Atif Mian on why we need inclusive prosperity
The textbook model of finance says that credit is used to finance real investment: savers deposit their surplus funds in the banking sector which then lends these funds to firms for investment. In other words, credit is used to finance production, or the supply-side of the economy. However, evidence suggests that a relatively small fraction of the increase in credit has gone towards funding production. For example, despite the large increase in credit creation, rate of investment has not gone up. The average U.S. gross investment rate was 22.5% from 1947 through 1979 and 21.8% from 1980 onwards.
Other evidence is also at odds with the idea that the additional credit has gone into increasing productive capital. Overall growth is not any higher post-1980. Moreover, there is strong evidence that productivity growth has slowed down significantly over the last decade and a half. If additional credit has not gone into financing production as much, then the other possibility is that credit has increasingly been used to fund demand. There is indeed robust evidence to support this view.
I have already shown that most of the increase in credit since 1980 has been used to fund government fiscal deficits, or household financial deficits, especially households outside of the top 1%. The concentrated growth in government and household debt suggests that aggregate demand is increasingly reliant on credit creation for support.
The reliance on credit creation for supporting aggregate demand is a natural consequence of a higher share of income being saved due to increased inequality. Equilibrium condition for the real economy implies that as a larger fraction of the output is saved, the increased savings must be channeled back to the real economy either as investment or consumer demand. In the absence of such a channel, the real economy will be forced to contract — or not grow as fast — in order to equate supply and demand in the real economy. This phenomena is sometimes referred to as “liquidity trap” or “savings trap” in the literature (e.g. Eggertsson and Krugman (2012)).
Theoretically, as long as certain sectors within the economy such as the government or households below the top 1% are willing to run larger deficits, the real economy can continue to grow at full capacity. However, as the economy continues to rely on credit-creation for supporting demand, it becomes increasingly more difficult to do so. The reason is that as household and government credit builds up, interest rate needs to fall in order to keep the debt service requirement manageable. The reduction in interest rate also tends to raise asset prices, especially housing values, which enables household to borrow more easily. But the dependence on ever lower interest rate to support a larger stock of debt cannot go on forever.
At some point it becomes difficult for interest rate to drop any further without adding a cost of its own. First, there is the natural zero lower bound constraint on nominal interest rate. Second, and perhaps more importantly, very low interest rates introduce other problems that are damaging for the overall economy. For example, asset markets are more prone to bubbles at very low interest rate. It becomes increasingly difficult to fund pension plans and insurance funds with long-dated liabilities.
The combination of high debt and increased likelihood of bubbles makes financial sector more fragile. Low interest rates can also inhibit productivity growth due to greater misallocation of capital (Gopinath et al. (2016)) or increased market concentration (Liu et al. (2018)).