We all believed in 2009 what Mian and Sufi have now conclusively demonstrated – that reducing mortgage debt would spur consumer spending.
In The Social Network, when the Winklevii go to a Harvard administrator to complain about Mark Zuckerberg, the administrator they go to is Larry Summers -- the same Larry Summers who popularized the phrase "secular stagnation".
Summers offers some thoughts on Mian and Sufi's book House of Debt. He (Summers) writes in part:
Mian and Sufi, professors at Princeton and the University of Chicago respectively, have examined a profoundly important question: what causes protracted downturns in economic activity?
A profoundly important question, indeed. Summers continues:
They have marshalled new data – for example, on spending by zip code – to test their hypotheses, assembling such a range of evidence from so many different sources that their conclusions are not susceptible to challenge by those looking to point out statistical errors.
They have strong evidence, in other words -- with a sideways reference to the attacks on Thomas Piketty's new book.
[Mian and Sufi] argue that, rather than failing banks, the key culprits in the financial crisis were overly indebted households. Resurrecting arguments that go back at least to Irving Fisher and that were emphasised by Richard Koo in considering Japan’s stagnation, Mian and Sufi highlight how harsh leverage and debt can be ...
"The key culprits in the financial crisis were overly indebted households."
So their story of the crisis blames excessive mortgage lending, which first inflated bubbles in the housing market and then left households with unmanageable debt burdens. These burdens in turn led to spending reductions and created an adverse economic and financial spiral that ultimately led financial institutions to the brink.
Summers says that this view "resolves the anomalies" found in other explanations that the book evaluates. He calls it "a persuasive and novel idea". In other words Summers, the secular stagnation guy, seems to agree with Mian and Sufi that debt is the problem. This is a big deal.
I do have to point out one thing: The "key culprits" were overly indebted households this time. In the Great Depression the key culprits were excessively indebted businesses (or so I've read). The point is this: The problem is always excessive debt. Who owes the debt may vary from crisis to crisis, but there is always excessive debt. Don't be fooled by whack-a-mole explanations that focus on who is in debt.
After expressing strong agreement with the book's analysis of the problem, Larry Summers disagrees with "the last third of their book, where they discuss the policy responses to the crisis." Summers was involved in the policy response, and has some good insights to offer. An interesting read.
And Summers leaves us with a great ending:
The reality that the post-crisis policy challenges were more complex than they recognise detracts only slightly from Mian and Sufi’s accomplishment in House of Debt. All future work on financial crises will have to reckon with the household balance sheet effects they stress. After their work, we can still believe in the necessity of financial rescues; however, we can no longer believe in their sufficiency. And after their work, we have an important new agenda of reforms to consider if future crises are to be prevented.
Just remember, when it comes to preventing future crises, it's excessive debt that is the problem -- not households, and not mortgages. If you dam up the stream against excessive household debt exclusively, the problem will just spill over somewhere else.
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10 comments:
Of course "excessive debt" leads to economic depressions. Whether they admit it or not, everybody knows that fact. If people didn't believe that, it wouldn't be a fact. Irving Fisher explained how that works in 1933.
The problem is that without a reliable time machine that enables you to see the future you don't know what is going to be "excessive debt".
In 2007 households did not believe they had excessive debt. Their assets far exceeded their liabilities. In 2009 households believed they has excessive debt even though actual household debts had decreased slightly and (for the average household) assets still exceeded liabilities by quite a lot. It is the change in what was considered "excessive debt" that mattered.
The problem is that without a reliable time machine that enables you to see the future you don't know what is going to be "excessive debt".
This is my reliable time machine. Here's why I say that.
Some people seem to think we should keep pushing debt up more and more until the very last moment before it's too late, and then somehow solve the debt problem while avoiding a crisis. You and I both realize we don't know when that very last moment will occur. I think we should instead stop pushing debt up at the first moment it seems to be creating problems.
It is in that first moment that debt becomes excessive.
There are fundamental problems with your position.
Going into debt has a cost benefit trade off. Hanging cinder blocks on a 2X4 has no benefit. It is all cost. That makes it is dead simple to figure out when to stop piling on cinder blocks. You stop before first one.
Let's say I give you $50 for each cinder block you hang successfully and if the 2X4 breaks then you give me $200. Now tell me what is the number you call "excessive"
Suppose you have to pay me $100 if it breaks. Now how many blocks do you decide are excessive?
Suppose you have to pay me $2000 if it breaks. Now how many blocks do you decide are excessive?
micro, micro, micro. Got a macro example? The crisis was a macro result, not micro.
Debt level conveys very little useful information without a relative comparison to the equity and/or income which supports that debt.
When looking at a firm to make a judgement about whether it's debt is excessive the usual measuring stick is to look at the ratio of debt to equity.
When looking at a household to make a judgement about whether its debt is excessive the usual measuring stick might be debt to income or debt to net worth.
When looking at the private sector in aggregate to make a judgement about whether the level of private debt is excessive, the measuring stick would be private debt to ________.
When looking at the private sector in aggregate to make a judgement about whether the level of private debt is excessive, the measuring stick would be private debt to the money we have that can be used to pay down debt, without having to borrow more to do it. In aggregate.
Hi Art,
It is not the quantity of debt that matters it is the quality. That in a nutshell is the macro cause of the financial meltdown.
An enormous quantity of bad quality loans were made because the markets had fooled itself into believing that the modern information technology had made it possible to achieve the economic alchemy of converting bad quality loans into good quality.
There was no govt policy or FED policy that was driving the markets towards a high quantity of poor quality debt instruments. It was entirely driven by the markets self-delusion that it had achieved the economic Nirvana of pricing risk with pin point accuracy.
Then suddenly the markets realized that the current tools for predicting the future are no better than any from the past.
Jim: "It is not the quantity of debt that matters it is the quality. That in a nutshell is the macro cause of the financial meltdown."
As I understand Minsky, "hedge" financing -- good debt -- generates income sufficient to pay down both interest and principal owed. "Ponzi" financing -- bad debt -- generates income insufficient to pay down either interest or principal. And "speculative" financing is somewhere between.
The difference between good debt and bad debt, then, is not in the debt, but in the income generated by use of the borrowed money. But a vigorous and healthy economy generates more income than a weak and ailing one. The generation of income depends on the state of the economy.
The state of the economy depends on the level of debt that it must support. Gradual, persistent growth of debt reduces demand among consumers, raises cost among producers, and increases income among financiers. The growth of debt itself is a powerful and relentless force that makes finance more profitable than productive activity. The growth of debt is a force that drives debt away from "hedge" toward "speculative" first, and finally to "Ponzi".
Therefore, the "quality" of debt is largely determined by the "quantity" of debt.
//
"An enormous quantity of bad quality loans were made because the market had fooled itself..."
"It was entirely driven by the markets self-delusion..."
"Then suddenly the markets realized that..."
These three paragraphs of yours are based on your view of what other people were thinking. That is not an evaluation of economic costs. It is a morality tale.
My only criticism of your piece Art is that I DO think there is a difference between which portion of the private sector is holding the debt, corporate or household. I think there is a difference because there is a difference in which policies will help relieve the crunch when it happens.
Japans debt problem of the 90s was largely non household. So households continued their level of spending and GDP and employment levels muddled through. Japan never experienced the unemployment levels the US and EU have during this more recent crisis as I understand it. Our households were crushed and stopped spending leading to business closures from falling sales.
One mistake I think we make is comparing debt levels to asset prices instead of income. Asset prices are volatile, income is much more steady. As our debt to income ratios were rising thru the 2000s many sounded warning bells, but the cheerleaders kept saying "But the value of the house is rising too so its not a problem!!"
Art wrote:
"These three paragraphs of yours are based on your view of what other people were thinking. That is not an evaluation of economic costs."
It seems obvious to me that what-people-were-thinking has everything to do with why debt expansion rose to a pinnacle of 33% of GDP and then suddenly plunged to less than 0% of GDP.
People don't just think about economic cost - they also think about economic rewards, and they do weighted analyses of the trade-off between the two. Sometimes the analysis produces the expected result and sometimes the result turns out to be far different than what was expected.
"The growth of debt is a force that drives debt away from "hedge" toward "speculative" first, and finally to "Ponzi"."
No you got that backwards. You better reread Minsky. It is long-term stability that leads people to go farther and farther out on the limb of risk taking. That risk taking in turn leads to greater debt expansion.
The quality of lending is a limiting factor on credit expansion. Credit expands when borrowers and lenders are willing to take on more risk (or when they miscalculate risk and take on more risk than they would like). When only the lowest risk is tolerated by borrowers and lenders then you have what now exists - credit expands slowly or not at all.
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