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bankruptcy laws passed in the aftermath of bad financial crises to assign the losses and move the economy forward, and repealed shortly thereafter.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.

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14 Responses to Robert Kuttner on the Aftermath of Debt Bubbles and Restructuring Debts

  1. Mike writes: “A housing and credit bubble built on debt collapsed. ”

    No, a bubble built on fraud collapsed.

  2. K. Williams says:

    Mike, you should be a bit more skeptical of that chart, because there’s no way it’s accurate. It shows the financial industry having only one quarter of losses, and those losses amounting to a minuscule fraction of what it supposedly earned over the previous decade. But we know that AIG alone lost hundreds of billions of dollars. We know that in 2007 and 2008 Merrill Lynch lost roughly one-third of all the money it had made since 1971. We know that Fannie Mae lost $60 billion in 2008 and another $72 billion in 2009, and that Citigroup lost $20 billion in 2008. And these numbers don’t even include writedowns (which are effectively admissions that the “profits” from previously issued assets didn’t in fact exist). The profits that the industry supposedly “earned” in the middle of the decade were illusory — in a literal sense. They were accounting fictions. And the losses were much greater than this chart shows.

    • You forget something. The banks are still insolvent today. They are just allowed to paper over that fact thanks to our elites threatening FASB to make them change the rules.

      • K. Williams says:

        “The banks are still insolvent today.”

        Actually, I think this is pretty unlikely, at least when it comes to the biggest banks. Having raised as much equity as they have over the past two years, while paying little or nothing in dividends, and enjoying the benefits of a low-interest-rate economy, their finances are in much better shape than they were in 2008. They’ve also already taken big writedowns. So while I’m sure they’re carrying plenty of assets at inflated values, I’m skeptical that they’re insolvent.

    • Mike says:

      K. Williams,

      The graph is from the BEA. Any reason to think they might bias one way versus the other? It’s probably a pretty big net, so other types of firms may have balanced out the losses you refer to, but banks went to profitability pretty quickly (by design of policy). If I get a chance I’ll dig around and see what’s going on under the hood.

      • K. Williams says:

        “The graph is from the BEA. Any reason to think they might bias one way versus the other?”

        Yes. The BEA numbers don’t include capital gains/losses, nor do they include bad debts: http://www.bea.gov/scb/pdf/2011/03%20March/0311_profits.pdf. As a result, they massively understate the losses that the banks suffered. Look at the numbers for the S&P 500 by sector — the financial sector lost sizeable amounts of money beginning in the fourth quarter of 2007, and lost money in every quarter of 2008, and while it was profitable in 2009, it accounted for only 1/10 of the S&P’s profits. (Last year, it accounted for around a fifth.) In effect, the way the BEA accounts for profits, issuing tons of bad mortgages gives you lots of profits in the short term (as long as payments are being made), but you never see the aftereffects when all those loans go bad, all of which leads people to overestimate how profitable the financial industry actually was.

        The BEA numbers have also significantly overstated the recovery of the financial industry in the past couple of years because the profit numbers for the “financial industry” include the Federal Reserve’s profits, which make up a sizeable chunk of the industry’s profits. In the first quarter of 2009, for instance, the Fed’s profits (annualized, as the BEA lists them) accounted for half of the industry’s profits, and even in the first quarter of this year, the Fed accounted for more than 15% of the industry’s profits: http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=239&Freq=Qtr&FirstYear=2009&LastYear=2011. The chart above shows the financial industry accounting for better than a third of corporate profits in 2010 — the real number, ex-Fed — is closer to 25%.

      • Ted K says:

        Gosh Mike, aren’t you going to get Yves’ “I used to work at Goldman Sachs, and I’ve taken many payments from investment banks and derivatives firms for consulting” super-duper seal of approval first??? I mean, come on Mike. She knows hypocrisy and possible questionable motives when she sees it Mike. That’s why she returned those checks from those firms!!! I just don’t know how you’re going to look yourself in the mirror after today if you don’t check with Yves first. Besides, Yves might blow an artery in her neck or something.

      • Ted K says:

        Mike is too young and too classy to fully “take the gloves off” with Yves, but I’m not. Here is a link to Yves site. A short list of clients her firm has consulted in the past:

        http://www.auroraadvisors.com/our_clients.htm

        and some “assignments” here:

        http://www.auroraadvisors.com/recent_assign.htm

        Now those are the names Yves wants people to know. You could possibly imagine large firms (investment banks) which they didn’t decide to “show and tell”. Does Yves forfeit her write to commentary when her firm takes large payments from investment banks, hedge funds, and what she calls “a leading derivatives firm”??? It seems if Yves holds herself to the same measuring stick she holds to others, the answer would easily be YES.

  3. Mike:
    So what you are saying is that Santayana is being forgotten by our elites? Where is Captain Renault when we need him?

  4. Pingback: interfluidity » Bank bailouts & the rentier class

  5. Tim says:

    This reminds me of a post that linked to an article (might have been here) over the fight over interchange fees. One congressman said that most people would be astounded how much of what congress does is decide which party gets access to a specific piece of the economic pie.

    On a larger scale, this seems remarkably similar. There is only so much money and income available to debtors, which is far less than necessary for the meeting of all the demands upon them. Thus congress makes decisions about what side will take the hit for the crisis.

  6. Ted K says:

    Mike is too young and too classy to fully “take the gloves off” with Yves, but I’m not. Here is a link to Yves site. A short list of clients her firm has consulted in the past:

    http://www.auroraadvisors.com/our_clients.htm

    and some “assignments” here:

    http://www.auroraadvisors.com/recent_assign.htm

    Now those are the names Yves wants people to know. You could possibly imagine large firms (investment banks) which they didn’t decide to “show and tell”. Does Yves forfeit her write to commentary when her firm takes large payments from investment banks, hedge funds, and what she calls “a leading derivatives firm”??? It seems if Yves holds herself to the same measuring stick she holds to others, the answer would easily be YES.

  7. SPECTRE of Inflation says:

    The banks are insolvent. They have hidden losses which will be ultimately realized, as the FASB will have to move at some point on the SIV debacle where it, the pure crap, is all currently hidden. When you lever up 30 to 1, it only takes small losses to send you to the dust bin of history. Enjoy the band, as you talk yourself into believing that it will all work out just fine with help coming just beyond your horizon. By the way, has anyone seen the Captain or First Mate?

  8. Pingback: Why the Budget Ceiling Fight is good news to the Traders Crucible « The Traders Crucible

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