Tuesday, April 1, 2014

Williamson: "If you weren't seeing the debt overhang effect in the 1981-82 recession, why are you seeing it now?"

From that Williamson post I've been looking at...
Here is a set of explanations that I have heard for the recent behavior of economic time series:

Wow. I think he means the recent behavior of the economy. Anyway...

Here is a set of explanations that I have heard for the recent behavior of economic time series:

(i) Wages and prices are sticky.
(ii) There is a debt overhang. Consumers accumulated a lot of debt post-2000, the recession has compromised their ability to service that debt, and they have reduced consumption expenditures substantially.
(iii) Consumers and firms are anticipating higher taxes in the future.
(iv) Sectoral reallocation has caused mismatch in the labor market.
(v) Capacity has been reduced by a loss of wealth, or perhaps more specifically, collateralizable wealth.

It's obviously number two there that gets my focus: There is a debt overhang. That's where I'm going. I just have to work up to it.

On the first item, sticky prices, Williamson says

The 1981-82 recession occurred in the midst of a rapid disinflation, from close to 15% (CPI inflation) in early 1980 to 2.5%, post-recession. If there was a time when wage and price stickiness would matter, that would be it.

Stickiness didn't matter then, Williamson says, so it can't make much difference now. Then he moves on to his second point:

Debt Overhang: Again, think about the 1981-82 recession. The unanticipated disinflation would have made a lot of debts much higher in real terms than anticipated. If you weren't seeing the debt overhang effect in the 1981-82 recession, why are you seeing it now?

See, this time it's a question. Williamson leaves a door open. I'm going in.

If you weren't seeing the debt overhang effect in the 1981-82 recession, why are you seeing it now?

Maybe because, in 1981-82, the significant increase of debt had not even begun:

Graph #1: Total Credit Market Debt relative to GDP

Maybe because, in 1981-82, people were fed up, but not yet desperate:

Williamson's 8th: Employment Picked Up in the 1980s, but not This Time.

Maybe because, in 1981-82, President Reagan was putting a whole new economics in place. People were optimistic.

Graph #3: "Consumer Sentiment"
After falling from its 1965 peak, in 1983 confidence skyrocketed.
Confidence remained high until the 1991 recession, then fell.
After the '91 recession, confidence grew only slowly and did not
reach a high level until economic performance itself was good.
"Expectations" worked in 1983, but have not worked since.
Fool me once, shame on you. Fool me twice, shame on me.

Why were people optimistic? Well obviously if the old economics was wrong, Reaganomics had to be right. Didn't turn out that way, no. But that's what people thought. Some still do, blaming the old economics for the new problems.

In comments on Williamson's post, JSR said

As far as debt goes, leverage was much smaller in 1980 -- the ratio of private debt / GDP was nowhere near the levels just before 2008, so there wasn't a significant debt overhang problem.
Graph #1, above, confirms this. Williamson, however, sees it differently:

Depends how you measure private debt, I think.

So, like, if we don't count the debt we won't find an overhang, dude!

Williamson also says "The 1981-82 disinflation is huge." I agree. I wish Williamson said more about that. For example, if inflation had continued at high levels, it would have pushed GDP and new borrowing up. But it would not have increased existing debt. And since existing debt is a good big chunk of total (existing+new) debt, continued high inflation would have prevented the dramatic increase that occurred in the 1980s.

Graph #4: Total Credit Market Debt relative to GDP (blue) and the Rate of Inflation
Debt relative to GDP (the blue line) is pretty flat until 1980. Then it curves up sharply until about 1986. This period, 1980-1986, by no coincidence, is the exact same period when inflation fell from a 15% annual rate to well under 3%. This disinflation slowed the growth of nominal GDP, so the ratio of Debt to GDP began to climb rapidly -- as Graph #4 shows.

To be sure, the growth of debt itself also contributed to that climb. Graph #5 shows the growth rate of total credit market debt, independent of GDP. In the early 1980s debt (blue) grew rapidly while the rate of inflation fell. Certainly this contributed to the upsurge of the blue line shown on Graph #4, above.

Graph #5: Total Debt Growth and the Rate of Inflation
But there are two other massive peaks of debt growth on Graph #5, in the 1970s. These were accompanied by massive spikes of inflation, as the red line shows. The inflation spikes prevented the debt spikes from appearing as upsurge on Graph #4.

The 1980s Upsurge
Not only the growth of debt, but also disinflation was required to generate the upsurge of the 1980s. The two debt spikes in the 1970s came with corresponding inflation spikes. In the 1970s, the high inflation prevented sharp increase of the Debt-to-GDP ratio. Then, with the disinflation of the 1980s, this changed. Without rising inflation to offset the growth of debt, the debt ratio climbed rapidly in the 1980s.

The sharp upturn on Graph #4 occurred only in the 1980s, and not in the 1970s, not because debt growth was slight in the 1970s, but because the rate of inflation fell in the 1980s.

The disinflation is huge, Williamson says. He is right about that. It was the disinflation, and the low inflation since, that allowed leverage to increase. It was disinflation, and low inflation since, that allowed the "debt overhang problem" to develop. But it is foolish to focus on the disinflation and not the growth of debt. For if debt growth had been contained, the disinflation could not have had such a huge effect on debt.

There was a question about debt overhang.

Williamson asks why we're seeing the debt overhang effect now, but not in the 1981-82 recession. His question is not quite right. We're seeing the effect now, certainly; but the Great Recession ended four or five years ago. We're seeing the effect now -- since the 2009 recession, not just in it. So the proper question to ask is this:

If you weren't seeing the debt overhang effect since the 1981-82 recession, why are you seeing it now?

And now the question is an easy one to answer. We were seeing the debt overhang effect since the 1981-82 recession. Economic growth slowed significantly at that time. And since the 1981-82 recession, the economy continued to underperform. It was only the massive and sudden, much worse underperformance since the time of the Great Recession that made the previous underperformance look good.

Graph #6: Stages of the slowdown in real growth

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