Updated below.
I have heard the argument so many times: "Low interest rates caused people to want to borrow and spend, and that's what caused debt to increase". It's such a simple and obvious explanation; only someone with a PhD in economics could fail to understand it. Unfortunately it's also an explanation that makes no sense at all. You don't need a PhD to see what's wrong with it; you just need to understand ECON 1000's supply and demand properly. But that begs the question: if that explanation makes no sense, what did cause debt to increase?
First, what's wrong with the simple and obvious explanation?
Debt requires a borrower and a lender. The same drop in interest rates that causes an increased demand to borrow causes a decreased supply of lending. Just as a drop in the price of apples causes an increased quantity of apples demanded, it causes a decreased quantity of apples supplied. And the number of apples bought is always equal to the number of apples sold, just as the number of dollars borrowed is always equal to the number of dollars lent. To get an increase in debt, you need both an increase in willing borrowers and an increase in willing lenders.
There is no obvious relation between the price of apples and the quantity of apples bought and sold. It depends what caused the price of apples to drop. An increase in supply causes a drop in price and an increase in quantity. A decrease in demand causes the same drop in price but a decrease in quantity. (Econometricians call this the "identification problem"; the rest of us call it the "what caused the price to drop?" problem.)
Step back a bit: why do any apples get bought and sold at all? The answer is that people are different: they have different abilities to produce apples and different desires to consume apples. If everyone were identical, we would all just grow our own, consume them ourselves, and neither buy or sell apples.
It's the same with debt. If everyone were identical, there would be no borrowing or lending. There would be one interest rate at which everybody would want to neither borrow or lend. At any lower interest rate, everybody would want to borrow, nobody would want to lend, so there would be an excess demand for loans, so nobody would be able to borrow, so that wouldn't be an equilibrium. At any higher interest rate, everybody would want to lend, nobody would want to borrow, so nobody would be able to lend, so that couldn't be an equilibrium either.
Which leads me to my first possible explanation of the increase in debt.
1. People became more different in their willingness to borrow and lend. You borrow if, at market interest rates, you want to spend (on consumption and investment) more than your current income. You lend if, at market interest rates, you want to spend (on consumption and investment) less than your current income. If people became more different over the last few years, in their willingness to borrow or lend at any given rate of interest, the flow of borrowing and lending would increase, and the total amount of debt would rise over time.
2. Financial markets became "better" at intermediating between borrowers and lenders. Markets, whether for apples or loans, always have transactions costs. Transactions costs are like a tax, and reduce the quantity of apples or loans traded. If apple markets became better, making it easier and cheaper for buyers and sellers to find each other, and to be more sure of getting what they wanted out of the exchange, the transactions costs would fall, and we would see an increase in the quantity of apples traded. Moral hazard and asymmetric information problems loom large in financial markets, and any reduction in these transactions costs would cause the flow of loans to increase, and the stock of debt to rise over time.
(But I put scare quotes around "better". Because it is possible that financial markets polished the apples and fooled buyers into thinking that the apples would taste better than they really did. So too many apples got bought and sold. Rather than eliminating a tax, financial markets went further and created what looked like a subsidy.)
3. Forced savings. Suppose the government forces you to save more than you want to save, by introducing a compulsory pension plan, for example. The right hand is forced to save, so the left hand chooses to dissave, to restore the original equilibrium. The right hand is the lender, and the left hand is the borrower. Even if everybody is identical, there can still be debt, because each individual both borrows and lends money. He has a credit in his pension plan, and a debit in his mortgage.
4. Low interest rates (sensible version). I already disposed of the silly version above. Suppose people are different, and so some borrow and some lend. Starting at an initial equilibrium level of debt, suppose there's a change, and that everyone now wants to borrow less and lend more at the initial equilibrium rate of interest. The rate of interest falls to a new lower equilibrium, where once again the demand to borrow matches the supply of loans. Why should debt increase? Well, it is possible that what limited the amount of borrowing and lending in the old equilibrium was the requirement that borrowers be able to service the interest on their debt. If the rate of interest halved, for example, the debt could double, while still maintaining the same ratio of interest payments to borrowers' income.
So, that's 4 possible explanations for why debt might have increased. All 4 make theoretical sense (there are probably others that make sense too). I don't know which make most empirical sense.
[Update: 5. Increased financial intermediation. (This is really a variant on 2 above). Suppose everybody is identical regarding producing and consuming apples. There is no trade in apples, because everyone just grows their own. Then someone invents a cheap and simple process for converting apples into apple juice. People like eating apples, but prefer drinking liquid apples. So everyone sells apples to the juicing companies, and buys back the juice. So trade in apples (and juice) increases. A financial intermediary performs much the same function, by converting illiquid into liquid financial assets, for example. Each dollar lent from ultimate lenders to ultimate borrowers is now lent and borrowed twice: first to the financial intermediary, and then on to the ultimate borrower. If financial intermediaries got "better", we would see less direct borrowing and lending, and more indirect borrowing and lending via financial intermediaries.
This could explain increasing aggregate debt (if we count the financial intermediaries' debts as well) in theory. But doesn't everyone say there was disintermediation in practice?]
Worthwhile Canadian Initiative 
mh: I think your explanation is a variant of my 2. above, where financial markets get “better”, and so reduce transactions costs, that are like tax on borrowing and lending. Only you argue that they acted like a subsidy, by mis-representing the quality of the loans, so the lenders thought the loans were better quality (lower risk) than they really were. Polishing the apples to fool buyers into thinking they will taste better.
Too much Fed: Have a look at my latest post, where I bring in money.
Bill: you and I think much the same way on these questions. That means we must be right;). Yes, a lot of the false reasoning is like a fallacy of composition, or what I referred to above as ignoring adding-up constraints.
I think you are right on the long-run flexible price implications of introducing fractional reserve banks into the model. No effect on the results for a change in monetary policy. But it may change the short-run effects. And the introduction of fractional reserve banking may itself change the equilibrium amount of debt. I’m going to try that in a future post.
Bruce: I see where you are going now, I think. In a closed economy, an increase in gross debt does not change aggregate net debt, which stays at zero (of course). But what you are saying is that an increase in gross debt might not even change any individual’s net debt. Each individual increases both his borrowing and his lending, and by the same amount. Agreed. I considered a similar case in my “3. Forced Savings” example. But your example gets the same results without it being forced; it’s a voluntary response to increased risk. (Presumably you could also get the same results through a tax system that encouraged people to be both borrowers and lenders at the same time).
I agree. I would see it as an increased demand for liquidity. It also matters, because if your interpretation is the whole truth (or a large part of it) of the increase in gross debt, then it’s not at all true that even some of us are “increasingly living beyond our means”. I’m not sure whether or not it works empirically. I don’t think there was an increased perception of risk in the last few years (until the last few months).
I’m sure that what Bruce Wilder is (as ever) at least part of the truth. But I think it misses the big picture (and here I am old enough and have moved around enough to have a good perspective). What really has massively increased is mortgage borrowing, consumer credit is relatively small beer.
And it is very much a shell game.
My parents generation (the lucky generation born in the 1930s) benefitted massively by borrowing modestly to buy homes which were cheaply paid off (as inflation inflated wages in the 1970s in particular) and appreciated greatly – at least in nominal terms.
New entrants in the housing market, have much greater entry costs (as a number of factors – not least urbanisation and greater equality – have pushed up real housing values – against disposable income if not against raw family income). Lower NOMINAL interest rates have had some effect, because people forget that you have to pay off the real debt – not just service it. And then along comes lower real income growth and people suddenly people are in potentially big trouble.
I think most people just extrapolate from historical experience and have failed to notice major secular trend changes, let alone more dramatic changes (such as peak oil). People have bought the shadow of house ownership, where they only in reality get to own the liabilities (such as maintenance), but the bank owns the rest.
So perhaps I would put it like this is demand and supply terms, on the demand side there is a certain amount of irrationality, with unrealistically optimistic expectations being a big factor, on the supply side there is a big agency problem with incentives being to lend and pass on the “asset” no matter how dirty it is to someone else.
That made me realise of course – the real big point that is missing in the list above – speculative demand for money! People are borrowing to gamble!
reason: but on the supply side there must also be more people willing to spend (on goods and services) less than their incomes so that the people on the demand side can spend more than their incomes. Who are these savers, the ultimate lenders? Or rather, why are they willing to save more than they did in the past? Because otherwise, the borrowers can’t borrow more and spend more?
But Nick, with fractional reserve banking couldn’t banks have reduced reserve ratios to expand credit instead of relying on increased savings from other agents?
Moreover, to the extent that the additional loans needed lenders who already had cash, isn’t the answer to the question “Who are these savers, the ultimate lenders?” quite obviously the Chinese (and other Asian savers)?
Hi Adam:
I took up fractional reserve banks in my latest post. They don’t affect the accounting identity S=I. That’s why I insist on some sort of general equilibrium perspective.
I was about to say “the Chinese?” at the end of the last comment. In a GE (i.e. closed world economy) they are clearly part of the picture. If people with a high propensity to save get richer, the total supply of savings goes up.
That might be part of the answer for the US, but I don’t think it works for Canada, since we didn’t have much in the way of a capital account surplus. Net foreign debt is approx zero.
Nick,
you are of course correct, but I could then point to increased profit share and increased inequality of income and ask which came first the chicken or the egg (since the increased share of profit is ENABLED by wage earners spending more than they earn).
I’m sort of wondering if we aren’t drifting into some sort of vague Marxism here?
Profit, that is, the rate of return on capital investment, is part of the yield curve, or should be regarded as such. Since the spread between profits and interest bearing assets is due to pyschological factors like time-preference and risk aversion/seeking, it should be noted that since the monetary policy of the fed cannot change these values, it follows that it cannot change the spread, which, ceteris paribus, stays constant, regardless of fed induced changes in interest rates. That is, interest rates have no affect on investment demand whatsoever.