In The General Theory of Employment, Interests, and Money, University of Cambridge economist John Maynard Keynes argued in 1936 that the distribution of income mattered for the stability of the macroeconomy. Increased spending, be it from consumers, government, greater exports, or investment, will multiply as it works its way through the economy. If additional income goes into the hands of those with a high marginal propensity to consume then the multiplier for consumption demand will be relatively larger. But if additional income goes into the hands of those with a lower marginal propensity to consume then the multiplier on consumption demand will be relatively weaker.
Two decades later, University of Chicago economist Milton Friedman hypothesized that although rich households appear to consume less, they have a pretty clear sense of what their standard of living will be on average year after year and they adjust their savings to keep themselves at that level. In good years, when they get an income bonus, they will save a more while in bad years, they won’t save as much—or will borrow—to maintain that average standard of living.
Yet neither Keynes nor Friedman had access to the kinds of data now at the fingertips of Mian and Sufi. Thus the Keynes-Friedman debate was theoretical, not grounded in empirical reality. Now, Mian and Sufi provide a definite “yes” to the question of whether we could have prevented the Great Recession—and the conclusion isn’t pretty. They argue that policymakers could have seriously mitigated the damage, pointing out that debt forgiveness would have been much more effective that the policies implemented because it would have targeted households with the largest marginal propensity to consume. This is a failure on a massive scale and more economists need to follow the lead of Mian and Sufi and look deep into the data to understand what we got wrong.
Mian and Sufi’s argument hinges on the conclusion that it was the supply of credit that drove the bubble and the heightened debt burdens, rather than increased demand from consumers. They discuss some reasons why people may have wanted to borrow more, such as the idea that people who expected higher incomes were borrowing constrained, but come down on the side that people were just acting irrationally—given that the massive increase in borrows during the credit boom was among borrowers with declining incomes, not those with rising incomes. From this, they conclude that “whatever the reason, however, consumers who were offered more money by lenders took it.”
Were people behaving irrationally? And, what (really) does that mean? The late 1990s saw the strongest labor market in decades. The typical male earner saw his annual earnings finally grow, after over a decade-and-a-half of inflation-adjusted declines; women’s employment rates hit an all-time high of 58 percent; and the typical family income grew by an average annual rate of just under 2 percent. The middle was (finally) back, so it may have been the case that people were optimistic that the recession of 2001 would not just be short and shallow, but that the recovery would look like the late 1990s.