Matt Rognlie has two important posts – Deleveraging and monetary policy, balance sheet and reality- arguing against the idea that deleveraging is a special problem for the economy (“Few popular terms irritate me as much as ‘deleveraging’”). You should read both posts. Rognlie is arguing that there is nothing interesting in the purple housing and debt circle, or at least nothing interesting that can’t be solved by monetary policy. There’s a market that isn’t balanced and we just need to bring the price to clear.
Now this is different from arguments that there is debt hangover problem but fiscal and/or monetary policy – getting people jobs and better wages – is the best way to deal with it. This argument would say focusing on debts first is the wrong end to grab the stick. And looking at savings rates versus weak income growth it’s not obvious that savings rates are the drivers in keeping consumption in check. See Christina Romer’s recent editorial here:
…evidence suggests that high debt is holding back consumer demand. But it doesn’t follow that the government needs to directly lower debt burdens to stimulate job growth…
History actually suggests that the “tackle housing first” crowd may have the direction of causation backwards. In the recovery from the Great Depression, economic growth, which raised incomes and asset prices, played a big role in lowering debt burdens. I strongly suspect that fiscal stimulus will be more cost effective at speeding deleveraging and recovery than government-paid policies aimed directly at reducing debt.
I will say some meta-things in support of Rognlie before listing the counter-arguments. I have seen way too many people invoke this argument and Reinhart and Rogoff’s “This Time It’s Different” as a way of absolving responsibility for taking on the crisis. This is both inside the administration (Secretary Geithner, President Obama) and outside. Indeed saying a version of “Obama didn’t take ‘Reinhart/Rogoff’ seriously” is becoming a go-to critique on the Right, even though the causation problems aren’t clear in the RR thesis at all. Indeed Reinhart/Rogoff can be read just as much as an indictment of not acting than trying to act.
Secondly, let’s take heed to not go out of our way to make up problems to solve. Aggregate demand is weak. Okun’s law is holding since the 1980s, the BEA’s update showed us the economy had much more of a hit to GDP than we thought, structural unemployment as viewed through the Beveridge Curve is on target for what we expect, etc. Let’s be clear on what we need explanations to solve.
That said, I have some disagreements. First off, he argues that ”In the aggregate, the assets of American households are still far higher than their liabilities” and implies that it is tough to see why the current level of liabilities would or wouldn’t be sustainable.
I haven’t updated this graph (from Fed Flow of Funds) but the relationship continues:
Short-term interest rates are at zero, yet consumers are still deleveraging. Think that through – debt is “free” but consumers want less of it. That defies normal economics and any type of regular good unless you start to bring balance-sheet issues.
But can’t some level of monetary policy fix this? Rognlie would say that debt is not free and interest rates can in fact go lower through operations like QE. The future path of interest rates can be communicated by the Fed which will push rates as well. I think these are a fantastic ideas, if only on the corporate side, but I’m not sure it hurdles the fence entirely.
Again, what is driving what here. As Henry Kaspar argues:
Excess indebtedness forces debtors to reduce expenditures in order to be able to service their debts – i.e., it forces a transfer from debtors to creditors. The creditors’ propensity to spend is lower than that of debtors; after all this is why they are creditors. They would want to lend on the means transferred to them, but do not find enough households or firms willing and able to take on more debt. To use Brad DeLong’s term: there is a lack of safe assets…
Because of the lack of safe assets creditors hoard money… But money hoarding is a symptom of the crisis, not its cause. Put differently, causality goes from lack of aggregate demand to money hoarding, not the other way round.
Rognlie also brings in the idea that for every debtor is a creditor, and if consumers are paying down debts someone else is getting a windfall and that should balance.
But let’s take an example I’ve been thinking about. Let’s say you sell your house for $100,000, but your mortgage and closing costs are $110,000. As such, you bring $10,000 to the closing to give to the bank that held the mortgage. What are the economic consequences of that? Is that the same than if you bought a $10,000 car? Spent an extra $200 every weekend on leisure activities?
If the bank can’t find profitable opportunities for loans, which by all accounts it can’t, then it isn’t the same. And if the bank has a weak balance sheet – let’s pretend it is Bank of America, which needs as much cash as it can get – then it also doesn’t get lent out. So that’s a problem.
And to the extent that monetary policy works through housing then we have some other major problems to deal with. As QE architect Joe Gagnon has argued, QE was blunted by the inability for underwater homeowners to refinance. The threat imposed by an addition 2-3 million foreclosures in 2012 would make any rational homeowner wary. Indeed a simple lesson of combining finance and macroeconomics is to never force the mass selling of assets into a weak market where there are balance-sheet feedback loops, especially if you can keep productive uses going. And unless hosting a crackhouse is productive, the “shadow inventory” of abandoned housing is just mucking up the normal building cycle. Securitization fraud is a mess of conflicting legal liabilities that are being fought through the courts and the AGs right now, which also hurts the market.
Now the link between debt and low employment is just that, a link. The causation isn’t specified, but evidence on foreclosures gets us closer. Here’s Mian and Sufi with the best empirical evidence there is:
We also find much sharper drops in employment, both during and after the recession, in counties with high household leverage. The theoretical links between leverage and employment do not yield an obvious prediction. First, we would expect over-levered households to supply more labor in order to pay off their debts. Second, employment in a given county is not directly linked to consumption in that county, given that the factors of production are often outside of the area. Despite these issues, we find that employment in high household leverage counties dropped by 8 percent from 2008 to 2009 and remained depressed through the end of 2010…
The recent financial crisis has led to almost 3 million U.S. households going into foreclosure, and the number is expected to increase….By comparing states with different legal requirements on foreclosures, we find that state laws have a large impact on the incidence of foreclosures. We find that foreclosures have large price and real effects. From 2007 to 2009, foreclosures were responsible for 20 to 30 percent of the decline in house prices, 15 to 25 percent of the decline in residential investment, and 20 to 35 percent of the decline in auto sales.
So I think there’s something here, but I think it is important to understand it doesn’t negate the other solutions. What’s your take?