A Quick Note on Wealth and Balance Sheet Debates

I still like using my map for understanding why people disagree on the best course of action on getting the economy going even if they are in agreement that something needs to be done.

Take this exchange in Democracy Journal – Arguing About Growth – between Larry Mishel of EPI and William Galston of Brookings Institute.  Galston:

As Mishel says, I’ve been skeptical about the adequacy of the traditional demand-side stimulus strategy that the Administration has pursued. That’s not because I thought then, or think now, the government should stand back and do nothing, or because I thought stimulus was completely wrong-headed…

Mortgages are the epicenter of household debt, and thus of our economic woes as I understand them. Stimulus without debt relief palliates the pain without curing the disease. That’s why I’ve criticized the Administration for its failure to move early on a bold plan to reduce not only interest rates, but also principal amounts on millions of underwater mortgages that could avert foreclosure with suitable adjustments.

And Mishel responds:

Galston is correct in noting that the aftermath of a financial crisis must be treated differently from your plain vanilla, high-interest-rate-caused recession, as Rogoff and Reinhart argue. As my EPI colleague Josh Bivens has stressed, this means we need to have full guns blazing to ensure we do not suffer protracted stagnation or just rely on low interest rates. The right measures here include having higher inflation targets for monetary policy and addressing the foreclosure crisis. It also means going beyond the comfort zone of deficit hawks and running large deficits to pump up demand for a number of years while deleveraging proceeds. Failure to do so will dampen the robust job growth needed to help households deleverage.

I’m with Mishel and Bivens.  We should be operating on all fronts on this recession.  Getting wages up and unemployment down is a great way to deal with debt overhangs.  Having median wages crash 10% alongside a sustained period of very high unemployment is a good way to make debt loads more unbearable.  Committing to a period of higher inflation on the Federal Reserve’s side makes debt loads less unbearable.  Christina Romer made this point early on in the Obama administration, noting GDP growth will help fix the financial system and balance debt loads.

But how much you emphasize a balance-sheet issue has implications for how much you think debt relief is an important part of the recovery.  Galston wrote a New Republic article about seeing the light on debt relief from Amir Sufi and Atif Mian’s research.  I discussed it in my interview with Amir Sufi, but I want to expand a bit.

People in areas where house prices crashed are spending less.  Is it because they feel poorer (wealth effect) or because they have too much leverage and debt (balance sheet)?  Debt relief is a very useful tool if the second is in play.  Here’s a writeup in the New Yorker by James Surowiecki, The Deleveraging Myth, making the case that the wealth effect is important and the balance sheet issue isn’t that important.

Here’s the argument for the balance sheet being more important than the wealth effect from Sufi and Amin’s latest paper, Household Balance Sheets, Consumption, and the Economic Slump (my bold):

The household balance sheet shock in high leverage counties came from two sources:
high ex ante debt levels and a large decline in house prices. One natural question to ask is: could the decline in house prices alone explain the collapse in consumption in these areas? Our answer to this question is a definitive no–it was the combination of house price declines and high debt levels that drove the consumption decline. A number of results support this view. First, the elasticity of consumption declines with respect to house price declines implied by our estimates are far too large to be driven by a pure housing wealth effect. We find elasticities on the order of 0.3 to 0.5 for non-durable goods and 0.5 to 0.7 for durable goods. Previous research suggests an elasticity of consumption with respect to housing wealth of 0.05 to 0.10 (Bostic, Gabriel, and Painter (2009)).

Second, we show that households responded to the balance sheet declines by aggressively  reducing their debt burdens. Debt balances for households declined by $1.2 trillion from 2007 to  2010. While a substantial fraction of this decline was driven by defaulting households, we also show that households that did not default reduced their debt burden by more than $250 billion during this time period. Both the increase in defaults and debt paybacks by non-defaulting households were much larger in high debt growth counties. This is consistent with the arguments in Eggertsson and Krugman (2011) and Guerrieri and Lorenzoni (2011) on the importance of the deleveraging process in explaining the severity of the recession.

Third, homeowners in high debt accumulation counties were unable to refinance their  mortgages into historically low interest rates from 2008 to 2010….Fourth, we show that the effect of house price declines on consumption declines during the recession was much stronger among zip codes with a lower non-housing wealth to total wealth ratio. In other words, the effect of house price declines was non-linear across the net wealth distribution–the consumption of households with low financial assets fell much more sharply for a given decline in house prices.

I find their elasticities and well as the non-linearity across wealth to be convincing against the primacy of the wealth effect, but you should check out the research.  Indeed, if mortgage debt relief becomes more of an issue in 2012 it will be useful to understand this research inside out.