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Randall Krozner looked at this question for the Great Depression and concluded "it is better to forgive than receive." The analysis doesn't answer the long-run effect of debt forgiveness, but we do know that the long-run trend of real GDP was not affected by the Great Depression.


Abstract: This paper examines the consequences of large-scale debt relief during the Great Depression in order to examine theories of debt overhang and the costs of bankruptcy. When the U.S. went off the gold standard and devalued the dollar with respect to gold, the government declared that the courts would no longer enforce gold indexation clauses which appeared in virtually all long-term private and public debts up to that time. If the gold clauses had been enforced, the debt burden of borrowers would have increased by the extent of the devaluation, which was 69 percent. I examine asset price responses to the Supreme Court’s decision to uphold this effective debt jubilee. Equity prices rise, but more surprisingly, the debt relief also led to higher prices for corporate bonds (all of which contained gold clauses). In contrast, government bonds with gold clauses fall in value. These responses suggest that the benefits of eliminating debt overhang and avoiding bankruptcy for private firms more than offset the loss to creditors of some chance of trying to recover the additional 69 percent. Consistent with large costs of debt overhang and bankruptcy, in the cross section, stock and bond prices of firms closer to bankruptcy rose more than other firms. The results suggest that in these circumstances it is indeed better to forgive than to receive

The other option is, of course, a monetary stance that deals with the debt overhang without repudiating the debt itself. Borrowers probably go into contracts without anticipating that the government will just abrogate the contract. Disturbing that expectation likely will have consequences. But I doubt any borrowers go into contracts without anticipating that the price level will change over time due to the decisions of the monetary authority. That may disappoint some people, but it won't violate expectations in the same way.

It is important to consider the impact on the market process of these sorts of decisions, as you say. But we also need to consider the impact on the market process of the decision to maintain below-trend nominal spending (which - to touch on another important point you raise - seems to be by far and away the most politically expedient path. It seems to be politically expedient for Democrats, Republicans, and libertarians alike, in fact! That's never a good sign!).

Trade deficits matter politically since they can result in currency valuation changes and hence employment dislocations.

I have not read Kroszner's article but I guess a lot depends on how long-run a perspective one takes. Continual forgiveness breeds contempt for contract and I should imagine moral hazard. But realizing this, agents might adapt so that effects can be reduced.

1. Forgive the debtors, punish the lenders -- yeah, I'm sure that's going to help. Well, actually it might help a lot in the case of sovereign debt, if it served to discourage future lending to governments.

2. Skidelsky suggests that lenders are partly responsible for bad debts, since they made bad loans. Of course, in a free market they do pay for that indiscretion, if they have to foreclose on property and take a bath on its resale. Why were so many bad loans made in the first place? Why aren't more loans being restructured to reflect subsequent reality? Why hasn't the market cleared? Could these be the consequences of government intervention that people like Skidelsky advocate? The childishness of Keynesian short-run thinking never ceases to amaze.

3. Skidelsky is displeased that all the money the Fed has printed up recently hasn't flooded into the economy. Lord help us all when it does.

Massive trade deficits are part of monetary / trade cycle disequilibrium across time -- see F. A. Hayek, _Monetary Nationalism and International Stability_ for an explanation.

"Libertarians" are truly out to lunch on this one -- unthinkingly recycling free trade talking points that are non sequiturs when it comes to the issues involved,

Would it not have been better to have sent mortgage holders a $10,000 voucher each so they could get caught up on their mortgages than what happened? I can't imagine it would have cost nearly as much, it would have fixed many of the "toxic" mortgages that are, as far as I know, still in existence (only held by government-approved parties), would have kept people in their homes, and probably led to a recovery by now. Surely something like this would have been a real "second best." Certainly what was tried was hardly "best" on any level. This kind of loan forgiveness might have made sense given the crisis.

I would also point out that given the levels of student loans, defaults on those loans, etc., we are facing a higher education bubble that is bound to burst soon. Do we want another bailout, meaning the loan holders will still owe the money, or do we want some sort of relief for the loan holders? Which would be better economically?

You ask: "Is that debt forgiveness option less costly than the policy path chosen to date?"

As I see it, the current policy path has been largely to make private creditors (banks) whole, often through public funds when private funds were no longer available. Looking ahead, one might therefore expect that if income growth remains weak and house prices remain flat (or drop), future private debts will also be covered by public spending. This path obviously creates incentives that distort (ultimately destroy?) markets.

The option of debt forgiveness outlined by Skidelsky would also distort markets, however in the opposite direction. From my perspective, the difference is that private creditors would be burdened with a larger share of the costs. Also, if one believes that consumer demand is the weak link in the economy, then this plan is the most economically expedient path to recovery. Further, while the devil would be in the details, there seems to be a decent chance that a plan of debt forgiveness is far more progressive than the current path (although that may or may not be ideal).

The third path that seems to have garnered significant attention in recent years is higher inflation rates (often through nominal GDP targeting). As I see it, this plan also attempts to distort markets in favor of debtors (as long as their incomes rise).

Given these assumptions, markets are likely to be distorted in one way or another. Of these options, debt forgiveness might have the greatest effect and, based on history, be least likely to be used repetitively. This path, however, appears to be the least politically feasible given current constraints. Despite all the economic arguments against the current path, the political calculus will likely have to experience a significant change before a new path is tried.

The answer to the question is, "Maybe, but it's the lender's job to figure that out." There's no reason to think losses for creditors are better or worse than losses for borrowers. The one thing you can assume pretty safely is that in any given loan, the one entity that doesn't know whether it's better to try to at least recover part of it or write it down is the government.

I think that "quantitative easing for the people" as its been called would be a good way to stop the bleeding in the economy. Basically distributing the printed money and forcing those with debts to use it to pay their debts down first and letting savers simply keep it. Banking would have to be completely re-envisioned afterwards, either by privatizing money or ending FRB, so that these explosive debt levels could never be reached again. Changes in private debt is what distorts the short term economy from Say's Law, so creating a banking system, such as a full reserve banking system, that would maintain a stable change in debt throughout time is the most important thing once debt levels are reduced.

I've taken a post-keynesian starting point to end at an austrian conclusion. Economists should be able to agree in the policy space even if they disagree in their principles because policy prescriptions overlap!

Read your article, thanks for sharing. By yzi112
I have noted, understood and agreed the contents of these NOTES and IIM policy on personal data privacy.

It is too late to do anything about TARP, which preserved all that debt on bank and Fed Balance Sheets. Since it prevented the market from clearing, TARP is the number one cause for anemic growth which will be with us for years (a decade?) until markets clear. That is the true cost of TARP.

Put another way, the market has been trying to do away with the artificial banking system since it was conceived.

But that brings up the larger issue; western government unfunded debt is moving like a glacier into the forefront. Forget the interest payments; American debt will consume 20%+ of GDP; who is going to roll that over every year? The Fed and the large banks are already cornered by bad government debt; they will go through QE57 if they have to.

I suggest one option is to see the thing for what it is; let the Fed print money and instead of bolstering bank balance sheets, it begins filling SS and Medicare coffers, converting those programs into investment vehicles (assuming that privatizing them is not politically possible) instead of redistribution/Ponzi schemes.

The Fed's money is the public money anyway, and that money would seek ROI producing investments almost immediately, rather than making the banking cartel rich by buying government bonds with printed money.

It would also provide an avenue to eventually get the government and money back on sound financial feet, and end up with something constructive in return for debasing the currency.

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