A Proposed Fix for a Balance Sheet Recession?

|Peter Boettke|

Vernon Smith proposes that in a world of imperfect policy choices, but within the reality that a choice will be made nevertheless, that rather than a scattershot fiscal "stimulus" we would do better to target households and in particular the problem of homeowner negative equity.

Before commenting, remember that Smith agrees that policies that bailout anyone (banks, firms, households, etc.) are problematic.  He is discussing a policy choice within the context of choosing the least bad option, and not the first best possibility.

I disagree that the "recalculation" process will necessarily be long and result in the destruction of wealth creating opportunities, just as I disagree that the Great Depression provides evidence on the "recalculation" process, rather than what happens when government continues to attempt to off-set that "recalculation" process.  But I also understand that this historical interpretation is an on-going debate among economists and historians.  I imagine that the Great Recession will also be the subject of an on-going debate for decades to come, just as the collapse of communism and the failure of development planning are subjects of heated debate.

First, what do you think about Smith's proposal within the context he proposes it?  Second, what do you think is the best way to tackle the thorny empirical issues that would address the historical narrative in a way that might move the debate over both the Great Depression and the Great Recession toward resolution?

Comments

[Bill Woolsey]

Fails on the basic macroecnoomic principle that for every borrower there is a lender.

All of those debtors can't can't spend because they are paying down their debts.

Well, all of those creditors are receiving payment of their debts.

If one assumes that people who receive repayment of debts simply hold money, then repaying debts is an increase in the demand for money.

However, they could instead use the funds repaid to purchase consumer goods (households) or capital goods (firms.)

If the creditors are foreigners, then they can purchase consumer or capital goods (exports.)

Of course, maybe they want to hold more money. If they do, then either that additional nominal money demand needs to be accomodated, however large that is by historic standards, or prices and wages need to fall to raise the real quantity of money however much is needed, or the nominal yields paid on monetary assets needs to fall enough to reduce money demand.

But if money is not treated explicitly and just just spending is considered, then you end up with this errors. Just as an individual with too much debt reduces spending to pay down debt, everyone together must reduce spending to pay down debt. No, what about the creditors who are receiving these payments?

[Richard Ebeling]

Pete, thanks for bringing this article by Vernon Smith to our attention. I, for one, had not seen it.

If we follow Smith's suggestion to revalue these "negatively" valued homes downwards for mortgage payment purposes, who, then, "takes the hit"? If the banks do, who pays for the "losses" on their books?

Or if we assume that the Fed re-prices the mortgages that are now on their books (resulting from their earlier additions to their balance sheet), then I take it that this is simply formal (or informal) partial "debt forgiveness"?

I take it that after re-pricing these mortgages for debt-serving purposes for the home "owners," any improvements (that is, future increases) in housing prices will accrue to those home owners?

Thus, profit gains on housing are "private gains," but losses on housing values are "socialized" or "monetized."

What "rational expectations" will that generate in people's minds looking to housing price cycles in the future during economic ups and downs?

And if this applies to the housing market, why not to various business sectors of the market when during future economic downturns (color me a cynic, but I don't expect this to be the last business cycle through which we pass in this century) the market value of these enterprises falls below their investment and operating costs, and they cannot stay in business due to a "negative" value of their firm?

I would draw upon a passage in a Supreme Court decision from 1886 (Boyd vs. U.S.), "Illegitimate and unconstitutional practices get their first footing in that way, by silent approaches and slight deviations from legal modes of procedures . . .It is the duty of the courts to be watchful of the constitutional rights of the citizen, and against any stealthy encroachments thereon. Their motto should be 'obsta pincipiis' [resist the first beginnings]."

This is not, obviously, "stealthy," but it takes a "reasonable" and seemingly "exceptional" situation in supposedly exceptional circumstances to, well, make an "exception." An exception to what? That individuals bear the burdens of losses as well has retain any profits from their actions, choices, and investments in the market. And virtually everyone considers their home as an "investment" looking to the future.

To be honest this argument about "negative" home values as a basis of people "walking away" from their houses, or not meeting their financial obligations in full (monthly mortgage payments), has never seemed reasonable to me.

If I've bought a home, I probably expect to live there for a period of time. Just because the market is currently evaluating that property below what I, earlier, paid for it, is only a possibly "paper loss," unless I want or "need" to sell it now. I'm concerned with what my house might have as a market value, say, ten or fifteen years from now; not, necessarily, today. That is why I may make home improvements as the years go by. Not only for my own comfort and enjoyment, but as a further investment looking years ahead when I might put it up for sale.

So, who might this be a problem for? Oh, the housing "flipper" who viewed his home purchase, perhaps, as a short-term investment from the start during the "boom" years? Or the person who loses their job and can't make their mortgage payment? Well, housing markets always, in general, are slow and "bad" during the downturn of the cycle (this one, admittedly, more than in some others). And, people have lost their homes before.

"You's buy your ticket and you's take your chances." Northwood University, where I teach, does not have tenure. In principle, I could be fired at the end of this academic year, and I doubt that I'd be able to sell my house (which I've been in for about a year and a half) for a price that would cover what I still owe, plus the improvements I've already made.

I don't consider it the responsibility of the taxpayers or the Fed to subsidize or monetize by housing debt.

And once the precedent is established, as the quote I used from that Supreme Court decision suggests, you run the risk of a growing applications of this exception to the rule. "If him, why not me?"

So, Pete, I think that option two in Vernon Smith's set of alternatives remains the best: let the market do its job.

Richard Ebeling

[Roger Koppl]

I think Smith is right. He is indeed saying (Richard) that the government should have financed debt forgiveness for households underwater on their mortgages. Doing so would have helped ordinary Americans. It would also have propped up creditors, although I'm not sure that's a benefit! The whole business would have increased mobility in labor markets. Mostly, it would have been a great way to minimize the financial pain suffered by ordinary Americans who were basically burned by the combination of loose money and bad housing policy.

[RPLong]

Whose debt is "better" than whose reminds me of the runaway train ethics problems. Ethicists typically proclaim that it is always better to save the greater number of people, if someone must die.

But my objection has always been: how can you really know which person's life is of greater worth?

Well, in the marketplace, we have a pretty good guide: Those people who are most likely to do the most for the economy at large are also those who happen to need the least amount of "stimulus." Realizing that, any bailout or stimulus is going to be a double-loss; first, for taxing it away from society and large and second, for redistributing it to inefficient producers.

So my view is the (I guess) Mankiwian view of simply taxing less. The best way to stimulate me is not by subsidizing me, but rather to stop taking my money away in the first place; and a tax rebate is a second-best option.

But that's just my opinion.

[Current]

I agree with Bill Woolsey about this.

I made the same argument here:
http://www.cobdencentre.org/2010/11/debt-delusion-indeed/

People who talk about the "vast amount of debt" associated with housing seem to forget about the vast amount of financial assets it supports.

[Mathieu Bédard]

It would probably be impossible to implement without causing a huge moral hazard problem. And it doesn't seem obvious to me that this "stimulus" would not interfere with the recalculation of home prices...

[Bill Woolsey]

To add a bit more to Current, a "balance sheet recession" is nothing more than the paradox of thrift. If assets prices fall, or there are defaults, and asset owners are poorer, they may save more. If people are worried about their high debts and pay them down, they are saving. If people would be willing to borrow, but creditors refuse to lend more, so people are compelled to reduce their total debts by paying off the ones they have as they come due, they are saving.

A "balance sheet" recession is people are saving more, so spending less on consumer goods, and supposedly, this leads to recession. It is the paradox of thrift. If firms use profits to pay down debt rather than pay out dividends, they are saving. If they pay down debts rather than purchase capital goods, they are investing less. Firms that receive debt repayments can either pay them out as dividens or purchase capital goods. (Or buy other financial assets, or accumulate money, of course.)

To remind you of basic classical economics, what is supposed to happen is that when saving increases, the interest rate falls. This dampens the reduction in consumption and expands investment.

When we tie all this in to the "balance sheet recession story," the lower interest rate tends to raise asset prices and make debts less burdensome.

Now, if the lower interest rates result in an increase in the demand to hold money, as it might, and almost surely would if the natural interest rate approaches zero, then we get an excess demand for money.

But when I read Smith, I see no evidence that he even gets this far, it is like, people pay down their debts, and those receiving the payments just hold the money. (I read an article by Smith some time ago explain how housing problems cause recessions while a drop in the stock market doesn't. It has to do with people financing their homes.)

If there is an increase in the demand for money, then either prices (and wages) need to fall for the real quantity of money to rise or else the nominal quantity of money must rise. With inside money, this should lower interest rates too. With outside money, the lower price level (and wage level) can increase real wealth and result in less saving--the Pigou effect, which leads to more consumption spending.

Of course, I have already said that there are issues about expected future spending that can offset all of this, and the 'balance sheet recession' can end with higher interest rates. That requires more investment demand and less saving supply. Debt can still be paid down, but those who receive the payments would need to be spending them on consumer goods (saving less) or capital goods (investing more.)

My question is why do so many Austrians take the "balance sheet recession" seriously? Why does dressing up the paradox of thrift with some institutional details about debt suddenly make it plausible? Surely it is because of the Austrain Business Cycle Theory. A prior excess supply of money supposedly caused an excess supply of credit, lower market interest rates, and a higher equilibrium quantity of credit. Perhaps the basic analysis of the paradox of thrift is hard to accept when the "problem" was supposedly excessively low interest rates and the recession is supposedly about adjusting to some kind of change in the allocation of resources to reflect higher, correct, levels of interest rates.

I know that most Austrians don't use supply of saving/demand for investment analysis. I sometimes wonder if the "pure time preference" theory of interest combined with round about methods of production creates what I would see as a perfectly elastic supply of saving and a demand for investment that is based upon the physical productivity of round about methods. I am sure no one really believes this. But my question is how is that "balance sheet recessions" are not immediately seen as an aspect of the paradox of thrift.

[Roger Koppl]

I'm not sure I see such big problems with Smith's proposal.

Bill points out that every debtor implies a creditor, and says, "All of those debtors can't can't spend because they are paying down their debts." But the point is that they are *not* paying, which is why those mortgage-backed securities lost so much value and why we have high mortgage default rates. Bill’s subsequent appeal to “classical economics” shows that he is not thinking about the difference between notional and effective demands. The two separated in the Great Recession, which is what make it great. When you have that separation, it takes a long time for the system to heal itself.

Similarly, Richard seems to underestimate the force of Smith's argument on recalculation. We've been bumped out of Leijonhufvud's corridor and it takes time to get back in. In the meantime, ordinary Americans who are not responsible for our financial debacle are paying the price.

It looks to me as if RPLong is making two errors. First, we don't have that much of a free market, so appealing to the judgment of "the marketplace" seems a bit out of place to me. We have corporatism, which is a rigged system, rather than anything very close to laissez faire. I think RPLong also errs in suggesting that 1) one person's life may have "greater worth" than another's and 2) "the marketplace" is a "pretty good guide" to who the better people are. I do not believe that the human worth of "inefficient producers" is lower than that of others. I think all men are created equal and each counts for one.

Smith’s proposal underlines an important fact about the American political system: National policies are meant to serve not the people, but the elites. If the Bush and Obama administrations had been interested in helping ordinary Americans, they would have done what Smith said. Bush’s bailout and Obama’s stimulus were never meant to speed recovery. They were meant to redistribute income to the rich and powerful.

[Bill Woolsey]

Roger:

I don't think I am confused about notional and effective demands.

As you should know, I favor quantitative easing to fix the problem. My only question is why did they wait so long?

As Yeager explained, we only get pushed out of Leijonhufvud's corridor if there is shortage of money.

People who are unemployed because of an excess demand for money, and therefore can't pay their mortgages, have a gripe.

People who paid more for their houses than they could afford, and could only make payments if they refinanced after they received the capital gain they (and their lenders) were speculating on, have no complaint.

Similarly, people who purchased homes with variable rate mortgages who will not be able to afford the mortgages when interest rates return to whatever the level they might be post recovery have no complaint. Speculating that the current level of interest rates will last for the next 30 years is your fault.

Who exactly is left? People who bought a house with a fixed rate mortgage and they could afford the paymennts, and they continue to work maybe need to consume less than they otherwise would. They aren't building equity in their house that they can plan to sell and fund their retirement. But having the government dissave even more to cover the losses is probably a mistake.

Hey, I didn't favor TARP either.

I don't believe there such a thing as a "balance sheet recession." Now, if you want to bail out people in overpriced houses so they can spend more on consumer goods, then fine.

If you really believe that the problem is a surplus of the consumer goods that indebted households would buy, and of the capital goods that indebted firms will buy matched by a shortage of the consumer goods that creditor households would buy, or capital goods that creditor firms would buy, then fine.

But please provide some evidence of the bottlenecks limited the production of all of these goods. Money expenditures are 12.5 percent below the trend of the Great moderation, and have only just reached their previous peak. Do you really believe that prices and wages continued to rise nearly every quarter because of shortages?

As I see it, the notion is that there is a call need to bail out people in underwater mortgages because increasing the quantity of money is just too difficult. Or, letting interest rates fall to balance saving and investment given current expectations is just... well, there you go. It means that creditors will earn less interest income.
But too much debt doesn't result in too little spending on consumer and capital goods--or at least not for any reason that an adequate quantity of money and an interest rate equal to the current natural interest rate won't solve.

[Richard Ebeling]

Roger,

My car is currently worth less than I paid for it. It has a "negative" value. And this has an adverse affect on my wealth position and my desire to spend, and my "credit worthiness" to borrow more.

I need for the government to give me auto debt forgiveness.

So . . . what's the problem?

And if you say, "But its the housing market! It's important! It has a 'big effect' on the economy!" Then who decides the next time -- other than pressure group politics or whatever group or segment of the market can attract the greatest amount of ideological emotional appeal?

I think a reading of chapter 3 on 'Principles and Expediency' in volume 1 of Hayek's "Law, Legislation, and Liberty" might be useful.

Richard Ebeling

Richard

[The Cuttlefish of Cthulu]

" I think all men are created equal and each counts for one."

Pfft. You're saying you regard a stranger as morally equal to a family member? Rubbish, I (and everyone else) know you don't. So knock off the grandstanding.

[George Selgin]

I find myself solidly with Bill and Richard on this one, and hence for Vernon Smith's second option while entirely against his first. I'm also glad to see that Bill, like me (but unlike David Beckworth), worries that QE2 came too late to do more good than harm.

[Lee Kelly]

That some people are in too much debt (and other people are bearing too much risk) is a problem, but it is not a problem for government to address (especially with fiscal policy). Let the market do its thing with debtors and creditors. The only thing for the government to do is provide the least bad monetary conditions for these microeconomic processes to occur, i.e. some kind of nominal income/spending target.

If the world's central banks were pursuing goo monetary policy, then I suspect the other problems would be greatly alleviated (though not entirely resolved).

[Roger Koppl]

I think I'm gonna stick to my guns even if I have to disagree with George Selgin to do so.

If Smith's option 2 came with some magic guarantee that the state would never misbehave again, ever, ever, then I too would support it. Absent such a magical guarantee, I don't think option 2 is laissez-faire. It's just letting the chips fall where they may, which is to say, choosing not to bother about who is harmed most by government misbehavior. I don't see how economics or politics supports such a posture. Given that we have a misbehaving Fed, I prefer that any remediation be targeted as much as possible to ordinary households and as little as possible to Big Finance, Big Business, and Big Just-About-Anything-Else.

My preferences are based on the assumption of a long and painful recalculation period, which Pete has rejected. I don't see how you can assume the readjustment is speedy and still think the business cycle is all that much of a big deal. So we wasted a few resources. We get back on track and carry on.

BTW, I'm not sure how serious C of C really meant to be in accusing me of grandstanding. Anyway, he seems to have an innovative interpretation of the ancient doctrine that all men are created equal. I guess I'll let the reader decide whether I mean what I say.

[Richard Ebeling]

Roger,

The problem is that if there is a very prolonged period of market adjustment, it may be precisely due to the degree of intervention and manipulation (of various monetary, fiscal, and regulatory sorts) that the government introduces.

If the government were not to intervene, what are the reasons for thinking that it would be prolonged process of readjustment? And especially if people did not have the expectation that the government would intervention in various ways to maintain the distorted and imbalanced positions the boom has put them in, again, why would this be an particularly prolonged process?

Do we not presume that "markets work"? Not instantaneously or simultaneously in all markets -- after all, we are "Austrians," not "Walrasians"! But I have no reason to assume that markets would not do their "job."

Do we not tell our students that markets and prices have "work to do," which they cannot do (or at least not so effectively) when the government intervenes in these matters? So, what new or different?

Richard Ebeling

[Roger Koppl]

Richard,

First, I am willing trade off market freedom for other values, like relieving the distress of the innocent victims of past policy blunders. Second, as I have already said, we do not have laissez-faire and keeping hands off on this particular adjustment process will not give us laissez-faire. Again, if Smith's option 2 came with some magic guarantee that the state would never misbehave again, ever, ever, then I too would support it. No such guarantee is in evidence. I don't think the issue here is really so much about economic theory, is it? Isn't really just that I'm not that much of a libertarian, or at least not that hard core?

[Matt Stiles]

Lowering taxes across the board is always the best among Keynesian prescriptions. Simplifying the tax-code would be next - but that's going to put thousands of accountants, lawyers and IRS employees (temporarily) out of a job - so some of the "stimulus" is offset.

Doing anything that benefits one group of people over the other is unethical and unacceptable as a solution. An across the board tax cut is the only thing I can think of that doesn't fit that description. I suppose the allowance of new industries currently prohibited (such as cannabis/hemp production) could make a minor difference.

[Roger Koppl]

Okay, Pete, so how would you answer your two questions?

[Peter Boettke]

Roger,

More or less what Richard said to be honest, but I suspect you would have guessed that. At least with regard to Vernon's proposal.

I don't have an answer to the second question because I persuade myself too quickly and cannot actually wrap my head around why others see the situation differently. I keep trying.

I am currently reading Lance Taylor's Maynard's Revenge. Perhaps that will help me come to a better understanding. But I think the sort of Rothbard/Higgs interpretation of the Great Depression is the right interpretation and the right way to frame current events.

[Roger Koppl]

I guess I misinterpreted your second question. I thought you were asking about empirical strategies. You know: What statistical test would discriminate between an Austrian and Keynesian story. That sort of thing. I think ABCT fits the crisis better than any rival, but we have not done a good enough job is carrying it across to the rest of the profession. It's good moment for the theory, the door is open for us, and so on. But I think we need to adapt our theory and our empirics if we are to be persuasive to mainstream economists, as plenty of people have been noting lately. I don't think I have a very good picture of what those adaptations should be, beyond my repeated call for ditching the capital theory (in empirical macro) in favor of the humble notion of "duration." What's your take on such issues?

[Supra Shoes]

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