Robert Kuttner on the Aftermath of Debt Bubbles and Restructuring Debts

Robert Kuttner has a really important article in The American Prospect about the aftermath of the credit bubble, Debtor’s Prison:

Economic history is filled with bouts of financial euphoria followed by painful mornings after. When nations awake saddled with debts incurred to finance wars, episodes of failed speculation, or grand projects that haven’t paid off, they have two choices. Either the creditor class prevails at the expense of everyone else, or governments find ways to reduce the debt burden so that the productive power of the economy can recover….

The real issue is how to restructure debt when it becomes impossible to repay. This is not just a struggle between haves and have-nots but between the claims of the past and the potential of the future.

You should read it all (Adam Levitin has more). I was just talking with someone about how the issue of “debt deleveraging” in the United States’ weak recovery is talked about in very technical terms as opposed to political terms. A housing and credit bubble built on debt collapsed. When the technology stock bubble collapsed it was very easy to assign losses and to pick up the where our economy left off. When a debt bubble collapses that is very difficult, as creditors have a much larger interest in dragging out the processes. Creditors are politically powerful and well-coordinated, and debtors are not and function as scapegoats. Most deleveraging is taking place in the form of foreclosures, a brutal way to delever the economy, inflicting maximum damages on communities and people.

Finding ways to assign losses after financial crises is a long-standing tradition in American history. During the 19th century you saw bankruptcy laws passed in the aftermath of bad financial crises to assign the losses and move the economy forward, and repealed shortly thereafter. You saw this with the Panic of 1837, which had a devastating recession following it (see this Whig cartoon from the period).

From John F. Witt’s Narrating Bankruptcy / Narrating Risk:

When Congress finally did enact a second federal Bankruptcy Act in 1841, the Act (like the 1821 bill) authorized both involuntary and voluntary bankruptcies, this time for all persons. Under the 1841 Act, no creditor consent was required for a debtor to receive a discharge. So long as the debtor complied with the statute by turning over all of his property to the bankruptcy trustee, the debtor was entitled to a discharge as a matter of right, regardless of how the debtor had accumulated the debts at issue.

And in the thirteen months after the Act became effective in February 1842, some 44,000 individuals entered into bankruptcy proceedings in the United States federal courts. The overwhelming majority of these bankrupts were voluntary. Thirty-three thousand of them received discharges.

The 1841 legislation lasted for an even shorter time than the 1800 Act. By 1843, the financial panic of 1837 that had helped propel the legislation had receded into the past.

This wasn’t limited to the 19th century. Finding ways to share the losses between debtors and creditors was an essential part of the way the New Deal fought off the Great Depression. It’s easy to remember this as a purely economic decision, though it was a vicious political battle at the time. As Anna Gelpern and Adam J. Levitin wrote in Rewriting Frankenstein Contracts: The Workout Prohibition in Residential Mortgage-Backed Securities, the New Deal had to deal with the ability of creditors to lock in debitors:

By mid- April [1933], Roosevelt announced that he would take the United States off the gold standard. A new monetary framework passed within weeks as part of a farm bill. It gave the executive discretion to inflate by remonetizing silver, printing money, or changing the gold content of the dollar, but did not mandate devaluation. As the year wore on, fears of “marching farmers” and “an agrarian revolution” in New Deal policy circles eclipsed the calls for stable money. On January 30, 1934, Congress enacted the Gold Reserve Act, requiring a 40 percent minimum reduction in the value of the dollar, and directing all gold coin to be melted into bullion. Roosevelt formally devalued the next day.

The gold clauses represented a simple indexation mechanism to protect creditors from devaluation, commonplace throughout history and still popular in many parts of the world… But like many indexation devices, these clauses created economic rigidity: they purported to lock the debtor into a commitment to pay a prespecified value notwithstanding inflation. And the ubiquity of the clause worked as a policy constraint on the government…

Congress responded on June 5, 1933, with a joint resolution that rendered the gold clauses unenforceable and allowed nominal payments “dollar for dollar” to discharge the underlying obligation. In response, creditors sued….

Four cases challenging the constitutionality of the joint resolution reached the Supreme Court in January 1935…They were…foremost among the president’s preoccupations. Roosevelt described the cases in terms of essential sovereign prerogatives. He briefly considered ways of pressuring the Court to uphold the joint resolution and prepared a scathing radio address to deliver in the event of an adverse ruling.

As Randall S. Kroszner found there was a market rally when the Supreme Court sided with the New Deal, likely because bankruptcy costs and debt deflation were suddenly put in check.

It’s simply amazing to compare and contrast the New Deal – with Roosevelt ready to go to the radio to fight the Supreme Court on this – and the Obama Administration – where Obama and Summers promised movement on cramdown to get key progressives to vote for the second round of TARP, and then lost interest – on this issue of how debt losses are assigned through formal mechanisms like bankruptcy in the aftermath of a massive credit bubble.

Because think where we are today in terms of the distribution. Felix Salmon looked at the the resurgence of financial sector profits here, creating this graph:

Whatever you think of the financial sector being that profitable, it is important to remember what those post-crisis profits represent. Those profits aren’t the reward for effectively allocating capital to a recovering economy. The financial sector actually did a terrible job of that in the past decade. And capital isn’t being allocated anyway. Much of the capital in the economy is sitting on the balance sheets of banks and large corporations.

These profits are based off milking the bad debts of the housing and credit bubbles while Americans struggling under a crushing debt load. Instead of sharing the losses, the financial sector has locked itself into the profit stream and left the real economy to deal with the mess. These profits reflect, in Kuttner’s excellent phrasing, the claims of the past, not the potential of the future.