Is There Even Demand For New Debt?

If only we could just get banks lending again, we could go back to those heady pre-Lehman days of credit-fueled consumption growth - that seems to be the rationale animating the Geithner banking plan. If we get these toxic assets - er, I mean "legacy assets" - off of banks' balance sheets, then they'll be sound enough to extend credit again. Economic recovery will follow soon thereafter. But can we return to the status quo ante? Or has the deleveraging process gathered such momentum that even if households could take out new loans, they'd choose not to, as they instead try to pay off their existing onerous debt obligations?

Count James Galbraith among those skeptical that even a successful bank bailout would reverse the economy's death spiral. Rather, restoring household solvency is the key issue. Indeed, in a piece in the Washington Monthly, Galbraith makes the case that until households are made creditworthy again, lending will not resume at anything close to normal levels. Galbraith begins by noting that:

For the first time since the 1930s, millions of American households are financially ruined. Families that two years ago enjoyed wealth in stocks and in their homes now have neither. Their 401(k)s have fallen by half, their mortgages are a burden, and their homes are an albatross. For many the best strategy is to mail the keys to the bank. This practically assures that excess supply and collapsed prices in housing will continue for years.

Simply put, American households are drowning in debt. As unemployment rises, wages fall, and option ARM mortgage rates reset to higher levels, increasing numbers of households will not be able to service their debts. Furthermore, now that the game of debt musical chairs is over, and many households have by and large lost access to credit, they must save more to pay off their debts. This means less money for consumption. Businesses in turn will face declining profits, necessitating further layoffs and wage cuts. And of course, all of these losses will reverberate on bank balance sheets, since they hold securitized mortgages, credit card debt, auto loans, student loans, etc. And on and on it goes. Throughout this downward spiral, only debt levels do not fall, posing a rising real burden. This is debt deflation - or a "d-process".

Making the banks solvent again is necessary but not sufficient to resume normal credit expansion. If banks remain de facto insolvent, as the credit losses pile up in both the real and financial economies, then the creditworthiness of American households will be irrelevant - there will be no lending. But this is not to say that fixing the financial system will remedy this collapse in credit. If there is a dearth of creditworthy borrowers, or creditworthy borrowers lose their appetite for new debt - either because they want to pay off their old debts or economic uncertainty makes new business investments seem risky - then the soundness of the banks will be irrelevant. In short, credit depends on both lender and borrower. Both must be solvent and willing to extend or accept a loan for normal credit expansion to occur. But this simple point often gets lost in policy discussions about the banking system. Galbraith points out that

In banking, the dominant metaphor is of plumbing: there is a blockage to be cleared. Take a plunger to the toxic assets, it is said, and credit conditions will return to normal....But the plumbing metaphor is misleading. Credit is not a flow. It is not something that can be forced downstream by clearing a pipe. Credit is a contract. It requires a borrower as well as a lender, a customer as well as a bank.

The obvious question is whether there is any reason to expect American households to fix their balance sheets in the near future so that they are creditworthy?

Unfortunately, the answer seems to be no. The wealth effect of vanishing stock portfolios and plummeting housing values not only makes households less willing to spend, but it also leaves them with no collateral with which to take out a loan. Indeed, creditworthiness depends on

a secure income and, usually, a house with equity in it. Asset prices therefore matter. With a chronic oversupply of houses, prices fall, collateral disappears, and even if borrowers are willing they can’t qualify for loans.

Here, the especially pernicious effect of falling house prices becomes clear. And unhappily, housing prices still have roughly another 20% to fall from their peak just to revert to historic norms, as the following chart shows.

With foreclosures flooding the market, compounding the problem of a housing glut, the chance that housing prices will overshoot on the downside - and possibly stay there for a prolonged period - is very real. Most American households simply will not have the collateral to secure a loan for quite a few years at the least.

There is also the question of "animal spirits" - will creditworthy individuals want to take out loans? Again, the answer seems to be no. The psychology of this crisis has frozen economic activity. As consumer spending has collapsed, there is little incentive to invest in expanding business operations. The future seems so uncertain that people only want to hold cash or liquid assets like Treasuries. Fear rules the scene. A recent New York Times profile of individuals and businesses in Portland, Oregon captures this sentiment well. Writing about the local Portland economy, the New York times reports that

Even banks that are eager to lend find some of their best customers reluctant to extend themselves.

“The problem is trying to get qualified people to borrow,” said Raymond P. Davis, president and chief executive of Umpqua Bank, a regional lender based in Portland....

“The people that want the money don’t deserve it, and the people that deserve it don’t want it,” said John B. Satterberg, president of Community Financial Corporation. “Everybody’s sitting on the fence.”

This is a liquidity trap. The bank-centric economic rescue plans oftentimes lead us to think of a liquidity trap as a supply problem; the banks will not lend because there is no incentive to lend. As Paul Krugman explains

Here’s one way to think about the liquidity trap — a situation in which conventional monetary policy loses all traction. When short-term interest rates are close to zero, open-market operations in which the central bank prints money and buys government debt don’t do anything, because you’re just swapping one more or less zero-interest rate asset for another. Alternatively, you can say that there’s no incentive to lend out any increase in the monetary base, because the interest rate you get isn’t enough to make it worth bothering.

This could be certainly be true, and perhaps even was true early on in this crisis, but as fear has gripped the real economy, and households scramble to save every penny they can in guaranteed assets - i.e., cash and Treasuries - it seems clear that there is no longer any demand for debt. This situation will likely continue until insolvent households fix their balance sheets, at which point they will be creditworthy again, and already solvent households will stop putting off taking out new loans, as the fear strangling the economy subsides.

What is to be done to hasten recovery? Absent government intervention, the economy will eventually recover, to be sure. As households cut back, saving to pay down their debts, pent up demand builds throughout the economy. Once households reestablish their financial footing, this pent up demand will cause a new credit expansion and virtuous circle of economic growth. As Paul Krugman explains, this is how nineteenth century panics resolved themselves. The problem is that this can take years - or longer. Economic growth can stagnate for decades, as it did between 1873 and 1897, when the economy was in recession more often than not. An economy depressed over the mid-to-long term means lower tax revenues, and consequently likely increased deficits (absent large spending cuts, which would only exacerbate the downturn). Given that deficits will increase even without aggressive action, the case for proactive deficit spending to get us out of this economic slump becomes strong. But what should our priorities be?

Fixing balance sheets. That is the short answer. Banks and households. Doing one without the other is pointless. Regarding the banks, Nouriel Roubini has made a convincing argument that the Geithner plan is appropriate for solvent but illiquid banks, but not for outright insolvent ones. Of course, distinguishing between illiquid and insolvent banks can be quite difficult. But paying insolvent banks for toxic assets will be like AIG bailout fiasco on a grand scale: black holes sucking in taxpayer money across the economy. For truly hopeless banks, FDIC-style receivership and restructuring is the best answer. This means bondholders, who have heretofore not taken any losses, will not be made whole. Taxpayers will still be on the hook for enormous losses, but they will get all of the upside from selling these institutions back to private investors, and the total bill will be less, since bondholders will chip in. This is not, however, a free lunch. It is fraught with risk. Bondholders could panic, and pull their money out of banks. But it is the least bad option at this point. Just like banks, households need financial restructuring as well. This means writing down debts, particularly the principals on underwater mortgages. Roubini has proposed reviving the Depression-era HOLC, with the government buying up mortgages, and then renegotiating the principal owed, not just the interest payments as the Obama Administration has already done.

Aside from restructuring bank and household balance sheets, we must increase the buying power of the middle class to boost aggregate demand. This means creating jobs and strengthening social safety nets. The stimulus bill is a good first step towards putting the unemployed back to work, but the talk of cutting Social Security or Medicare benefits out of a sense of "fiscal discipline" seems dangerously wrongheaded. Again, from Galbraith

The prospect of future cuts in this modest but vital source of retirement security can only prompt worried prime-age workers to spend less and save more today. And that will make the present economic crisis deeper. In reality, there is no Social Security "financing problem" at all. There is a health care problem, but that can be dealt with only by deciding what health services to provide, and how to pay for them, for the whole population. It cannot be dealt with, responsibly or ethically, by cutting care for the old.

We must not confuse reforming the health care system - expanding coverage and lowering costs - with reducing benefits. Stronger safety nets ensure everyone a minimum living standard, and act as automatic stablizers in a downturn. The challenge Obama faces is incorporating the best aspects of the welfare state, without importing the rigidity in the labor markets that European countries face. This is a fundamental pivot away from the deregulatory, private-sector mania of the last thirty years, and instead imagining a system where not just the rich and connected win, but all share in the benefits; where the government does more to reduce economic uncertainty without choking off economic opportunity. It means creating an economy that grows from the bottom up, rather than the top down. Let us hope Obama is sufficiently bold to meet these opportunities.