specification did not capture. Perhaps, for example, high leverage only matters for consumption when the leverage ratio is above a certain level. In addition, the effects might have changed over time, as credit conditions have evolved, thanks in part to the government efforts to address the hardships imposed by high leverage. The measurement error likely imparts a downward bias to my estimated effects, but it is hard to call the direction of bias associated with the other factors.

Finally, I could not tell whether it is leverage per se that matters for consumption or whether it might be a different debt-related variable. We know, for example, that lenders look at how much of a household’s income goes toward required debt service payments when considering whether to extend credit and at what price. When I substituted the debt service ratio for the leverage ratio in my regressions, the results were very similar, which is perhaps not surprising given that both variables are a function of the level of debt. But, knowing the relative importance of these two variables is critical for assessing what is going on now because mortgage leverage and mortgage debt service have moved very differently over the past few years. While the aggregate mortgage leverage ratio has retraced very little of its jump during the housing bust, the aggregate homeowners mortgage debt service ratio has declined to its lowest level in a decade in part because of falling interest rates.

One more result from my research that I would like to feature pertains to how deleveraging is occurring. The United States has in fact seen a substantial drop in aggregate outstanding household debt (slide 18). Household debt has fallen by 6½ percent since its peak and the ratio of household debt to income now stands at its lowest level since 2003.

It would be a mistake, though, to think that these trends represent the experience of most households. In fact, the reduction in debt has been very uneven (slide 19). A large share of the decline in aggregate outstanding household debt has been accounted for by loans that were written off after going bad—in work that I did about a year ago, I calculated that the dollar volume of defaults on household debt was about two-thirds as large as the as-then total decline in household debt.

Another substantial share of the decline in aggregate household debt has been accounted for by reduced new borrowing, amid the extremely tight credit conditions that have prevailed in the United States in recent years. Many households with less-than-perfect credit applications have found it difficult, if not impossible, to obtain new loans. So, for example, in an analysis of credit records released earlier this year, Bhutta (2012) found that the pace at which people are becoming homeowners for the first time has dropped to about half that seen around the year 2000.[5]

The implication is that there are two types of households that have much less debt as the result of their experiences over the past few years—those who defaulted on their loans and would-be borrowers who could not get loans.

What about other households (slide 20)? My research suggests that many other households have made little to no progress reducing their leverage. I considered different benchmark levels of leverage that households might be trying to get back to. This chart compares excessive mortgage leverage as of 2009 (the dark blue bars) with that as of 2011 (the light blue bars) under the assumption that households are trying to get back to the same level of mortgage leverage as they had in 2005 (with the exception being new homeowners who are assumed to be trying to get back to a leverage ratio of 90 percent). Each pair of bars corresponds to the share of the full sample with different degree of excess leverage. So, for example, looking at the leftmost bar, about 8 percent of the sample had a leverage ratio that exceeded their benchmark by less than 0.1 in 2009.

The chart shows that the fraction of the sample with a little bit of excess leverage fell between 2009 and 2011, but that the fractions with higher degrees of excess leverage actually rose. So, on net, there does not appear to have been an improvement in the leverage situation of these households. In addition, this conclusion does not appear to be very sensitive to the choice of the benchmark levels of leverage.

Near-term Policy Challenges (slide 21)

This balance sheet research is highly relevant to certain challenges that U.S. policymakers are facing as they seek ways to both strengthen the as-yet weak economic recovery and to promote robust growth over the longer run.

One challenge is that the various traditional ways for households to strengthen their balance sheets—saving more, paying down debt, and borrowing less—are good for economy over the longer run but bad over the shorter run. Over the longer run, such behavior will leave households in more secure and sustainable financial positions and thus presumably will leave the household sector and, in turn, the broader economy less vulnerable to shocks. But, over the shorter run, of course, these steps are all associated with spending less and therefore imply weaker aggregate demand. A recent Tom Toles cartoon that appeared in The Washington Post (slide 22) depicts the basic dilemma, with the pointy-headed economist staring harshly down at the American consumer saying “Your excess saving is thwarting the recovery” and then adding “Start spending so I can rap your knuckles for unsustainable profligacy.”

An issue that frequently comes up in policy circles is whether we can “have our cake and eat it too” through debt forgiveness, sometimes also referred to as “principal writedowns” in mortgage circles (slide 23). The idea is that if we could somehow make households’ excess debt disappear, then we would enjoy a substantial immediate strengthening of household balance sheets, which would be good for the economy both over the short run and over the longer run.

The problem is that lenders are not likely to undertake such programs on their own. It is true that it is better for lenders to forgive mortgage debt that exceeds the value of the underlying property rather than have a troubled mortgage go into foreclosure because the latter entails considerable legal and administrative costs and, when all is said and done, the lender will have to take the loss on the property anyways. But, the vast majority of underwater borrowers—more than 70 percent according to a study that the Federal Reserve Board released earlier this year—are actually still making their mortgage payments.[6] So, lenders would take enormous losses were they to do broad-based forgiveness of negative equity. They could narrow any debt-forgiveness program to include just those mortgages in default and likely to go into foreclosure, but then they would encourage the current borrowers to stop making their paying their mortgages and again suffer losses.

Of course, the U.S. government could incentivize debt forgiveness by paying lenders to do the write-downs. However, this idea is probably infeasible for political reasons—there has already been great public debate over whether such a program would be fair. True or untrue, there is a perception that many troubled borrowers came to be so because they were imprudent or gamed the system. Fairness issues aside, there are important efficiency questions associated with the debt forgiveness issue—is it worth it to use tens of thousands of dollars to save a single mortgage when that money could, for example, be put toward saving the job of a teacher in a fiscally challenged state?

Lessons and Directions for Future Research

I would like to finish off with the lessons I draw from the recent research on deleveraging as well as the broader experience of the U.S. economy over the last several years (slide 24).

One important take-away is that high leverage does seem to be holding back economic activity. Recall that when I say this, I mean that high leverage is having a damping effect on consumer spending that goes above and beyond the pure wealth effects associated with the plunge in home prices during the housing bust.

That said, the work I described was really only a starting point—there are some very important unanswered questions about the relationship between consumption and debt that we need to tackle. One priority is getting a better handle on the current quantitative importance of the debt overhang. Strong advocates of government debt forgiveness programs tend to argue such programs would be well worth it because excess household leverage is a central force holding back the economy. At face value, my own results suggested that while excess household leverage may be creating hardship for some families, the effect on the U.S. economy as a whole is only modest. But, as I noted earlier, limitations in my data source mean that you should take this sort of calculation with a large grain of salt.

A related question for future research concerns why high leverage seems to be associated with weaker consumption. As I noted earlier, there are several possible channels. Households may be paring back their consumption to pay down debt and bring leverage back into what they view as their comfort zone. Alternatively, highly leveraged households might not be choosing lower consumption so much as having it forced upon them because of difficulty obtaining new loans to finance consumption or refinancing old ones at lower interest rates. Distinguishing which of these channels are behind the finding that higher leverage is associated with weaker consumption is important, of course, because it informs U.S. policymakers about where they should direct their efforts.

Finally, let me offer a couple of specific thoughts about the tools policy analysts to have traditionally used to monitor household financial conditions.

The first is that, for the purposes of preventing a crisis like this in the future, we need better ways to identify the risks associated with household balance sheets. A central lesson of the past few years is that the tails of the distribution can matter, and that the traditional household financial indicators that many analysts were focusing on during the credit boom—such as the various aggregate debt and debt service ratios—simply do not offer much information about what is going on in these tails.

Furthermore, information about the distribution of debt may be necessary for understanding the risk being taken on by households but it is not sufficient. We need to learn more about how much debt represents too much debt for any given household.

U.S. policy analysts are, in fact, making much more use of micro data, such as mortgage records and credit bureau data, but it is important that such efforts continue even after the economy is fully healed. And, we should also consider whether it is enough that government agencies are using such measures internally or whether there is a case for releasing more information about the distribution of debt to the public such that the issues can be examined and debated openly, including in forums like this one.

My second thought about tools has to do with how we analyze the relationship between debt and consumption. The macro models traditionally used for forecasting aggregate consumer spending typically make limited use of balance sheet information, including just overall net worth or net worth divided into a couple of components. It is not clear that these models can be improved upon given that it is generally difficult to disentangle any negative effects of excess debt from the positive (and endogenous) relationship that arises from the fact that debt is often used to finance spending spurred by an unrelated development. This means that policymakers need to be complementing the purely macro approach to analyzing and projecting consumer spending, with more use of micro data, a thought that surely resonates with the attendees of this conference.

Thank you.

[1] See “Is a Household Debt Overhang Holding Back Consumption?” by Karen Dynan, Brookings Papers on Economic Activity Spring 2012, available at: http://www.brookings.edu/~/media/Projects/BPEA/Spring%202012/2012a_Dynan.pdf.

[2] See “Reasonable People Did Disagree: Optimism and Pessimism About the U.S. Housing Market Before the Crash,” by Kristopher Gerardi, Christopher Foote, and Paul Willen, Federal Reserve Bank of Boston Public Policy Discussion Paper No. 10-5, 2010, available at http://www.bos.frb.org/economic/ppdp/2010/ppdp1005.pdf.

[3] See http://www.corelogic.com/about-us/researchtrends/asset_upload_file486_16724.pdf.

[4] See “What Explains High Unemployment? The Aggregate Demand Channel Household Balance Sheets, Consumption, and the Economic Slump” by Atif Mian and Amir Sufi, 2011, available at: http://faculty.chicagobooth.edu/amir.sufi/MianSufi_WhatExplainsUnemployment_Nov2011.pdf and “Household Balance Sheets, Consumption, and the Economic Slump” by Atif Mian, Kamalesh Rao, and Amir Sufi, 2011, available at http://faculty.chicagobooth.edu/amir.sufi/MianRaoSufi_EconomicSlump_Nov2011.pdf.

[5] See “Mortgage Debt and Household Deleveraging: Accounting for the Decline in Mortgage Debt Using Consumer Credit Record Data” by Neil Bhutta, Federal Reserve Board Finance and Economics Discussion Series no. 2012-14, 2012, available at http://www.federalreserve.gov/pubs/feds/2012/201214/201214pap.pdf.

[6] See “The U.S. Housing Market: Current Conditions and Policy Considerations,” Federal Reserve Board, 2012, available at: http://www.federalreserve.gov/publications/other-reports/files/housing-white-paper-20120104.pdf.

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Karen Dynan

Publication: De Nederlandsche Bank

Unconventional Times, Unconventional Measures: A Conversation with Federal Reserve Board Governor Jeremy Stein

Thu, 11 Oct 2012 10:00:00 -0400

Event Information

October 11, 2012
10:00 AM - 11:00 AM EDT

Falk Auditorium
Brookings Institution
1775 Massachusetts Avenue NW
Washington, DC 20036

Amid a weak and uneven economic recovery, the Federal Reserve announced in mid-September that it would undertake further large-scale asset purchases, sometimes known as “quantitative easing,” in order to provide additional support to the U.S. economy. With its traditional tool of monetary policy—the federal funds rate—at close to zero, the Federal Reserve has entered new policy territory by implementing several waves of quantitative easing over the last four years. While such programs are designed to ease financial conditions and, in turn, foster demand and increase employment, they are thought by some to carry important risks. As a result, they have been the source of some controversy.

On October 11, Economic Studies at Brookings hosted a discussion with recently appointed Federal Reserve governor, Jeremy Stein. Vice President and Co-Director of Economic Studies Karen Dynan gave introductory remarks, and Brookings Senior Fellow Donald Kohn moderated a question and answer session. Governor Stein also took questions from the audience.

The event was broadcast live on C-SPAN »

Read Jeremy Stein's prepared speech at federalreserve.gov »

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Unconventional Times, Unconventional Measures: A Conversation with Federal Reserve Board Governor Jeremy Stein

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Higher Personal Saving: Who Needs It?

Karen Dynan — Mon, 01 Oct 2012 11:40:00 -0400

Americans have tightened their belts relative to the spendthrift days preceding the financial crisis. Since that time, we have seen a meaningful increase in the U.S. personal saving rate, measured as the combined savings of all households divided by their combined after-tax income. The personal saving rate averaged 3¾ percent over the last year, up from a low of 1 percent in 2005.

Over the near future, there is a downside to higher personal saving. Saving more means spending less, and, with consumer demand accounting for such an important part of the U.S. economy, the economic recovery will not be as strong as it otherwise would be. But, over the longer run, higher saving has important benefits. It provides more funding for investment, which will increase our capital stock and lead to stronger economic growth. In addition, households that save more will attain a more secure financial footing. For many, accumulating wealth is critical to making downpayments on homes, paying for college tuition and big-ticket consumption items, enjoying a decent standard of living in retirement, and weathering unexpected expenses and income disruptions.

How much progress have Americans made toward achieving financial security? We do not actually know because we lack up-to-date comprehensive information about household balance sheets. Moreover, the amount each household needs to be saving differs depending on its circumstances and aspirations. But, we do know that a lot of households lost substantial ground when home and stock prices plunged during financial crisis. According to the 2010 Survey of Consumer Finances, after adjusting for inflation, median household net worth was 28 percent below its level half a dozen years earlier in 2004—before we even hit the frothiest part of the home price boom.

The need to make up for these capital losses is the most obvious reason that many Americans should be doing more saving. But four additional considerations reinforce the point and argue for yet higher rates of savings:

Incomes have gotten more volatile. My coauthors and I found that the volatility of household income rose nearly 30 percent between 1971 and 2008 as U.S. labor markets became more competitive and dynamic. The harsh labor market conditions of recent years may well have exacerbated this trend. More ups and (particularly) downs in income heighten the importance of households having financial reserves that they can use to buffer cash-flow shocks.
Borrowing will be harder, even over the longer run. Borrowing has traditionally taken the place of having savings in some contexts—credit cards helped households get through hard times and longer-term loans helped households purchase items (including homes) in advance of having the income to do so. But, many households have found it difficult if not impossible to get loans in the extremely tight credit environment of recent years. Conditions should ease with improvements to the economy, but the lessons taken by lenders and regulators from the financial crisis mean such that we are unlikely to see a return to the easy lending standards seen during the credit boom.
We cannot count on our homes to do our saving for us. Rapid house price appreciation during the early- to mid-2000s meant that household net worth was growing without households have to forego consumption (indeed, home price gains allowed them to consume even more). Even though home prices are growing again in many parts of the country, the gains have been modest and we should expect them to continue to be so.
Austerity-driven cuts to social programs are coming. As policymakers look for ways to reduce growing budget deficits, they are likely to take a whack out of various social programs. Greater retirement saving will be needed to offset cuts to programs helping older Americans, and greater precautionary saving will be needed to replace reductions in transitional benefits.

Many households seem to be having trouble increasing their saving. Only 52 percent of the households participating in the 2010 Survey of Consumer Finances reported having saved over the preceding year—down from more than 56 percent three years earlier. But, Americans do recognize the need to save more: In a recent survey by Absolute Strategy Research, 71 percent of respondents reported that they were “saving too little.”

As part of the coming fiscal negotiations, we should consider ways in which policy might encourage saving by households over the longer run. Existing programs like tax-favored employer-provided plans and college savings accounts are a step in the right direction, but they primarily benefit higher-income tax payers. A variety of interesting ideas have been forward to reach other types of households, including Automatic IRAs and a matched-savings program for households receiving the Earned Income Tax Credit. If we want to achieve broad-based household financial security, we should be exploring these and other options.

Authors

Karen Dynan

Publication: Yahoo! Finance

Is a Household Debt Overhang Holding Back Consumption?

Karen Dynan — Sun, 30 Sep 2012 11:38:00 -0400

Editor's note: this paper was published in the Spring 2012 edition of the Brookings Papers on Economic Activity. In accordance with that journal's open access policy, this paper's data and programs are also available for download (ZIP).

Abstract

The recent plunge in U.S. home prices left many households that had borrowed voraciously during the credit boom highly leveraged, with very high levels of debt relative to the value of their assets. Analysts often assert that this “debt overhang” created a need for household deleveraging that, in turn, has been depressing consumer spending and impeding the economic recovery. This paper uses household-level data to examine this hypothesis. I find that highly leveraged homeowners had larger declines in spending between 2007 and 2009 than other homeowners, despite having smaller changes in net worth, suggesting that their leverage weighed on consumption above and beyond what would have been predicted by wealth effects alone. Results from regressions that control for wealth effects and other factors support the view that excessive leverage has contributed to the weakness in consumption. I also show that U.S. households, on the whole, have made limited progress in reducing leverage over the past few years. It may take many years for some households to reduce their leverage to precrisis norms. Thus, the effects of deleveraging may persist for some time to come.

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Karen Dynan

How Bright is the Housing Bright Spot?

Karen Dynan — Fri, 21 Sep 2012 10:30:00 -0400

The last few months have seen a mounting consensus among experts that the housing market has bottomed out and begun to recover. Having waited years for this turning point, people have rightly made much of the development. The term “bright spot” abounds in the recent news coverage.

But, our optimism should be tempered. As yet, the gains in housing construction, home sales, and home prices have been quite modest in comparison to the spectacular drops we saw earlier. For example, the rate at which builders are starting single-family homes has retraced only about 10 percent of its earlier plunge. At a little above 500,000 units (at an annual rate), the recent pace of housing starts is much less than half that seen in the late 1990s, prior to the beginning of the housing boom.

The current low levels of housing activity suggest a lot of scope for growth that could stoke the broader recovery. In fact, though, the pick-up does not seem to be happening fast. The pace of single-family housing starts has risen only about 100,000 since the summer of 2011. Housing investment has contributed only a couple of tenths of a percentage point to overall GDP growth over the last year, and there has been little change in the number of jobs in residential construction.

The relatively meager gains in home prices in recent months are also not doing much to support economic growth. During the housing boom, rapid home price appreciation led to large increases in household wealth, which, in turn, gave many homeowners both the willingness and wherewithal to spend voraciously. The plunge in home prices between late 2006 and early 2009 caused roughly $6 trillion of household wealth to evaporate, the equivalent of about 7 months worth of after-tax income. Data released by the Federal Reserve this week show that aggregate housing wealth, like home prices, has continued to show very little rebound (see Figure 1). A much bigger turnaround will be needed to see significant “housing wealth effects” on economic growth.

Moreover, the lack of rebound in home prices is not helping the 11 million “under water” homeowners for whom the value of their mortgage exceeds the value of their home: Their excess leverage is making it difficult for them to finance spending with new borrowing and, in many cases, to realize lower mortgage payments by refinancing into lower-rate loans.

When it comes to thinking about ways to hasten the recovery in housing, policymakers might take note of the similar pattern of single-family housing starts across the four regions for which the Census Department releases data. In all regions, housing starts moved sideways after the bust, with some modest uptilt over the past year or so (see Figure 2). The similarity occurs despite important differences in the employment situation and borrower distress across regions, providing support to the view that addressing broad issues—such as the high rate of joblessness, impediments to lending, and uncertainty about future economic conditions and policies—is key to boosting activity.

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Karen Dynan

The Household Debt Picture: Better, But Still a Drag

Karen Dynan — Thu, 06 Sep 2012 11:00:00 -0400

A report from the New York Fed last week showed that debt held by U.S. households has fallen to its lowest level since mid-2008. The report also showed that delinquency rates on most types of household loans have retraced a significant portion of their run-ups (see Figure 1).

Figure 1

While it is encouraging that Americans are continuing to chip away at the enormous debt overhang that has weighed on the economic recovery, digging into the data more deeply shows that the picture is more complicated and less cheering than it initially appears.

First, much of the paring back of household debt reflects loan defaults. Of the eleven states for which the New York Fed releases data, those with the largest declines in per capita household debt are also those that have seen the highest rates of late payments and foreclosure filings (see Figure 2). While being relieved of unmanageable debt payments frees up income to spend in other ways, a household that defaults can bear high personal costs such as loss of a home and reduced future access to credit. Analysis using credit bureau data suggests that credit scores decline sharply after a foreclosure and take several years to recover, if recovery comes at all.

Figure 2

A second complication is that another part of the decline in household debt occurred because many people cannot get loans. Surveys of bankers and other indicators suggest that lenders remain very cautious, having eased terms and standard only modestly from the stringent levels seen during the credit crunch, particularly for mortgages. Restrictive credit conditions mean that many people cannot get loans to finance purchases of homes and big-ticket consumption items. Indeed, a recent study found that the rate at which first-time homebuying is occurring is only about half of what it was at the beginning of the 2000s, suggesting that even those households with very little debt to begin with are having trouble accessing credit.

Tight terms and standards are not the only factor shutting some households out of the credit market. Many cash-strapped mortgage borrowers have not been able to qualify to refinance into loans at the historically low prevailing mortgage interest rates because their mortgages exceed the value of their homes; estimates suggest that these “underwater” households represent more than one-fifth of mortgage borrowers. Recent changes to the government’s Home Affordable Refinancing Program (HARP) have made it easier for such refinancings to occur, but about half of the banks surveyed recently by the Fed reported participating very little in the HARP program and, of those remaining, about one-third anticipated approving 60 percent or less of the HARP applications they received.

A third consideration to bear in mind is that the amount of debt reduction has been very uneven across households. While some households have dramatically reduced their debt load by defaulting, others who found themselves highly leveraged immediately following the financial crisis have remained so. In my own research, I compared households’ current mortgage leverage with reasonable target levels and found no decline in the share of households with excess leverage over the last couple of years. I also showed that high leverage is associated with lower consumption.

The economic recovery would be stronger if lenders were less reluctant to extend credit and households could more easily shed their excess debt. But the policy options for achieving these goals are not obvious. With fresh memories of the dangers of easy credit, regulators are (and should be) cautious about pushing financial institutions to make more loans, especially because their economic environment is challenging people’s ability to repay debt. In addition, government-subsidized loan forgiveness programs raise important questions of both efficiency and fairness. It may be the case that a stronger economic recovery spurred by others sorts of policies or other economic developments will ultimately improve debt burdens and conditions in credit markets rather than the other way around.

Authors

Karen Dynan

Publication: Real Clear Markets

What’s Been Weighing on Consumption? An Overview of the Recent Experiences of Different Types of Households

Karen Dynan — Mon, 14 May 2012 00:00:00 -0400

When most economists think about consumer spending, they start by thinking about an individual household. A household’s spending patterns depend on its economic environment. That environment includes the household’s income, its wealth, and the return to saving it faces. It also includes the household’s ability to borrow and the uncertainty about its future income and spending needs. In addition, the household’s spending depends on its preferences—such as its patience and aversion to risk—and any behavioral limitations for the household—such as an inability to plan effectively.

The intuitive appeal of this framework makes it a natural starting point for analyzing aggregate consumer spending. Empirical models of consumption commonly start from an implicit assumption that a single representative household accounts for all spending, so that aggregate consumption depends on aggregate income, aggregate wealth, the average interest rate for the economy as a whole, and so on. Such models are not only straightforward to specify but also convenient from a practical point of view because U.S. statistical agencies publish timely estimates of those data at a quarterly frequency.

Of course, it is widely understood that the results from such models only approximately describe the actual dynamics of aggregate consumption. The actual dynamics reflect the choices of millions of heterogeneous households—households that face very different economic circumstances and have different preferences. Therefore, a key question for analysts and policymakers is whether empirical models of aggregate consumption based on the representative household framework produce only small errors or could be astray in more significant ways.

Indeed, the dramatic developments in the U.S. economy and financial system in recent years may have diminished the usefulness of that traditional approach to modeling aggregate consumer spending. Different types of households had vastly different experiences before, during, and after the recent financial crisis. Further, aggregate consumption has failed to see the robust growth in this economic recovery that it has typically experienced in past recoveries—as can be seen in Figure 1 (available in the PDF), which plots the path of real personal consumption expenditures following the most recent business cycle trough (the thin red line) as well as the average path of this series following the cyclical troughs in 1970, 1975, 1982, 1991, and 2001 (the thick black line). Some analysts have argued that the behavior of certain subgroups of the population—such as those with very large amounts of debt—is contributing importantly to the weakness in aggregate consumer spending. If they are correct, then the usefulness of the traditional approach to modeling aggregate consumption depends on the degree to which the historical relationships between the aggregate explanatory variables capture such behavior.

As yet, there is no consensus about how best to capture heterogeneity in empirical models of aggregate consumer spending. Further, lags and gaps in data about individual households have made it difficult to even gauge the importance of doing so. Potentially, though, achieving a better understanding of the ways in which heterogeneity across households affects aggregate consumer spending could make an important difference in forecasting economic outcomes and thereby an important difference in the conduct of monetary policy. The goal of this meeting at the Federal Reserve is to fill some of the holes in our understanding. This paper presents an overview of the issues to lay some groundwork for the more detailed discussions of specific aspects of heterogeneity in the other papers.

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Household Heterogeneity and Aggregate Consumer Spending

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Karen Dynan