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May 3, 2010

Latest Posts from Economist's View

Latest Posts from Economist's View

Paul Krugman: Drilling, Disaster, Denial

Posted: 03 May 2010 01:08 AM PDT

Will the photogenic oil spill in the gulf revive environmentalism?:

Drilling, Disaster, Denial, by Paul Krugman, Commentary, NY Times: It took futuristic technology to achieve one of the worst ecological disasters on record. Without such technology, after all, BP couldn't have drilled the Deepwater Horizon well in the first place. Yet for those who remember their environmental history, the catastrophe in the gulf has a strangely old-fashioned feel, reminiscent of the events that led to the first Earth Day, four decades ago.
And maybe, just maybe, the disaster will help reverse environmentalism's long political slide — a slide largely caused by our very success in alleviating highly visible pollution. ...
Environmentalism began as a response to pollution that everyone could see. The spill in the gulf recalls the 1969 blowout that coated the beaches of Santa Barbara in oil. But 1969 was also the year the Cuyahoga River ... caught fire. Meanwhile, Lake Erie was widely declared "dead," its waters contaminated by algal blooms. And major U.S. cities ... were often cloaked in thick, acrid smog.
It wasn't that hard, under the circumstances, to mobilize political support for action. The Environmental Protection Agency was founded, the Clean Water Act was enacted, and America began making headway against its most visible environmental problems. Air quality improved... Rivers stopped burning, and some became swimmable again. And Lake Erie has come back to life, in part thanks to a ban on laundry detergents containing phosphates.
Yet there was a downside to this success..., as visible pollution has diminished, so has public concern over environmental issues. ... This decline in concern would be fine if visible pollution were all that mattered — but it isn't..., greenhouse gases pose a greater threat than smog or burning rivers ever did. But it's hard to get the public focused on ... pollution that's invisible, and whose effects unfold over decades rather than days.
Nor was a loss of public interest the only negative consequence of the decline in visible pollution. As the photogenic crises of the 1960s and 1970s faded from memory, conservatives began pushing back against environmental regulation.
Much of the pushback took the form of demands that environmental restrictions be weakened. But there was also an attempt to construct a narrative in which advocates of strong environmental protection were either extremists — "eco-Nazis," according to Rush Limbaugh — or effete liberal snobs trying to impose their aesthetic preferences on ordinary Americans. ...
And let's admit it: by and large, the anti-environmentalists have been winning the argument... Then came the gulf disaster. Suddenly, environmental destruction was photogenic again. ... For the gulf blowout is a pointed reminder that the environment won't take care of itself, that unless carefully watched and regulated, modern technology ... can all too easily inflict horrific damage on the planet.
Will America take heed? It depends a lot on leadership. In particular, President Obama needs to seize the moment; he needs to take on the "Drill, baby, drill" crowd, telling America that courting irreversible environmental disaster for ... a few barrels of oil, an amount that will hardly affect our dependence on imports, is a terrible bargain.
It's true that Mr. Obama isn't as well positioned to make this a teachable moment as he should be: just a month ago he announced a plan to open much of the Atlantic coast to oil exploration, a move that shocked ... supporters and makes it hard for him to claim the moral high ground now.
But he needs to get beyond that. The catastrophe in the gulf offers an opportunity, a chance to recapture some of the spirit of the original Earth Day. And if that happens, some good may yet come of this ecological nightmare.

links for 2010-05-02

Posted: 02 May 2010 11:01 PM PDT

"The 'Real' Causes of China’s Trade Surplus"

Posted: 02 May 2010 01:32 PM PDT

Zheng Song, Kjetil Storesletten, and Fabrizio Zilibotti argue, based upon their forthcoming AER article, that although China has accumulated nearly two and a half trillion in reserves in the last two decades, "it is wrong, and even dangerous, to blame this on a manipulation of the exchange rate." They argue that the existence of credit market imperfections leading to the need for high levels of internal savings provides a better explanation:

The "real" causes of China's trade surplus, by Zheng Song, Kjetil Storesletten, and Fabrizio Zilibotti, Vox EU: Over the last two decades, China has run large trade surpluses. Its foreign reserves swelled from $21 billion in 1992 (5% of its annual GDP) to $2.4 trillion in June 2009 (close to 50% of its GDP). The effect of this gigantic build up of reserves has been a source of growing public attention in the context of the debate on global imbalances. This debate has gained momentum during the global crisis. Lobbyists and politicians voice the popular concern that by swamping western markets with its products, China contributes to the failure of domestic firms and job losses. The call for protectionism is mounting.

Did China engineer a trade surplus?

A common argument, especially in the US, is that the culprit of global imbalances is the exchange rate manipulation carried out by the Chinese authorities, who peg the renminbi to the dollar at a low value. According to Fred Bergsten, head of the Peterson Institute for International Economics, the renminbi is undervalued by at least 25% to 40%. This "hostile" policy raises calls for robust retaliation.

While economists have so far opposed any measure that might ignite a vicious cycle of trade retaliations and protectionism, even their front is cracking. Krugman (2010) advocated using the threat of a 25% import surcharge to force China to revalue. Last month, 130 lawmakers signed a letter asking the US Treasury to increase tariffs on Chinese-made imports. On 12 April 2010, Barack Obama openly criticized the Chinese exchange-rate policy in front of Hu Jintao, arguing that currencies should "roughly" track the market so that no country has an advantage in trade. Meanwhile, Senator Charles Schumer called for high tariffs against Chinese imports in order to force Beijing to revalue its currency.

The exchange rate manipulation premise

The manipulation thesis rests on the simple postulate that the imbalance itself is evidence of a misalignment of the exchange rate. Letting market forces determine the exchange rate would restore trade balance.

This argument has weak foundations. What matters is the real exchange rate, not the nominal one. While the Chinese surplus has persisted for almost two decades, the real exchange rate has remained as flat as a pancake (see McKinnon 2006, Figure 3). A misaligned real exchange rate should feed domestic inflation, e.g., by increasing the demand of non-traded goods and stimulating domestic wage pressure. Yet, until very recently it does not appear as if China has experienced any major inflationary pressure – between 1997 and 2007 the inflation rate was on average about the same as in the US. Moreover, wages have grown slower than output per worker (see Banister 2007).

In a recent article on this site, Helmut Reisen (2010) shows that a large part of the alleged undervaluation of the renminbi can be attributed to the Balassa-Samuelson effect (i.e., the fact that non-traded goods do not follow the law of one price and are relatively cheap in developing countries). He concludes that "the undervaluation in 2008 of the renminbi was only 12% against the regression-fitted value for China's income level." This is by no means a large number: "Both India and South Africa (which had a current-account deficit) were more undervalued in 2008." In summary, while it is reasonable to expect some appreciation of the real exchange rate in the years to come (through either inflation or adjustments in the nominal exchange rate), the government manipulation of the nominal exchange rate is unlikely to be the primary cause of the two-decades-long imbalance.

A "real" explanation: Growing like China

What, then, can account for the Chinese surplus? We believe that the answer lies in real (i.e., structural) factors rather than in nominal rigidities. Let us look at the imbalance from an asset flow perspective: 

A trade surplus implies a net capital outflow. At first view, it is puzzling that China is a net capital exporter:

  • Aggregate and firm-level data show that the rate of return on investments is much higher in China than in OECD countries (see Bai et al. 2006; Song et al. forthcoming); and
  • Total factor productivity in Chinese manufacturing has been growing at a startling 6% annual rate in the last decade (Bosworth and Collins 2008; Brandt et al. 2009).

So why would Chinese savings be invested in low-yielding US government bonds instead of reaping the high returns of domestic investments?

In a forthcoming article in the American Economic Review titled "Growing like China" (Song, Storesletten, and Zilibotti), we propose an answer that relies on a simple economic mechanism without resorting to any exchange rate manipulation story. The predictions of our theory are consistent both qualitatively and quantitatively with the stylized facts of economic growth in China since 1992, i.e. high output growth, sustained returns on capital investment, an extensive reallocation within the manufacturing sector, and a falling labor share.

The building blocks of the theory are:

  • Differences in productivity across firms (some, mostly privately-owned, firms use more productive technologies;
  • Asymmetric financial imperfections (less productive, mostly state-owned, firms survive because of better access to credit markets).

Due to legal and financial market imperfections, private firms are financing themselves out of internal savings. The rapid growth of these self-financed firms and corresponding down-sizing of bank-financed firms creates and artificial lack of domestic investment opportunities for Chinese banks. As a consequence, a growing share of domestic savings is invested abroad and this generates a capital account deficit and matching current account surplus.

The theory rests on two sets of observations:

First, since 1992, China's urban sector has experienced a rapid transition from state-owned to private enterprises (see Figure 2 in SSZ). For example:

  • Using a firm-level data set including all firms with sales over 5 million yuan, the share of private employment in manufacturing increased from 4% in 1998 to 56% in 2007 (where the private share is defined as the ratio of employment in domestically owned private enterprises over employment in state-owned and private enterprises).
  • Aggregate data on urban employment indicate a similar trend, albeit more gradual, from 7% private employment in 1992 to 54% in 2007. The absolute numbers are large; private employment in Chinese cities increased by at least 129 million workers between 1992 and 2007 – equivalent to the entire US employment.

Since 1992, state-owned enterprises must play by market rules and can be shut down unless they are profitable. Moreover, since 1997, the ruling Communist Party has officially endorsed an increase in the role of private firms in the economy. In short, the main reason for this rapid reallocation is that private firms are more productive and more profitable than state-owned firms (see also Dollar and Wei 2005).

Second, private firms are more financially constrained than state-owned firms (Boyreau-Debray and Wei 2005).
In our paper, we document that state-owned firms finance investments through bank or equity finance more than private domestically-owned firms do – by a factor of three. The latter firms instead rely heavily on retained earnings, personal savings of entrepreneurs, and informal loans from family and friends.

The reason for this discrimination in credit markets is twofold:

  • Banks are state owned and favor state-owned firms;
  • The weakness of the legal system makes it hard for banks to have loans repaid.

There are other symptoms from private firms being credit constrained. For example, state-owned firms have substantially more capital per worker than private firms.

Putting these two observations together suggest an explanation for China's capital exports. China moved from a situation in the early 1990s where banks were lending substantial funds to the mostly state-owned manufacturing sector to a situation where bank loans to domestic firms have shrunk dramatically. The reason for the shrinkage is the downsizing of the banks' main borrowers (state-owned firms) teamed with legal and political problems that stymie bank lending to privately-owned firms even thought these private firms are credit constrained.

Just as this constellation of problems narrowed Chinese banks' domestic lending opportunities, the supply of deposits boomed. During the same period, households increased their savings deposited with banks. Chinese banks are awash with cash and it is this excess of funds that has fed the purchase of foreign bonds (through the central bank that formally has the monopoly on foreign assets).

Figure 1 below shows that the increasing difference between domestic bank deposits and domestic bank loans (dotted red line) very closely tracks the increasing foreign surplus (solid blue line).

Figure 1. China's foreign surplus and deposit-loans gap of Chinese banks

Source: China Statistical Yearbook, various issues.

Our theory is supported by two important facts.

  • First, the timing of structural change from state-owned to private enterprises closely follows that of the accumulation of foreign reserves.
  • Second, the breakdown of the net surplus (savings minus investments) across 31 Chinese provinces suggests the same pattern in the cross section. The net surplus is systematically larger in provinces with a larger increase in the private employment share (see Table 1 in SSZ).

Outside of China: South Korea and Taiwan

The Chinese build-up of foreign reserves is so spectacular because of the size of the country and its global implications. However, the coexistence of high productivity growth and trade surplus has been documented as a regularity that goes beyond the Chinese case (see Gourinchas and Jeanne 2007). Our paper shows that the reallocation from less to more financially constrained firms can explain salient aspects of the experiences of Korea and Taiwan. In particular, after 1980, both countries experienced accelerating productivity growth combined with a large balance of payment surplus.

In the early 1980s, during the initial stage of its industrialization process, Korea relied substantially on foreign loans and had one of the highest ratios of foreign debt to GDP among developing countries. This imbalance was significantly reduced in the second half of the 1980s when Korea saw booming growth and a series of large current account surpluses. This turning point coincided with a change in the Korean development strategy, which had earlier on relied on the strong integration between banks and large firms (chaebol). In the 1980s, reallocation from chaebol to small enterprises became an important driver of the growth process. The number of small enterprises more than doubled between 1980 and 1990, and their employment share in manufacturing increased accordingly, a trend that continued in the early 1990s.

Similarly, Taiwan experienced large trade surpluses in the 1980s. In the same period, the employment share of firms employing less than 100 persons (which were more credit constrained) increased from 39% in 1976 to 59% in 1991.

Both Korea and Taiwan, while not coming from a communist past, experienced a significant reallocation within the manufacturing sector characterized by a strong growth of credit-constrained high-productivity firms. Reallocation came hand in hand with an accelerating productivity growth and balance of payment surpluses. These features are common with the Chinese experience.


Our theory challenges the popular view that trade surplus is artificially engineered by the Chinese authorities. We argue instead that the surplus arises from structural factors.

What are the policy implications?

  • First, the West should push and help China improve the efficiency of its credit system so as to channel more of the growing domestic savings toward high-return private investments.
  • Such reform would yield a double dividend. It would reduce the foreign surplus while increasing both wage growth and the rate of return on domestic savings, in principle allowing China to sustain the same stellar growth rates with lower savings.
  • Second, part of the reason behind the large surplus is the high savings rate of China.
  • Why Chinese households save so much is not fully clear, but part of these savings may be precautionary (as argued by Mendoza et al. 2009) and related to the low safety net of families, or the gender imbalance (Wei 2010). Introducing welfare state elements could improve the lives of Chinese people and increase their consumption. The government could easily finance welfare state policies out of the surplus that is currently investing in low-yield bonds.

The final policy implication is obvious – the call for trade sanctions against China may be unwarranted as well as dangerous.

Disclaimer: The opinions expressed here are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.


Bai, Chong-En, Chang-Tai Hsieh, and Yingyi Qian (2006), "The Return to Capital in China", Brooking Papers on Economic Activity 2, 61–88.
Banister, Judith (2007), "Manufacturing in China Today: Employment and Labour Compensation", Economics Program Working Paper 07-01, The Conference Board.
Bosworth, Barry and Susan M Collins (2008), "Accounting for Growth: Comparing China and India", Journal of Economic Perspectives 22(1):45–66.
Boyreau-Debray, Genevieve, and Shang-Jin Wei (2005), "Pitfalls of a State-Dominated Financial System: The Case of China", NBER Working Paper 11214.
Brandt, Loren, Johannes Van Biesebroeck, and Yifan Zhang (2009), "Creative Accounting or Creative Destruction? Firm-level Productivity Growth in Chinese Manufacturing", NBER Working Paper 15152.
Dollar, David and Shang-Jin Wei (2007), "Das (Wasted) Kapital: Firm Ownership and Investment Efficiency in China", NBER Working Paper 13103.
Gourinchas, Pierre-Olivier, and Olivier Jeanne (2007), "Capital Flows to Developing Countries: The Allocation Puzzle", NBER Working Paper 13602.
Krugman, Paul (2010), "Taking On China", The New York Times, 14 March.
McKinnon, Ronald (2006), "China's Exchange Rate Trap: Japan Redux?", American Economic Review, 96(2), 427–431.
Mendoza, Enrique G, Vincenzo Quadrini, and Jose-Víctor Ríos-Rull (2009), "Financial Integration, Financial Development, and Global Imbalances", Journal of Political Economy, 117(3), 371–416.
Reisen, Helmut (2010), "Is China's Currency Undervalued?",, 16 April
Song, Zheng, Kjetil Storesletten, and Fabrizio Zilibotti. Forthcoming, "Growing like China", American Economic Review.
Wei, Shang-Jin (2010), "The mystery of Chinese savings",, 6 February.

This article may be reproduced with appropriate attribution. See Copyright (below).

"Reputational Capital and Incentives in Organizations"

Posted: 02 May 2010 11:52 AM PDT

Rajiv Sethi notes that if "the preservation of its reputation for serving the interests of its clients was a major organizational goal for Goldman, then something clearly went terribly wrong."  Rajiv argues there are two ways to get employees to avoid pursuing strategies that are profitable for the individual, but may put the firm's reputation at risk. One is to create the proper financial incentives, and the other is to "hire individuals who are predisposed to behave in a principled manner even in the face of incentives not to do so." He goes on to argue that the first solution, the use of financial incentives, is infeasible. Thus, firm's ought to hire people "who are predisposed to behave in a manner that meets organizational objectives: to place a premium not only on ability but also on character."

But how do we find such irrational individuals? After all, putting the interests of the firm ahead of your own interests sounds like a departure from the rational self-interest seeking behavior assumed in economic models. In fact, it sounds anti-capitalist to assume that individuals will work for the common good first and foremost rather than for what's best individually. Rajiv argues that this type of behavior may not be irrational after all. The absence of self-interested behavior can result in payoffs that are larger than when individuals maximize individual gains, and hence such behavioral traits -- the traits necessary for allegiance to what's best for the group even if it comes at the expense of individual incentives -- is rational:

Reputational Capital and Incentives in Organizations, by Rajiv Sethi: The following passage, jarring in light of recent revelations, appears in the opening pages of Akerlof and Kranton's recently published book on Identity Economics:

On Wall Street, reputedly, the name of the game is making money. Charles Ellis' history of Goldman Sachs shows that, paradoxically, the partnership's success comes from subordinating that goal, at least in the short run. Rather, the company's financial success has stemmed from an ideal remarkably like that of the U.S. Air Force: "Service before Self." Employees believe, above all, that they are to serve the firm. As a managing director recently told us: "At Goldman we run to the fire." Goldman Sachs' Business Principles, fourteen of them, were composed in the 1970s by the firm's co-chairman, John Whitehead, who feared that the firm might lose its core values as it grew. The first Principle is "Our clients' interests always come first. Our experience shows that if we serve our clients well, our own success will follow." The principles also mandate dedication to teamwork, innovation, and strict adherence to rules and standards. The final principle is "Integrity and honesty are at the heart of our business. We expect our people to maintain high ethical standards in everything they do, both in their work for the firm and in their personal lives."

If the preservation of its reputation for serving the interests of its clients was a major organizational goal for Goldman, then something clearly went terribly wrong. Consider, for example, Chris Nicholson's report on the manner in which the bank managed to shed its holdings of mortgage backed securities shortly before they collapsed in value, allegedly serving itself "at the expense of its clients." ...

This is a form of tail risk that is not unlike that taken by the folks at the AIG financial products division when they sold vast amounts of credit protection in the mistaken belief that they would never be faced with significant collateral calls. ... As in the case of tail risks arising from the sale of credit protection, damage to the firm's franchise value does not appear in standard compensation benchmarks. The problem in Goldman's case was not that such damage was "a hit worth taking" but rather that the incentives faced by its employees did not adequately reflect the value of the firm's reputation in the first place. To the extent that employee behavior is responsive to such incentives, the sacrifice of reputation for immediate profit will be made regardless of whether or not, in the broader scheme of things, the damage to franchise value exceeds the short term gains.

How, then, might a firm accomplish the subordination of short term goals to long term objectives in practice? There are two possibilities: one could hire individuals who are predisposed to behave in a principled manner even in the face of incentives not to do so, or one could design compensation schemes that adequately reward actions that preserve or enhance reputation. Economists, being fervent believers in the power of incentives, usually tend to favor the latter approach. But in this particular context, there are two possible problems with this. First, the contribution of any given transaction to the reputation of the firm is generally much more difficult to ascertain and quantify than any contribution to the firm's balance sheet. This makes it difficult to assign reward appropriately. Second, in order to serve as credible commitments to clients and customers, compensation schemes must be easily observable and not subject to renegotiation after the fact. This is seldom the case.

The alternative is to hire individuals who are predisposed to behave in a manner that meets organizational objectives: to place a premium not only on ability but also on character. But would this not create incentives for potential employees to simply misrepresent their values? As Groucho Marx famously said: "The secret of life is honesty and fair dealing... if you can fake that, you've got it made." 

Fortunately, the consistent misrepresentation of personality traits is often infeasible or prohibitively costly. There is an interesting line of research in economics, dating back to Schelling and continuing through Hirshleifer and Frank, that explores the commitment value of traits that are costly to fake. Hirshleifer went so far as to argue that the "absence of self-interest can pay off even measured in terms of material selfish gain, and... the loss of control that makes calculated behavior impossible can be more profitable than calculated optimization... we ought not to prejudge the question as to whether the observed limitations upon the human ability to pursue self-interested rationality are really no more than imperfections -- might not these seeming disabilities actually be functional?" 

One could take this a step further: not only might limitations on the unbridled pursuit of material self-interest be functional for individuals, they may also be functional for the organizations to which they belong. And in the long run, firms that manage to identify and promote such individuals will prosper at the expense of those who are unable or unwilling to do so.

Update: More on business reputation from Richard Green:

What Milton Friedman got wrong, by Richard Green: Friedman had two fundamental problems with business regulation. His first is that the business would capture the regulator, and therefore use regulation to establish monopoly power. My field leads me to find this line of argument compelling: real estate developers love (regulatory) barriers to entry that keep competitors from building.

His second, though, is just wrong. He argues that in order to preserve their reputations, businesses will self-regulate. Among other things, this ignores that managers often have short-term horizons. It also ignores that when large businesses implode, they leave victims with whom they never engaged in a transaction in their wake. BP did nothing illegal--how's that reputation thing working out? And having now read a whole lot on Goldman-Abacus (including the SEC complaint, the response on GS's web site, the offering circular, and excellent commentary from James Surowiecki, Yves Smith and others), it is not clear to me that Goldman did anything illegal or actionable (but I could be persuaded to change my mind). It is just that what it did (including investing long in CDS) should be unambiguously illegal and actionable. I can't think of anyone who had a bigger reputation franchise than Goldman.

As Rajiv notes, "If the preservation of its reputation for serving the interests of its clients was a major organizational goal for Goldman, then something clearly went terribly wrong."

"Consumer Credit: More than Meets the Eye"

Posted: 02 May 2010 10:17 AM PDT

This analysis of consumer credit from Michael Hammill, an economic policy specialist in the Atlanta Fed's research department, makes two important points. First, the biggest source of the recent decline in consumer credit has occurred for lending involving finance companies and securitized assets. Credit from commercial banks has remained relatively steady. Second, once "charge-offs" are considered, consumer loan growth is positive. This is in contrast to the negative growth in the as-reported series.

The bottom line is that although it is true that banks have tightened some -- it's harder to get a loan now than before -- the focus of policy of stimulate consumer credit ought to be directed at finance companies and securitized assets. But it's also worth asking whether we want consumers to go back to their old credit habits. I would prefer polices that increase business lending (i.e. investment) to compensate for declines in consumer credit rather than trying to revive the free-wheeling credit ways that households have displayed in the recent past:

Consumer credit: More than meets the eye, by Michael Hammill, macroblog: A lot has been made (here, for a recent example) of the idea that banks have shown a surprising amount of reluctance to extend credit and to start making loans again. Indeed, the Fed's consumer credit report, which shows the aggregate amount of credit extended to individuals (excluding loans secured by real estate), has been on a steady downward trend since the fall of 2008.

Importantly, that report also provides a breakdown that shows how much credit the different types of institutions hold on their books. Commercial banks, which are the single largest category, accounted for about a third of the total stock in consumer credit in 2009. The two other largest categories—finance companies and securitized assets—accounted for a combined 45 percent. While commercial banks have been the biggest source of credit, they have not been the biggest direct source of the decline.


The chart above highlights a somewhat divergent pattern among the big three credit holders. This pattern mainly indicates that credit from finance companies and securitized assets has been on a relatively steady decline since the fall of 2008 while credit from commercial banks has shown more of a leveling off. These details highlight a potential misconception that commercial banks are the primary driver behind the recent reduction in credit going to consumers (however, lending surveys certainly indicate that standards for credit have tightened).

To put a scale on these declines, the aggregate measure of consumer credit has declined by a total of 5.7 percent since its peak in December 2008 through February 2010. Over this same time period, credit from finance companies and securitizations declined by 16.2 percent and 12.4 percent, respectively, while commercial bank credit declined by 5.5 percent. Admittedly, securitization and off-balance sheet financing are a big part of banks' activity as they facilitate consumers' access to credit. The decline in securitized assets might not be that surprising given that the market started to freeze in 2007 and deteriorated further in 2008 as many investors fled the market. Including banks' securitized assets that are off the balance sheet would show a steeper decline in banks' holdings of consumer credit.

A significant factor in evaluating consumer credit is the pace of charge-offs, which can overstate the decline in underlying loan activity (charge-offs are loans that are not expected to be paid back and are removed from the books). Some (here and here) have made the point that the declines in credit card debt, for example, reflect increasing rates of charge-offs rather than consumers paying down their balances.

How much are charge-offs affecting the consumer credit data? Unfortunately, the Fed's consumer credit statistics don't include charge-offs. However, we can look at a different dataset that includes quarterly data on charge-offs for commercial banks to get an approximation. We can think of the change in consumer loan balances roughly as new loans minus loans repaid minus net loans charged off:

Change in Consumer Loans = [New Loans – Loan Repayments] – Net Charge-Offs

Adding net charge-offs to the change in consumer loans should give a cleaner estimate of underlying loan activity:


If the adjusted series is negative, loan repayments should be greater than new loans extended, which would lend support to the idea that loans are declining because consumers are paying down their debt balances. If the adjusted series is positive, new loans extended should be greater than loan repayments and adds support to the hypothesis that part of the decline in the as-reported loans data is from banks removing the debt from their books because of doubtful collection. Both the as-reported and adjusted consumer loan series are plotted here:


Notably, year-over-year growth in consumer loans adjusted for charge-offs has remained positive, which contrasts the negative growth in the as-reported series. That is, the net growth in new loans and loan repayments shows a positive (albeit slowing) growth rate once charge-offs are factored in. Over 2009, this estimate of charge-offs totaled about $27 billion while banks' average consumer loan balances declined by about $25 billion. Thus, a significant portion of the recent decline in consumer loan balances is the result of charge-offs.

Nevertheless, in an expanding economy, little or no credit growth implies a declining share of consumption financed through credit. Adjusting consumer loans for charge-offs suggests that the degree of consumer deleveraging across nonmortgage debt is somewhat less substantial than indicated by the headline numbers.

All in all, the consumer credit picture is a bit more complicated than it appears on the surface. A more detailed look suggests that banks haven't cut their consumer loan portfolios as drastically as sometimes assumed. The large run-up in charge-offs has also masked the underlying dynamics for loan creation and repayment. Factoring in charge-offs provides some evidence that a nontrivial part of consumer deleveraging is coming through charge-offs.

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