Expenditure Cascades And The Subprime Crisis

The subprime mortgage crisis, which ultimately resulted in a global recession at the tail end of the last decade, was the product of a number of factors, many of which are very widely publicised. Economist Robert H Frank, currently at Cornell University, strays beyond traditional economic reasoning and rationalises this seemingly improvident behaviour of high-risk spending using his own work on expenditure cascades. Frank's work on expenditure cascades is based on James Duesenberry's relative income hypothesis that assumes that an individual's spending pattern is dependent on the consumption pattern of his peers. For instance, if a person's neighbours all paint their houses, he will be more inclined to paint his own, to not fall behind in the race for social status. In his book, Choosing the Right Pond, Frank elucidates the wastefulness of positional arms races and the significance of status. According to Frank, this race for a more favourable position in the societal hierarchy is thought to have caused the increase in consumer spending, prior to the crisis. Studies conducted by Frank and Adam Seth Levine show that an increase in disposable income for people in the richest tax bracket of society causes expenditure to increase for the poorest. When top income earners spend more on bigger houses, for instance, it redefines the consumption patterns, in an effort to "keep up with the Joneses", of those slightly below them and they end up spending more on their own houses. This changes the frame of references for those below them and this cascades until those the at the very bottom end up spending a significantly higher proportion of their income on their houses. This is supported by the statistics for the median size of houses in the USA, which rose from 1,595 square feet in 1980, by 42.8%, to 2,277 square feet in 2007 (fell to 2,169 by 2010). The real median income, however, had only risen by 15% in that period, implying that the poor income families had to decrease their saving/increase their borrowing in order to finance house purchases. Frank suggests that the gradual decline in the rate of top marginal US income tax from 70% in 1980 to 35% in 2010, with the most recent reduction being 39.6% to the current rate of 35%, during the time of the Bush administration, was responsible for exacerbating the housing bubble that was a major precursor of the sub-prime mortgage crisis. Government projects intent upon increasing the number of homeowners not only increased the availability of home loans, but started a 'positional arms race' between low income households who were spending more of their disposable incomes on houses (under the false sense of security provided by the long-term trend of increasing house prices). This naturally resulted in a fall in the US savings rate/increased consumer borrowing. Empirical evidence also suggests that expenditure cascades are positively correlated with inequality in an economy (Frank et al. 2005). With the US scoring consistently highly on the Gini indices over the years, (highest index reported was 47.0 for 2006) the increased disposable income for the top few meant a high level of cascading expenditure for households in the lowest quartile. To finance the increase in consumption, the lower income families, many of which were considered subprime, had to borrow. The loans were made available to them by investors who bundled them with prime loans and were enticed by the high probable return since subprime loans carried high yield and were usually backed by assets, such as houses (the prices of which were increasing). When house prices crashed, the subprime borrowers were unable to pay back the loans and were forced to default, resulting in what we now know as the subprime mortgage crisis. Study of expenditure cascades poses questions about traditional, neoclassical economic models and government policies. The subprime mortgage crisis could, perhaps, have been averted had the borrowers been more prudent and unyielding to positional arms races that manifest no welfare gains to society. Since we haven't yet discovered a means to alter human nature, our best option is to fabricate policies that accommodate such human idiosyncrasies. Frank proposes we reduce inequality by increasing the progressivity of taxes to reduce incentive given to consumers to spend superfluously. We are yet to reach a general consensus on the efficiency gains of such a policy, but it is crucial that we indoctrinate new ideas into traditional economic models for greater potency in results and accuracy in forecasts.