Does Lending Cause Nominal Spending, or Does Nominal Spending Cause Lending?

A guest post by Mark Sadowski

Atif Mian and Amir Sufi have a post that is provocatively titled “Subprime Lending Drives Spending” and which opens with:

 “A concern that we highlighted in yesterday’s post is that the only way the U.S. economy can generate significant consumer spending is through aggressive lending to borrowers with low credit scores. Here is more evidence supporting that view.”

and which concludes with:

“It appears that the key to boosting spending in the U.S. economy is subprime lending. The financial system was lending against homes before the Great Recession, and now it has moved to lending against cars. But the basic message is the same.”

These are assertions about the macroeconomy which Sufi and Mian support with what I would characterize as borderline microeconomic evidence. I have no doubt that there is a strong correlation between mortgage loans and appliance, furniture and home improvement spending, and between auto loans and new auto spending. I also have no doubt that during periods of economic upswing that much of the increase in lending may be subprime. However they provide no evidence in their post that it is in fact subprime lending which is driving home and auto spending, and not home and auto spending that is driving subprime lending.

The reason why I bring this up is that one of the most robust results I have discovered, in my investigations into the relationship between lending and spending on the macroeconomic level is that changes in spending precede changes in lending, and not the other way around. In particular, changes in private nonresidential fixed investment precede changes in business sector credit market debt and bank lending, and changes in private residential fixed investment precede changes in bank lending.

To illustrate this general result let’s look at the history of U.S. household sector lending and spending. Here is nominal household sector credit market debt and nominal personal consumption expenditures and private residential fixed investment at quarterly frequency since 1951Q4 in log levels.

MSSWL4_0

And here’s a scatterplot of the year-on-year percent changes in each along with the elementary ordinary least squares (OLS) results..

MSSWL4_1

The correlation is statistically significant at the 1% significance level. But what we can’t tell simply from looking at this graph or from the OLS results is whether it is lending that is causing spending or if it is spending that is causing lending.

One established way of testing causality (Sims 1972) is to construct a bivariate Vector Auto-Regression (VAR) and test for Granger-causality. The following analysis is performed using a technique developed by Toda and Yamamato (1995).

The data I used is nominal household sector credit market debt (CMDEBT) and nominal personal consumption expenditures and private residential fixed investment (PCEPRFI) in log levels. Using the Augmented Dickey-Fuller (ADF) and Kwiatkowski-Phillips-Schmidt-Shin (KPSS) tests I find that the order of integration for each series is two. I set up a two equation VAR in the levels of the data including an intercept for each equation. Most information criteria suggested a maximum lag length of seven for each variable. An LM test suggests there is no problem with serial correlation at this lag length. Incidentally, an AR roots graph suggests that the VAR is dynamically stable and Johansen’s Trace Test and Maximum Eigenvalue Tests both indicate the two series are not cointegrated.

Then I re-estimated the levels VAR with two extra lags of each variable in each equation. But rather than declare the lag interval for the two endogenous variables to be from 1 to 9, I left the interval at 1 to 7 and declared the extra two lags of each variable to be exogenous variables. Here are the Granger causality test results.

VAR Granger Causality/Block Exogeneity Wald Tests
Date: 06/14/14   Time: 09:57
Sample: 1951Q4 2014Q1
Included observations: 241
Dependent variable: PCEPRFI
Excluded Chi-sq df
CMDEBT  10.69169 7  0.1526
All  10.69169 7  0.1526
Dependent variable: CMDEBT
Excluded Chi-sq df
PCEPRFI  38.02304 7  0.0000
All  38.02304 7  0.0000

I fail to reject the null that nominal household credit market debt does not Granger cause nominal personal consumption expenditures and private residential fixed investment, but I reject the null that nominal personal consumption expenditures and private residential fixed investment does not Granger cause nominal household credit market debt at the 1% significance level.

In other words U.S. household sector spending provides statistically significant information about future household sector lending, but not the other way around. As I said, the finding that spending precedes lending at the macroeconomic level is fairly robust across a variety of contexts, so anytime I see anyone jumping to the conclusion that lending causes spending merely based on their correlation, it causes me to cringe.

Do the Granger causality results actually mean that spending “causes” lending? No, in particular it could mean that a third variable is causing both lending and spending. But it does cast serious doubt on the idea that lending always causes spending based merely on their correlation.

On the other hand, there are strong theoretical reasons why we might expect spending to precede lending. At the macroeconomic level everyone’s spending is someone else’s income. The ability and willingness to take on debt arguably is income constrained. Thus we might expect to see changes in income and spending precede changes in lending.

And in fact if it is monetary policy which is the cause of nominal income and spending, as I strongly believe to be the case, then increased lending is not the key to boosting the U.S. economy. Rather increased lending is simply one possible consequence of an adequately expansionary monetary policy.

8 thoughts on “Does Lending Cause Nominal Spending, or Does Nominal Spending Cause Lending?

  1. Excellent blogging. The way money is created—through bank loans—raises interesting questions. No doubt lending increases demand. But this post suggests first incomes must rise.

  2. I don’t know how to explain the popularity of their whole narrative, that the mass of American households have stagnating income that they are supplementing with consumer debt. How could this lead to an environment defined mostly by rising prices in durable asset and fixed income markets, most clearly in a bidding war on real estate, which is owned by 2/3 of households? In America, increasing mortgage balances are a sign of savings, but they interpret it as a sign of debt-fueled consumption. I even know some baby boomers who bought investment homes at the height of the boom, in a scramble for long term investment income, and they think Sufi & Mian make perfect sense. I’d love to find one prediction from before 1998 of someone saying, “If the middle class starts getting squeezed, you know what we’re going to see? A housing boom.”

    I also have a question. Bank credit has seemed to flatten during QE’s and expand when the Fed has ended QE’s. Do you have an explanation for this?

    Thanks.

    • “I also have a question. Bank credit has seemed to flatten during QE’s and expand when the Fed has ended QE’s. Do you have an explanation for this?”

      At first glance, yes this might appear to be the case. Commercial bank loans and leases and loans and securities reached a post-recession low in February 2010 (on a monthly basis) about the time QE1 concluded, and have only been steadily increasing since March 2011, three months before QE2 concluded. But in fact Granger causality tests over the period December 2008 through September 2013 show that the St. Louis Source Base Granger causes commercial bank loans and leases at the 5% significance level, and that the impulse response is significantly positive in months four through seven.

      This is unusual, as during the period the Fed was targeting the fed funds rate (1982-2008) Granger causality tests show that commercial bank loans and leases Granger cause the monetary base and not the other way around, as is typical of some of the Post Keynesian empirical research on endogenous money, and as is hypothesized by Accomodative Endogeneity. Similar to the 2008-13 results, I find that the monetary base Granger causes loans at Federal Reserve System member banks at the 5% significance level from May 1933 through February 1937. another period of zero short term interest rates and rapid expansion of the monetary base.

      So the relationship between the monetary base and bank credit appears to be highly “regime” dependent.

  3. Mark, thanks for the post. I like that it sheds a little light on the way you go about your analysis for us non-experts.

  4. Mark this is some compelling evidence, I plan on rereading this post a few times.

    This part of their quote makes me want to toss all of their analysis out:

    “the only way the U.S. economy can generate significant consumer spending is through aggressive lending to borrowers with low credit scores.”

    It seems to be framing the lending as the causal event that kicks consumer spending off, throwing out the who New Keynesian/Market Monetarist emphasis on expectations of the nominal economy. I wonder if subprime lending was needed to kickstart consumer spending in Zimbabwe…

  5. I have understood their argument differently. Isn’t their argument that the lowest income group always wanted to spend, but banks have had very strict credit requirements, so they didn’t have funds to spend? And now when banks are giving sub-prime loans again, they can?
    I don’t see how you can say that people getting sub-prime loans can spend before they can get credit. They don’t have enough cash reserves to buy a car, so they have to have access to credit at the latest at time of the purchase.

    • Mian and Sufi’s claim that subprime lending drives spending. However in their post they provide no evidence for this claim other than to assert that there is a correlation between subprime lending and spending. Correlation, even if it exists, is not causation, and Granger causality tests routinely suggest that it is spending that drives lending.

      “I don’t see how you can say that people getting sub-prime loans can spend before they can get credit.”

      I’m not making any specific claim about the spending behavior of people receiving subprime loans. I’m saying that there is strong statistical evidence that changes in aggregate spending precede changes in lending. However, perhaps increases in aggregate spending raises the incomes of those with low credit scores and makes them willing and able to take on subprime loans. That might explain why subprime lending may increase during spending “booms”.

  6. Within the last 40 years advanced economies have proven capable of producing sustained NGDP growth anywhere from 0% to 10-20%. How can changes in the supply of sub-prime loans possibly explain all that variance? Are they claiming this thing is merely a recent US phenomenon?

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