“Skills gap” evidence or something (or The U.S. economy looks weird cont.)

Dean Baker makes a really insightful point using Jobs Openings and Labor Turnover Survey (JOLTS) data (I mention this because this data series has become really important since Janet Yellen started showing different types of employment statistics in explaining monetary policy, other than the unemployment rate alone).

Politicians love to talk about a “skills gap,” where U.S. workers are unemployed and businesses have jobs unfilled because workers just don’t have the requisite skills/education to do the jobs. (This seems to be an attempt to frame the Great Recession as a supply-side problem, when it really has to do with a shortfall in demand. This is important because the policy implications of one have to do with focusing on education and training workers, which is nice, but the other calls for fiscal and/or monetary stimulus to make up for the demand shortfall. The supply-side story distracts from the real problems and correct policies.) The skills gap story does not appear to be an important part of unemployment in today’s economy, but to the extent it does exist, Dean Baker only sees evidence of it in retail and restaurant business:

Floyd Norris has an interesting column comparing the numbers of job openings, hirings, and quits from 2007 with the most recent three months in 2014. The most striking part of the story is that reported openings are up by 2.1 percent from 2007, while hirings are still down by 7.5 percent.

While Norris doesn’t make this point, some readers may see this disparity as evidence of a skills gap, where workers simply don’t have the skills for the jobs that are available. If this is really a skills gap story then it seems that it is showing up most sharply in the retail and restaurant sectors. (Data are available here.) Job openings in the retail sector are up by 14.6 percent from their 2007 level, but hires are down by 0.7 percent. Job opening in the leisure and hospitality sector are up by 17.0 percent, while hiring is down by 7.4 percent.

If the disparity between patterns in job openings and hires is really evidence that workers lack the skills for available jobs then perhaps we need to train more people to be clerks at convenience stores and to wait tables.

I think he hits the exact right note with that last sentence.

I actually posted about some research a while back that touches on a de-skilling trend where higher skilled workers are increasingly performing jobs traditionally performed by lower-skill workers.

I’m not sure what all this means, but the U.S. economy sure looks weird.

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The U.S. Economy Looks Weird

We are in the middle of a fairly long period of economic expansion, but our economy does not look particularly strong compared to past recoveries and expansions. One obvious difference at the stance of monetary policy. Prof. Antonio Fatas imagines what it would be like if we had a negative shock and started a new recession next month (it wouldn’t be good):

Here is a thought experiment: what if the US economy entered a recession next month? Would it be too early for a recessions? How would it compare to previous recessions? And what stories we would tell to explain why the recession happened?

Let’s start counting months using the two phases of the business cycle as defined by the NBER business cycle dating committee. How long is the current expansion? The current expansion started in June 2009, which makes it already 62 months. Compared to all the previous post-WWII expansions it is already above average (60.5 months).


Another way to look at it is to realize that we are only one year away from reaching the length of the previous expansion (73 months). It is true that we are still far from reaching the 92 or 120 months of the previous two, but these were two of the largest expansion the US has ever seen. So for those who like to think about expansions and recessions in terms of length and they have the idea that crisis happen with a “certain” frequency, there would be nothing unusual if a recession started today.

What would be more unusual is the way the economy would look like as it entered a recession. There are no indications of the economy running out of slack (inflation, wage growth). It would also be very hard to find large financial excesses as we saw at the end of the 90s (the stock market reached price-earning ratios that are a lot higher than what we see today) or something similar to the large increase in investment in real estate in addition to highly overvalued housing prices that we saw in the years prior to the December 2007 recession. We could of course argue that the recession happened because of geopolitical uncertainty but any historical analysis of political events over the last decades would suggest that what we are seeing today (so far, keeps fingers crossed) is not that unusual.

And if a recession started today, one pattern that would also be very different is the stance of monetary policy. If we measure it by the difference between long-term and short-term rates we typically see that this difference displays a strong and consistent downward trend as we approach a recession, something that we have not seen at all in recent months (or years). Here is a quick comparison of the difference between 10 year and 3 month interest rates for the average of the last four recessions compared to what the data would look like for a recession starting today.

The average of the past 4 recessions shows that the interest rate difference displays a steady downward trend towards zero in the quarters that precede the recession. And if you want more details, here is the data for those 4 recessions (I am removing the July 1981 recession because the expansion before was too short to say anything meaningful).
 
While there are some differences across each of the cycles, they all share the same overall trend. We have not seen any of this pattern over the last quarters or years. The difference between 10 year and 3 month interest rate remains flat. And while it is possible that short term interest rates are about to start increasing in the US, it is very likely that when they do we also see increases in the 10-year rate. So if this was a typical cycle, we are far from seeing a flat or downward-slopping yield curve.
 
So what would a US recession today do to our understanding of business cycles? While it would not be a large surprise in terms of how soon it happened relative to the previous one, it would open many questions about the reasons why recessions happen and about the behavior of interest rates and monetary policy around the turning point of the cycle. It would be yet another “new normal”, this time for business cycles.
 
 

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“The free market is an impossible utopia”

Karl Polanyi’s The Great Transformation is probably the most influential book I’ve read on the framework I use to think about the economy. I had the privilege to read and discuss his book in a political philosophy seminar with Prof. Stephen Leonard junior year of college.

One of the world’s experts on Polanyi, I understand, is Prof. Fred Block, who recently released a new book (The Power of Market Fundamentalism: Karl Polanyi’s Critique). Henry Farrell, at WaPo’s Monkey Cage blog recently interviewed Block and co-author Somers. Their description of Polanyi’s work is too good not to block quote:

Polanyi’s core thesis is that there is no such thing as a free market; there never has been, nor can there ever be. Indeed he calls the very idea of an economy independent of government and political institutions a “stark utopia”—utopian because it is unrealizable, and the effort to bring it into being is doomed to fail and will inevitably produce dystopian consequences. While markets are necessary for any functioning economy, Polanyi argues that the attempt to create a market society is fundamentally threatening to human society and the common good In the first instance the market is simply one of many different social institutions; the second represents the effort to subject not just real commodities (computers and widgets) to market principles but virtually all of what makes social life possible, including clean air and water, education, health care, personal, legal, and social security, and the right to earn a livelihood. When these public goods and social necessities (what Polanyi calls “fictitious commodities”) are treated as if they are commodities produced for sale on the market, rather than protected rights, our social world is endangered and major crises will ensue.

Free market doctrine aims to liberate the economy from government “interference”, but Polanyi challenges the very idea that markets and governments are separate and autonomous entities. Government action is not some kind of “interference” in the autonomous sphere of economic activity; there simply is no economy without government rules and institutions. It is not just that society depends on roads, schools, a justice system, and other public goods that only government can provide. It is thatall of the key inputs into the economy—land, labor, and money—are only created and sustained through continuous government action. The employment system, the arrangements for buying and selling real estate, and the supplies of money and credit are organized and maintained through the exercise of government’s rules, regulations, and powers.

By claiming it is free-market advocates who are the true utopians, Polanyi helps explain the free market’s otherwise puzzlingly tenacious appeal: It embodies a perfectionist ideal of a world without “coercive” constraints on economic activities while it fiercely represses the fact that power and coercion are the unacknowledged features of all market participation.

This gives us a different framework for thinking about economic problems and policies. I’ve discussed it before, but again Block and Somers say it better:

By putting government and politics into the center of economic analysis, Polanyi makes it clear that today’s vexing economic problems are almost entirely political problems. This can effectively change the terms of modern political debate: Both left and right today focus on “deregulation”—for the right it is a rallying cry against the impediments of government; for the left it is the scourge behind our current economic inequities.  While they differ dramatically on its desirability, both positions assume the possibility of a “non-regulated” or “non-political” market.  Taking Polanyi seriously means rejecting the illusion of a “deregulated” economy. What happened in the name of “deregulation” has actually been “reregulation,” this time by rules and policies that are radically different from those of the New Deal and Great Society decades. Although compromised by racism, those older regulations laid the groundwork for greater equality and a flourishing middle class.  Government continues to regulate, but instead of acting to protect workers, consumers, and citizens, it devised new policies aimed to help giant corporate and financial institutions maximize their returns through revised anti-trust laws, seemingly bottomless bank bailouts, and increased impediments to unionization.

The implications for political discourse are critically important: If regulations are always necessary components of markets, we must not discuss regulation versus deregulation but rather what kinds of regulations we prefer: Those designed to benefit wealth and capital? Or those that benefit the public and common good? Similarly, since the rights or lack of rights that employees have at the workplace are always defined by the legal system, we must not ask whether the law should organize the labor market but rather what kinds of rules and rights should be entailed in these laws—those that recognize that it is the skills and talents of employees that make firms productive, or those that rig the game in favor of employers and private profits?

The interview also tied in importantly to some of Mattis’ thinking/blogging about European elections. Basically Polanyi’s framework for thinking about the economy provides us a mechanism or explanation for thinking about voting patterns and social movements (in that sense his work was really political-economic-historical-philosophy).

Polanyi argued that the devastating effects on society’s most vulnerable brought on by market crises (such as the Great Depression in the 1930s) tends to generate counter movements as people struggle to defend their livelihoods, their neighborhoods, and their cultures from the destructive forces of marketization.  The play of these opposing dynamics is the double movement, and it always involves the effort to remobilize political power to tame the apparent over-extension of market forces.  The great danger Polanyi alerts us to, however, is that mobilizing politics to protect against markets run wild is just as likely to be reactionary and conservative, as it is to be progressive and democratic. Whereas the American New Deal was Polanyi’s example of a democratic counter movement, fascism was the classic instance of a reactionary counter-movement; it provided protection to some while utterly destroying democratic institutions.

This helps us to understand the tea party as a response to the uncertainties and disruptions that free market globalization has brought to many white Americans, particularly in the South and Midwest. When people demonstrate against Obamacare with signs saying “Keep Your Government Hands off My Medicare,” they are trying to protect their own health care benefits from changes that they see as threatening what they have.  When they express deep hostility to immigrants and immigration reform, they are responding to a perceived  threat to their own resources—now considerably diminished from outsourcing and deindustrialization.  Polanyi teaches us that in the face of market failures and instabilities we must be relentlessly vigilant to the threats to democracy that are often not immediately apparent in the political mobilizations of the double movement.

HF – The European Union’s single currency creates many of the same tensions between international rules and domestic society as the gold standard did a century ago. What are the political consequences of these tensions?

FB & MS – We just saw in the European elections that right-wing, seemingly fringe parties, came in first in France and the U.K.  This is a response to the continuing austerity policies of the European Community that have kept unemployment rates high and blocked national efforts to stimulate stronger growth.  It might still be largely a protest vote—a signal to the major parties that they need to abandon austerity, create jobs, and reverse the cuts in public spending.   But unless there are some serious initiatives at the European Community and the global level to chart a new course, we can expect that the threat from the nationalist and xenophobic right will only grow stronger.

Having read and written this, I have to say that the implications for this way of thinking about political economy are unsettling. Polanyi theorized and wrote about the fictitious commodities and double movement, but, if I recall correctly, his work was weakest at coming up with solutions to the economic (and, really, political) problems of market society/capitalism.

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The Link Between Growth and Poverty is Broken

I really really like an article Neil Irwin published yesterday. Sometimes the tone and conclusions in economic reporting bother me, but this one gets it just right (one gripe is labeling EPI a “liberal-leaning group,” I mean they do more hard data and policy work than I could even dream of… why can’t you just call them “academics and wonks who care about things like poverty”).

Basically EPI just released a study on the link between economic growth and poverty that shows a strong link in the 1959-1973 period where there is substantial growth and falling poverty. Then the link breaks in the 1970s:

From 1959 to 1973, the nation’s economy per person grew 82 percent, and that was enough to drive the proportion of the poor population from 22 percent to 11 percent.

But over the last generation in the United States, that simply hasn’t happened. Growth has been pretty good, up 147 percent per capita. But rather than decline further, the poverty rate has bounced around in the 12 to 15 percent range — higher than it was even in the early 1970s. The mystery of why — and how to change that — is one of the most fundamental challenges in the nation’s fight against poverty.

From 1959 to 1973, a more robust United States economy and fewer people living below the poverty line went hand-in-hand. That relationship broke apart in the mid-1970s. If the old relationship between growth and poverty had held up, the E.P.I. researchers find, the poverty rate in the United States would have fallen to zero by 1986 and stayed there ever since.

Irwin is level-headed in his explanation and interpretation. I liked how he laid out the facts and asks U.S. policymakers for more than just meaningless platitudes in economic policy:

“The federal government,” Paul Ryan, the House Budget Committee chairman, wrote in The Wall Street Journal, “needs to remember that the best anti-poverty program is economic growth,” which is not so different from the argument put forth by John F. Kennedy (in a somewhat different context) that “a rising tide lifts all boats.”

In Kennedy’s era, that had the benefit of being true.

 

[T]he facts still cast doubt on the notion that growth alone will solve America’s poverty problem.

If you are committed to the idea that poor families need to work to earn a living, this has been a great three decades. For households in the bottom 20 percent of earnings in the United States — in 2012, that meant less than $14,687 a year — the share of income from wages, benefits and tax credits has risen from 57.5 percent of their total income in 1979 to 69.7 percent in 2010.

The percentage of their income from public benefits, including Medicaid, food stamps, Social Security and unemployment insurance, has fallen in that time.

The fact that more of poor families’ income is coming from wages doesn’t necessarily mean that they’re getting paid more, though. In fact, based on the E.P.I.’s analysis of data from the Census Bureau, it appears that what income gains they are seeing are coming from working more hours, not from higher hourly pay.

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EU Blues

First post in a while. Kudos to Sam for his amazing take down of austerity and other such economic illiteracy. The little Rogoff/Reinhardt spreadsheet error was responsible for major delusions about the “right” ratio of debt to GDP. Perceptions that had a real impact on thousands (millions?) of lives/jobs in Europe.

Austerity was a terrible idea for a sluggish EU economy (0.3% GDP growth in 2014) and it did little to heal emerging rifts in the European community. Fast forward to today, and we are seeing major gains made by eurosceptic, populist and right-wing political parties in local and European elections.

In France, the National Front, Marine Le Pen’s bigoted, anti-immigrant, nationalist party, won 26% in recent elections, far ahead of the conservative UMP and the Socialists. Similar results in Britain, where the UK Independence Party made huge gains. A party that claims it is not homophobic OR racist, which just had to suspend one of its worst offenders, a certain Councillor Dave Smalls, for posting on facebook that gay people are “perverts” and Malians are “scroungers.” Similar folks got elected in Denmark, Austria, the Netherlands and elsewhere.

The Financial Times summed up the results:

“Ukip is forecast to be the biggest winner in the UK’s European race seizing 30 per cent of the popular vote and securing 24 seats in the EU assembly, 11 more than in 2009.

Among other eurosceptic parties, the Danish People’s party was set to become the biggest in Denmark with about 25 per cent of the vote. Meanwhile, Austria’s populist party, the FPÖ, is set to finish third with 20 per cent of the vote – against 12.7 per cent in 2009.

The gains of the populists could be sufficient for Ms Le Pen to form an anti-EU group with other like-minded parties. That would give them extra funds and speaking rights to destroy the “Brussels monster”.

According to exit polls released by the European Parliament, the European People’s party centre-right grouping in the assembly is set to win the elections with 212 seats, followed by the Socialists with 185; the Liberals with 71; and the Greens 55. Eurosceptic and anti-establishment parties from both left and right won 228 seats.”

228 seats? Europe, you are seriously scaring me right now.

“Voter turnout across the continent was estimated at 43.11 per cent, practically unchanged from 2009.”

No change in voter turnout in five years, and at a percentage that rivals sham elections like the ones Egypt just held. I wish it was just a sad joke, but it’s just the state of EU politics. We had our little experiment with Europe, now its time to crawl back under our rocks.

But wait, just watch this video from the European Commission:

 

 

There, all better.

 

Full EP election results here: http://www.results-elections2014.eu/en/election-results-2014.html

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Lessons After Reinhart & Rogoff: Not Just Wrong, the Opposite of Right

(I want to apologize to the people to whom I tried to explain Vector Autoregressive (VAR) models at bars this weekend)

Carmen Reinhart and Ken Rogoff, two prominent and smart economists, are best known for their research on debt and financial crises. Their research “found” a link between debt and economic growth, so they postulated that higher debt causes lower growth, and that this effect particularly occurs at 90% public debt -to-GDP. They believed and argued strongly and convincingly that high levels of public debt hurt the economy, though they did provide the disclaimer that the causal relationship may partially run in the other direction (slow growth causes high growth). This provided cover for deficit hawks and conservatives to argue for cutting government spending in the U.S. and EU.

Turns out this work on debt and growth was wrong and the lessons and policies resulting from it had the opposite effect than was intended.

Last summer, a UMass graduate student, Thomas Herndon, tried to replicate R&R’s results for a class assignment, found mistakes (some small, some less small), and ended up publishing an awesome paper.

I’ve talked about this before, but there is fun new research to share.

I am fairly confident that the thorough debunking of a “90% threshold” or a “tipping point” for public debt is basically complete.

In addition to debunking the tipping point concept, evidence that the causal relationship learned from R&R’s research is incorrect is accumulating. Miles Kimball and Yichuan Wang put up a great argument in Quartz last year. Their conclusions?

Here is the bottom line. Based on economic theory, it would be surprising indeed if high levels of national debt didn’t have at least some slow, corrosive negative effect on economic growth. And we still worry about the effects of debt. But the two of us could not find even a shred of evidence in the Reinhart and Rogoff data for a negative effect of government debt on growth.

More recently, Professors Matthijs Lof and Tuomas Malinen wrote their own paper where they find that not only does high public debt not cause low growth, the relationship appears to run in the opposite direction! They use Vector Autoregressive (VAR) models to tease out the inherent problem of endogeneity in this type of question where the variables being studied may affect each other

Even if a negative correlation between debt and growth seems undisputed, this does not imply that debt is harmful for growth, since correlation does not always imply causation. In fact, Reinhart and Rogoff (2010b) have emphasised the possible bi-directional causality between debt and growth. They argue that high debt may lead to higher taxes and/or lower government expenditure, which is harmful for economic growth, while on the other hand periods of low growth may lead to high deficits and accumulation of debt. Nevertheless, these hypotheses are not backed by a quantitative analysis to establish the relative size and significance of each direction. To decompose the correlation into cause and effect, we apply Vector Autoregressive (VAR) models. Our main result is that debt does not seem to have any significant impact on growth.

Methods and results

We estimate a VAR for sovereign debt and GDP growth on panel data for 20 OECD countries over a period of 55 years, which we obtain from the dataset of Reinhart and Rogoff (2009). Detailed descriptions of the data and model can be found in our recent article (Lof and Malinen 2014). The application of VAR models has several advantages.

  • First, a VAR treats both debt and GDP as endogenous. Both are allowed to have an impact on each other, and these impacts can be separated.
  • Second, a VAR is a dynamic model, such that we can analyse and quantify intertemporal impacts. By computing so-called impulse response functions, we can visualise the long-run impact on both variables after a shock hits one of the variables.
  • Finally, a VAR is a fairly simple model, which is estimated by regressing both debt and GDP growth on both their own and each other’s past observations.

Eberhardt and Presbitero (2013b) emphasise the role of nonlinearities and cross-country heterogeneities, to show that there is no robust evidence for a significant effect of debt on growth. Our analysis shows that this holds even in this simple linear framework.

Awesome, right?

Based on a simple VAR analysis with panel data, we can conclude that there is little evidence for a negative long-run effect of sovereign debt on economic growth. Our findings are consistent with recent studies applying different methods, such as Panizza and Presbitero (2013), as well as Kimball and Wang (2013) who “could not find even a shred of evidence in the Reinhart and Rogoff data for a negative effect of government debt on growth”.

Using the negative correlation between debt and growth as a justification for austerity policies could be another example of confusing correlation with causation. While high levels of sovereign debt may surely be a burden for a country, the claim that debt is harmful for growth is not supported by our results.

So this is awkward, when the U.S. turned to austerity policies in 2010, with the leadership of Blue Dog Democrats, President Obama, and relentlessly hawkish Republicans, they claimed lower government spending was good and would cause lower public debt and higher growth. It turns out that cutting government spending when the economy is weak causes lower growth, and lower growth causes higher debt burden. We knew better and there were economists who told them not to do it, but the politicians didn’t listen. Why? Who knows, maybe Professor Wren-Lewis can figure it out.

This is why it annoys me when people say things like (sorry Chris, I know you said this today) “I think I’m socially liberal and economically/fiscally conservative.” What is “economically conservative”? Is it a code word for economically illiterate (or I guess macroeconomically illiterate)? Stop saying that and listen to me!! (or better yet do your own research (or get a PhD)!). I hope I didn’t get too mean here at the end and I’m sorry if I did. I think I’m naturally argumentative, this is stuff I care about, and the resulting policies affect millions of people’s lives.

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What I wish policy debates were like (on mortgage debt, financial crisis, and recession)

Jared Bernstein summarizes an awesome debate that is going on in the economics world and blogosphere right now:

There’s a very interesting, albeit down-in-the-weeds, analytic debate brewing around a confluence of recent publications.  Tim Geithner’s new book defends the interventions of the Treasury Department he led to reflate credit markets (and I worked with the team on this back then).   Mian and Sufi’s new book, reviewed here by Bin Appelbaum, argues that Treasury got it wrong by not recognizing the extent to which debt burdens were restricting growth and intervening in ways to write off more debt: “The fact that Secretary Geithner and the Obama administration did not push for debt write-downs more aggressively remains the biggest policy mistake of the Great Recession.”

Dean Baker has long argued the problem was not just the debt overhang but the wealth effect’s sharp shift into reverse when the housing bubble burst.  That’s similar to Main/Sufi except it implies that even had you forgiven the debt, consumption still would have tanked.  Brad DeLong articulates an “all-of-the-above” theory, suggesting each of these analyses gets at one part of the problem but you need all of them to understand what happened.

Here’s what I think.  It comes from a line Matt Yglesias once wrote, reflecting on the Reinhart/Rogoff view that balance-sheet recessions that result from a leveraged bubble bursting tend to be particularly hard to grow out of.  Matt said something to the effect of: “it’s like trying to drive out of a deep fog–you have to go very slowly or risk crashing.  However, if you have strong fog lights, you’re much less restricted.”

“Fog lights” in this context mean you have to do everything you can to get the system back up.  You have to reflate the credit system through both liquidity (as in the TARP) as well as Mian/Sufi-style principal reductions and cramdowns of mortgage debt that cannot realistically be serviced without sustained pain.  The administration did a lot of the former and little (not none) of the latter.

Why not?  From where I sat, and I didn’t see everything from my seat for sure, it was less about protecting creditors per se than the belief that breaking contracts was an interventionist step too far (though the fact that this principal was less active in the auto-bailout suggests a protection that extended more to white than blue collar industry).

It was also argued at the time that the administration tried to get Congress to write legislation allowing bankruptcy judges to allow cramdowns on primary residences but the members uniformly said no.  You ask me, I think we didn’t push hard enough, again, based on the perceived sanctity of debt contracts.

Dean’s point means that debt forgiveness and revived credit flows must be met with deep fiscal stimulus that lasts as long as needed (he also emphasizes the demand-zapping role of the US trade deficit).  No question that accelerating the deleveraging cycle will hasten the recovery, but as long as unemployment remains high, job growth slow, and real wages flat, demand will be seriously constrained by the negative wealth effect, even as debt forgiveness dampens that dynamic.

With the private sector still licking its wounds, absent committed stimulus there’s no reason to expect deleveraging, or even aggressive monetary policy, to trigger the growth needed to reach escape velocity.  In fact, you might expect to see a pattern as in the figure below, which plots households’ debt service as share of disposable income against real, year-over-year GDP growth.  Deleveraging would have surely been faster with more debt forgiveness, but without doing more to offset the crashing wealth effect, we may have still been in the slog you see there: basically, a return to trend growth before the output gaps were closed.

To be clear, the administration did, in fact, respond quickly and effectively with precisely this stimulative “fog light” but the headlights dimmed before the fog cleared.  Why?  Because of a precipitous pivot to deficit reduction.  And, of course, aggressive stimulus was not accompanied by aggressive debt reduction.

So I’m with Brad—all of the above.   And let’s keep it real: the problem was not only that we didn’t do all of the above.  It’s that even when we did the right things, we didn’t stick with them long enough.  The important thing now is to try to learn from our mistakes, and I for one am thankful to all of these authors for continuing to plumb these deep waters.

delev_grth

I was taken with Mian and Sufi’s argument until I read Professor Delong’s take:

But to the argument–to Amir and Atif, and Dean, and Ryan–what I want to do is to respond: “yes, but…” and “not really…”

As any monetarist will tell you (whether you want them to or not), an economic recession is an episode in which less money is supplied than the economy’s decision-makers wish to hold at full employment. In such a case, the consequence is a “general glut”: a critical mass attempt to cut their total spending below their incomes as they try to build up their money balances with no counterbalancing mass trying to spend more than their incomes, but such my spending is your income the result is depression. An excess demand for money accompanied, by virtue of Walras’s Law, by an excess supply of pretty much everything else. This process can be interrupted only if the system “prints” the extra money decision-makers want to hold. The banking system can print “inside” money–if it dares, and if decision-makers trust it enough to classify transferable banking-sector liabilities as means of payment. The central bank can print “outside” money. Or we can wait, mired in depression, until price levels fall enough to raise real balances supplied to a sufficient level.

The key to depression, in my view at least, is not a decline in any component of spending: it is the decline in one component of spending below its decision-makers’ incomes while the normal economic channels are blocked that would normally lead some other component of spending to rise above its decision-makers’ incomes.

We can see this from 2005-2007. Residential investment as a share of GDP collapses. But as residential investment collapses, does GDP shrink? No. The grey zone of GDP shrinkage starts only in early 2008, even though residential investment had already fallen from 6.2% to 3.7% of GDP beforehand. From 2005-2007 those who had financed residential investment did not decide to stop funding residential investment and start building up their cash balances. They decided to stop funding residential investment and use their money to fund something else–net exports, or additional government purchases, or business investment.

And then, from 2007-2009, collapsing home values significantly impact household wealth and lead them to cut their consumption spending back below their household incomes. But why is it that this reduction in money flow into the shopping malls as consumers cut spending below income to build up their cash balances is not properly compensated by an increase in money flow elsewhere as foreigners, governments, businesses draw down their gross cash balances, and as bankers draw down their net cash balances?

And to understand that we need to look at the banking system. We already know about the size of the negative shock to spending from the construction sector. Mian and Sufi do an excellent job of documenting the size of the negative shock to spending from the household sector via the housing equity-underwater mortgage-wealth channel–and in the process do, I think, successfully demolish Tim Geithner’s claims in his Stress Test that aggressively refinancing mortgages would not have materially helped the economy.

But to explain a deep, long, persistent downturn you need more than a big shock. You need: (a) a big shock, and (b) forces that make that shock persistent, and (c) an absence of damping mechanisms elsewhere in the system, and (d) an absence of recovery mechanisms elsewhere in the system. Mian and Sufi, I believe, do an excellent job of tracing the household wealth channel via (a) and (b)–how the overleverage followed by the collapse of the housing bubble delivered not juts a construction shock but a consumption shock, and how the failure to resolve underwater mortgages made the consumption shock persistent. (And I reflect that Chrysler and GM got resolved with their top executives fired and their shareholders and option holders zeroed out; the New York banks got fed huge amounts of money while their top executives kept their jobs and their shareholders and option holders got made large whole, and underwater homeowners got nothing.) But to explain (c) and (d) we need more than Mian and Sufi (and Baker) can give us: we need the banking, monetary, and fiscal policy stories as well.

Thus when Ryan Avent writes:

Shifting focus from banks to households, in turn, leads [Mian and Sufi] to very different remedies, the most radical of which is to replace many loans with equity-like contracts in which lenders share losses with borrowers…

Again I want to say: “yes, but…” As Larry Summers, Paul Krugman, Joe Stiglitz, and Laura Tyson all like to say: you don’t have to fill a tire through the leak. restoring consumer spending via successfully rewriting mortgage contracts to rebalance household balance sheets would have been a wonderful thing to do. It would still be a wonderful thing to do. But it was and is not the only thing to do to get us out of our current mess.

But let me endorse Ryan Avent’s endorsement of Mian and Sufi’s bottom line:

What is needed, they argue, is to make debt contracts more flexible, and where possible, replace them with equity. Courts should be able to write down the principal of mortgages as an alternative to foreclosure. They recommend “shared-responsibility mortgages” whose principal would decline along with local house prices. To compensate for the risk of loss, lenders, they reckon, would have to charge a fee equal to 1.4% of the mortgage, or receive 5% of any increase in the value of the property…

All I can say is that I thought that this was the system that we had. I thought–from the Great Depression era history of the HOLC and the RFC, from the 1980s history of the Latin American debt crisis, from the 1990s history of the RTC, from innumerable emerging-market crises, et cetera, that we understood very well that this is what we should do. Whenever the financial system got sufficiently wedged we resolved it–we turned debt into equity, and we crammed losses down onto debt holders whose investments were ex post judged to have been ex ante unwise.

And from my standpoint the true puzzle is why Bernanke, Geithner, and Obama were so uninterested in pulling out the Walter Bagehot-Hyman Minsky-Charlie Kindleberger playbook and following it in housing finance from 2009-2014. Did they read no history?

And let me qualify Ryan’s conclusion:

[But] while debt may be dangerous for the borrower, it is the opposite for the lender. Savers prefer the safety and predictability of a debt contract, which is why they accept lower returns on bonds over time than on equities. Many debt contracts exist primarily to satisfy this desire for safe assets—most notably bank deposits…

This is true only as long as the economy is not overleveraged. When it is overleveraged–when debt is underwater–the mismatch between cash-flow and control rights means that even lenders should prefer to “resolve” and transform debt into some more equity-like claim.

I wish that the politics/policy world had taken homeowner debt relief seriously. The proposed cram down legislation, in addition to dozens of other plans to help homeowners, could have improved millions of lives. Having the Delong historical perspective would have made the arguments for those policies that much stronger. With such a myopic and dysfunctional Congress, it seems to me that helping homeowners (not to mention housing finance reform) never stood much of a chance.

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