Must private-sector debt crisis necessarily lead to sharp recessions? Are impaired household balance sheets the reason for the Great Depression, the Great Recession, and the Eurozone crisis? For many observers the answer is an unequivocal yes. People acquired mortgages based on unrealistic expectations about future income streams from housing. They, therefore, overestimated the present value of their homes and took on too much debt. When these expectations failed them, they were forced to deleverage and the resulting drop in aggregate spending ushered in the Great Recession. This view is both intuitive and widely held. But is it complete? Or does it miss a deeper, more important story?
These are the questions I discuss in my review of Atif Mian and Amir Sufi's new book, House of Debt, in the July 7 print edition of the National Review. Here is an excerpt:
Why should the decline in debtors' spending necessarily cause a recession?Recall that for every debtor there is a creditor. That is, for every debtor who is cutting back on spending to pay down his debt, there is a creditor receiving more funds. The creditors could in principle provide an increase in spending to offset the decrease in debtors' spending. But in the recent crisis, they did not. Instead, households and non-financial firms that were creditors increased their holdings of safe, liquid assets. This increased the demand for money. This problem was exacerbated by the actions of banks and other financial firms. When a debtor paid down a loan owed to a bank, both loans and deposits fell. Since there were fewer new loans being made during this time, there was a net decline in deposits [and thus] in the money supply. This decline can be seen in broad money measures such as the Divisia M4 measure. These developments—increase in money demand and a decrease in money supply—imply that an excess money-demand problem was at work during the crisis.The problem, then, is as much about the excess demand for money by creditors as it is about the deleveraging of debtors. Why did creditors increase their money holdings rather than provide more spending to offset the debtors? ...Mian and Sufi do briefly bring up a potential answer: the zero percent lower bound (ZLB) on nominal interest rates.The ZLB is a floor beneath which interest rates cannot go. This is because creditors would rather hold money at zero percent than lend it out at a negative interest rate. This creates a big problem, because market clearing depends on interest rates' adjusting to reflect changes in the economy. In a depressed economy, firms sitting on cash would start investing their funds in tools, machines, and factories if interest rates fell low enough to make the expected return on such investments exceed the expected return to holding money. Even if the weak economy means the expected return to holding capital is low, falling interest rates at some point would still make it more profitable to invest in capital than to hold money. Similarly, households holding large amounts of money assets would start spending more if the return on holding money fell low enough to make household spending worthwhile. This is a natural market-healing process that occurs all the time. It breaks down when there is an increase in precautionary saving and a decrease in credit demand large enough to push interest rates to zero percent. If interest rates need to adjust below zero percent to spur creditors into providing the offsetting spending, this process will be thwarted by the ZLB.It is the ZLB problem, then, rather than the debt deleveraging, that is the deeper reason for the Great Recession.
Here is another way of seeing the importance of the ZLB problem. The present value of housing is affected by both the expected income streams it will earn as well as the interest rate at which they get discounted. The debt deleveraging story focuses on the fall in the expected income stream, the numerator. The ZLB problem focuses on the lack of offsetting fall in the interest rate, the denominator. Had the interest rates been allowed to reach their negative market clearing (or 'natural') interest rate level, then the present value of housing would not have fallen as much. Household balance sheets would not have been impaired so badly and there would have been less need for deleveraging. In short, there would been no Great Recession but only a ordinary, mild one. So again, the ZLB really is the deeper story here.
P.S. There are ways for policymakers to get around the ZLB and hit the natural interest rate level. So even though it was the deeper story, it is not insurmountable. But these approaches are politically difficult, especially for a central bank that has exhausted its political capital on bank bailouts and make-it-up as go along QE programs. If only the Fed had spent more of its capital on one of these approaches early on.