William Galston Sees the Balance Sheet Recession Light

Via Paul Krugman, William Galston has an story in the New Republic, What if the Right and the Left Are Both Wrong About Why the Economic Recovery Is So Slow? A New Theory. The “new” theory is a balance sheet recession, based on research by Amir Sufi. Sufi’s work is fantastic and a favorite around this blog (see here and here), and it’s always great to have a new addition to team balance-sheet recession, but as Krugman points out people have mentioned this for some time.

In fact, some liberals have been on this for a fairly long time. For fun, can you guess which person said the following on January 27th, 2008, one month into the biggest downturn since the Great Depression, a recession triggered by balance-sheet mechanisms?

Economists teach that if the economy is going into a recession, lower interest rates and give people money. That wisdom is so conventional that the only quibbling seems to be over timing, amount, and who gets the money.

But this recession has one very special feature: Never in history have we hit a recession with the American consumer so loaded down with debt. Shouldn’t that cause someone to pause before concluding that more consumer spending is the way out of this hole?…

The problem is that Americans owe a lot of money. They owe so much money that they can’t pay it off without substantially reducing future spending. And if they reduce future spending, they can’t keep the economy going…

Maybe the economic stimulus will work for a while, and maybe it won’t. But I’m sure that a real, long-term solution to the problems facing the American consumer and the economy will take something very different.

Do you have your guess? The answer is: Elizabeth Warren, over at creditslips. Maybe President Obama should find a job for her in his administration or something.

Going back to the article, I could not applaud this conclusion from Galston more:

…Meanwhile, the policies of the Federal Reserve Board have allowed these institutions first to recapitalize and then to profit handsomely from a benign interest rate environment.

It’s time, then, to reexamine our housing policy from the ground up. If employers won’t hire until consumer demand increases, and if demand won’t increase until household balance sheets recover, then policymakers should focus on accelerating that recovery. Here’s a back-of-the envelope calculation: If we need to return the household debt burden to where it stood before the bubble, we can either wait another four or even five years (which is what it would take at the current rate without additional intervention), or we can speed it up by allocating the losses of principal that lenders need to accept and remove from their books. Moving the household debt to disposable income ratio from 118 percent to the pre-bubble 100 percent implies a total debt reduction of roughly $1.5 trillion.

I wonder what would happen if the financial wizards whose innovations helped crater the world economy turned their attention to devising a plan for reducing household debt to healthier levels without destabilizing systemically important lenders. One thing, though, is clear: Nothing of the sort will happen unless President Obama and Treasury Secretary Geithner set aside their incomprehensible passivity and fealty to the financial community’s cramped vision and get to work on the problem.

Sing it!

But it’s this a little crazy science-fiction? We’d have to create sort of magical science-fiction technology that would be capable of sorting and managing bad debts. Why don’t we just ask Geordi La Forge to make the warp engine turn risky, uncertain assets into safe assets, by taking into account the interests of borrowers and lenders, readjusting the terms with the continued value of the household in mind while mitigating moral hazard, forcing borrowers to take first losses while giving lenders a piece of the upside after-the-fact and also handling the collective and evenhanded treatment of creditors?  That’s crazy talk.

Oh wait, we totally already have that technology, and its called the bankruptcy code. And it is awesome, except for the fact that it doesn’t work on the one thing we need it to in order for the economy to recover. I’m curious if those in the administration pushing for more stimulus now but were indifferent to or fighting against cramdown when that was in play – oh let’s say Larry Summers – feel that they made the bad call back then.

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5 Responses to William Galston Sees the Balance Sheet Recession Light

  1. teddyrex says:

    For those of us who are not familiar with Sufi’s work, how is it different than Richard Koo’s thesis?

  2. Pingback: Blog News- Left and Right Views » William Galston Sees the Balance Sheet Recession Light

  3. K. Williams says:

    The problem with the balance-sheet recession thesis is that you can’t see it in the data. The savings rate is 5%, which is significantly higher than it was in 2007, but below the US historical average and not especially high for non-bubble eras. PCE are rising, again more slowly than they were during the bubble, but not at an unusually slow rate given the weak economy (which makes people uncertain about their jobs) and the continued decline in the housing market (which makes people poorer). We saw a massive demand-side shock to the economy when the bubble burst — housing demand fell off the map, and there was a massive negative wealth effect. Given those two things, is the savings rate really much higher than we’d expect? In other words, are Americans really substantially reducing their spending because of their debt burden? You can’t see it in the numbers.

  4. K. Williams says:

    Mike, the fact that households are not adding to their debt load is not dispositive evidence that we’re in a balance-sheet recession, because it’s also what you’d expect if people had suffered a massive decline in wealth (which they have, as a result of the bursting of the housing bubble) and if people were more uncertain than usual about their jobs (which they are), and were therefore less inclined to borrow against the future.

    More to the point, the shrinking of household debt over the last two quarters is entirely due to shrinking of mortgage debt, largely a function of the fact that people aren’t buying houses (while homeowners are being foreclosed on, thereby erasing their debts). Consumer credit, by contrast, rose in each of the last two quarters, which hardly suggests that the main problem we’re dealing with is overleveraged consumers hoarding cash in order to repair their balance sheets.

    I’ll just say it again: do you really think a 5% savings rate is too high for the American economy to function well? If you believe the balance-sheet-recession theory, that’s basically what you’re arguing. And it seems like an absurd thesis on the face.

    Krugman, by the way, insists again today that it’s all about debt, citing a recent paper by Mian and Sufi — http://krugman.blogs.nytimes.com/2011/07/15/it-was-debt-what-did-it/ — showing that consumption in high-household-debt counties has lagged significantly behind consumption in low-household-debt counties during the “recovery.” But the comparison is amazingly unhelpful, since high-household-debt counties are also counties where the negative wealth effect is much greater (since they tended to be bubble counties), where unemployment is much higher (since the real-estate market crashed), and where job prospects going forward are likely to be poorer, all of which make it more likely that people will cut back on their spending. The fact that Mian and Sufin appear to have controlled for none of these other factors, and that Krugman uncritically embraces their work, suggests that the balance-sheet-recession theory has become more an article of faith than an actual theory.

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