There’s a mini-debate going on over the relationship between the housing crash and weak demand. As Cardiff Garcia of FT Alphaville recently summarized it: “This reminded us of the debate last year about whether the sluggishness in consumer spending was the result of households wanting to deleverage or was caused by the big negative wealth effect caused by the huge crash in home prices.” See this from James Surowiecki on the wealth effect and the Q&A I did with Amir Sufi on deleveraging. Which is the main driver, deleveraging balance sheets or a wealth effect?
I’m more on team balance sheet. It must seem like an esoteric debate, but it has some consequences. If it’s about deleveraging balance sheets, the problem is an income/debt issue. It can be solved by reducing debt through forgiveness, lower interest rates and refinancing, equity swaps, a jubilee, and many other options. The models used in these stories indicate that any kind of transfer from creditors to debtors will make the economy better off. If it’s a wealth effect, forgiving debt is likely to be less important — it’s not the root of the problem. Redistribution between creditors and debtors is unlikely to have a major impact outside of marginal propensities to consume. You’d need to get housing prices back up for there to be a significant adjustment.
(When Jim Bullard made two meta-conservative cases against additional monetary and fiscal stimulus recently, he switched between these narratives. The first case was about how the collapse of the housing bubble represents a technology loss. Though he didn’t specify it, people could refer to the collapse of the securitization model, the inability to use housing as collateral, and the now idle Wall Street machine –results from weak balance sheets — as a type of technology that has been destroyed. I don’t think that’s a particularly useful way to look at it. The second argument was pure wealth effect: we feel poorer, and the only solution is to beg policymakers to “please reinflate the bubble.” That’s a pretty significant change in the underlying theory.)
Garcia noted that the Federal Reserve looks like it is considering joining team balance sheet. It discussed three studies at its most recent meeting, all credit and balance sheet related. One of the studies “used data on borrowing, debt repayments, and other credit factors for individual borrowers; this study found that movements in leverage — resulting from voluntary loan repayments and from loan charge-offs — have had a substantial effect on the cash flow of many households over time, and thus presumably on their spending.” I’d really like to see that study!
The White House also looks to be on team balance sheet. See the latest Economic Report of the President(pages 110 to 114):
The standard approach in economics has been to assume that households consume about the same fraction of the increase in their wealth each year, regardless of its source… The severity of losses experienced during the recession that began in December of 2007 in both national output and in labor markets makes these estimates appear too small…
A growing economics literature highlights the importance of household debt balances in influencing the severity of economic slumps… A series of empirical papers attempts to quantify the effect of such deleveraging on consumption (Mian and Sufi 2010; Mian, Rao, and Sufi 2011). These papers broadly suggest that the levered nature of household housing assets amplified the effect of pure wealth losses from the crash in housing prices.
The report even includes this iconic chart of team balance-sheet:
When Noam Scheiber wrote about how the administration viewed the economy in late 2010, he explicitly contrasted its wonks’ opinions with that of the balance sheet recession theorist Richard Koo. So is this a revolution within the administration? Is this why it is now pushing for writedowns and refinancing, after having left housing on the side for the past three years? Let’s hope so, since I consider being three years late to the party better than never showing up.
Rortybomb 
I very much agree with you on both counts. Balance sheets are the major factor in decreased demand. This was the insight that was missing from the Obama econ team approach in 2009. They were clearly more focused on the wealth effect, trying to talk up housing prices and “green shoots” rather than talking haircuts and principal reductions. The HAMP was exhibit A of this approach, trying to get a lower monthly payment while preserving the principal, exactly the wrong approach to the household debt problem, ensuring a slow rate of deleveraging while confirming debt values that exceeded the true asset values.
I would argue that the modest recovery we’re seeing now is due to the deleveraging that has taken place to date, and Team Obama has finally caught on. This MarketWatch article from ’11 states that household debt-to-income ratio decreased from 130% at the peak to 115%. This factors in the paid debt, defaults, inflation, and income gains since the recession began.
http://articles.marketwatch.com/2011-09-16/commentary/30680873_1_household-debt-debt-burden-deleveraging
Go team balance sheet!
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So if this is a balance sheet recession, then wouldn’t we expect a direct tax rebate to help households deleverage? Give every household a check for $5K and see if they pay off credit card debt, catch up on late mortgage payments, etc. I read somewhere that this is what happened with the spring 2008 rebates.
Yes,
but not a tax rebate – that only helps people who pay tax.
You need a Team Income, which, although related to both wealth-effect and balance sheet effects, seems different. Neither of those concepts, with their focus on wealth, properly captures the dynamic in play of assessing the future. It’s either the inability (unemployed, with virtually no income) or the uncertainty as to future ability to replace spent wealth (no alternative jobs to find if the current one is lost) that is holding back demand. Neither reflating the bubble nor forgiving debt will restore the ability or confidence to spend more until a jobs machine really goes into effect. This is why only a committed, long term program of fixing and modernizing all elements of the national infrastructure, directly employing at least five million people for 20 years, will really heal this economy. Of course, only a Federal Government, and only one dedicated to educating the public not to listen to deficit obsessives, can do this. It would be the national infrastructure after all.
Eventually, too, fixed income investments need to pay income again to get the retired and retiring Baby Boomers to spend more.
Why would we do what already failed in Japan? A massive increase in unproductive inefficient gov’t directed infrastructure investments like high-speed rail and Bridges to Nowhere will just waste money and push us closer to a sovereign debt crisis.
I’m not sure the distinction is really useful — if you feel you’re poorer, then you have an increased need to deleverage. Most people have future expectations of their net worth, however vaguely or specifically envisioned, and a higher savings rate is the result of trying to reconcile being poorer with those expectations.
I think the real concern is the attitude that this is a “problem” the gov’t needs to “fix” — that’s how we got the housing crisis in the first place. Artificial deleveraging is just more well-intentioned meddling. Do we want markets or a quasi-command economy?
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