Because debt is a stock, its adjustment must take place over time; an economic unit targeting a substantially lower level of leverage will typically seek to reduce its consumption relative to its income over a number of periods, producing an ongoing drag on aggregate demand.
I was gonna let that stand by itself, because it is beautiful. But I kept reading, and I had a thought. This is the next sentence after the one quoted above:
Unlike other factors depressing output whose effects should not be expected to persist once the initial cause is removed, a crisis that results in many units finding themselves with leverage levels that are seen to be "too high" may lead to a long period of depressed output even after the initial crisis is resolved.
Well sure. Debt is not just a stock. Debt is an accumulation over time. (That's what a stock is, I guess.) It took sixty years -- from the start of the Golden age in 1947 to the start of the crisis in 2007 -- to accumulate enough debt that we couldn't deal with it. So it should come as no surprise that we cannot solve the debt problem in the blink of an eye. The solution is to reduce by half or more the debt it took a lifetime to accumulate.
And that's why I say the Fed has to stand up and say, "Oops, we made a mistake." And then they have to do things that reduce private sector debt -- not simply to reduce the risk to creditors, but to actually reduce that debt.
ReplyDeleteIt doesn't have to take half a lifetime, if we make a conscious effort.
Oh but the Fed cant do that! Say they made a mistake?!
ReplyDeleteAre you crazy!
What would happen to the "credibility" of the fed then? Would we ever be able to trust any of their proclamations after that?
Yeah Greg I think you're right. I overlooked the cozy comfort of infallibility!
ReplyDeleteSo many Popes, so few Believers.
Only 60+ yrs later can a current fed chief say that the other guy "might" have made an error..... but after painstaking study and analysis the current guy promises to not let THAT happen again.
ReplyDeleteRight. So the question is, how do you reduce leverage? My answer is that changes in borrowing behavior only work when the ratio of debt to income is relatively small. When it's large, debt dynamics dominate, so you have to do something to alter them. Seems hard to avoid the conclusion that reduction of private sector debt will require some combination of (1) write-offs on a very large scale; (2) high inflation; and/or (3) financial repression to hold interest rates below growth rates for an extended period. Is some mix of these options what you have in mind?
ReplyDeleteIncidentally, speaking of changing thinking at the Fed, you might enjoy Lawrence Ball's new NBER paper on Bernenake's, let's say, evolving thinking on monetary policy in the face of zero interest rates.
JW: "My answer is that changes in borrowing behavior only work when the ratio of debt to income is relatively small. When it's large, debt dynamics dominate, so you have to do something to alter them."
ReplyDeleteSweet. You are establishing the boundary between harmless and harmful debt -- the event horizon of a black hole, beyond which there is no escape.