Thursday, July 25, 2013

What about Expenditure Cascades?

Paul Krugman has an interesting post on the question of the causes of the explosion in household debt that was an important factor in our financial and economic crisis:
The president came down pretty much for what we might call a Stiglitzian view (although it’s widely held): debt was driven by rising inequality. The rich were taking an ever-larger share of the pie, but not spending to match, while working Americans took on ever more debt to make ends meet.

What’s the alternative? Minsky: debt exploded because the Great Depression was receding into the mists of forgetfulness, and both lenders and borrowers — enabled and encouraged by financial deregulation — forgot the dangers of leverage.
I'd add to this, importantly, expenditure cascades, from Cornell economist Robert H. Frank.

In an expenditure cascade, the tip-top pulls away in income, and thus spending, so level two notches up their spending to not lose their position and feel bad and embarrassed, and this involves more borrowing/less saving. When level two notches it up, this induces level three to do the same, and so on.

How much pressure do middle class people now feel to put granite, wood, and stainless steel in their perfectly functioning kitchens so they don't feel and look crappy and poor?

The 1/10th of 1% used to drive $120,000 Mercedes, and the 1% used to drive $70,000 Mercedes. Now the 1/10th of 1% are buying $400,000 Rolls Royces, making the 1% feel like their $70,000 Mercedes are crappy and embarrassing, so they save less/borrow more and buy $200,000 Bentleys. Now that the 1% went from $70,000 Mercedes to $200,000 Bentleys, the 5% feel like their $45,000 Mercedes are crappy and embarrassing, so they save less/borrow more and buy $80,000 Mercedes, and so on down the line.

I think expenditure cascades are important to add, especially since positional externalities are the pink elephant of economics.