The Non-Debt Overhang: Economics and Arithmetic #5467

Economists tend not to be very good at arithmetic. That's why almost all of them failed to recognize the $8 trillion housing bubble and to understand that it's collapse would wreck the economy.

Unfortunately their arithmetic (or logic) skills have not improved in the wake of the crash. Hence we have many economists telling us that the economy's problem is a debt overhang. This gets picked up endlessly (e.g. Joe Nocera's column today).

Let's think this one through for a moment. As a result of the ephemeral wealth created by the housing bubble, people ran up far more debt than would have otherwise been the case. This means that people have far less equity in their homes than in a counter-factual where house prices had never diverged from trend.

Let's say that collective indebtedness is $5 trillion greater than if there had never been a bubble. Now let's have the great god of economic correctness clap her hands and eliminate the $5 trillion in excessive debt. Do we now see a consumption boom that gets the economy back on course?

If you answered yes, you get a PhD from a prestigious economic department and flunk basic logic. Our god just destroyed $5 trillion in wealth. Any increase in consumption from this act would be the result of the difference in the propensity of the debtors to spend out of wealth as opposed to lenders. If this is even 2 percent, that would be surprising. While $100 billion in additional consumption would be a nice boost to growth, it would still leave us far from full employment. (btw, anyone who bothers to look at the data would know that consumption is still unusually high relative to disposable income, not low.)

The reality is that we need some new source of demand to replace the demand generated by the housing bubble. In the short-run, this can only be the government. This is true regardless of how much we hate or love the government. In the longer run it will have to be net exports. People who know logic and arithmetic understand this fact. Others work as economists.

I thought I would add a bit more on the ownership of mortgage debt. The vast majority of debt is held in mortgage backed securities. The holders of this debt would be comparable to the ownership of government debt, albeit with a somewhat smaller presence of foreign owners. The debt would show up in the portfolios of many individuals with 401(k)s and other retirement accounts. It would also be included in most pension portfolios. Losses in the latter would have to be made up with larger contributions in future years.

On the other side, not all the underwater borrowers should be viewed as low or even middle class. There are plenty of people who bought homes for $600k at the peak of the bubble that are today worth $300k. These people may have substantial other wealth, so they need not have reduced their consumption substantially as a result of the drop in housing values.

And of course our disappearance of $5 trillion in mortgage debt would mostly be for people who are not underwater, since there is only a bit more than $1 trillion in underwater debt. Most of the vanishing debt would be for people who owe $200k on a $300k home. Our god of economic correctness will have reduced this to $100k by extinguishing $5 trillion in mortgage debt.

Again, I would not doubt that the underwater homeowners have a higher average propensity to consume out of wealth than owners of their debt, but there is no reason to believe the latter is close to zero. I think a gap of 2 percentage points would be on the high side of the plausible.

I still don't get why magically eliminating debt won't increase consumption
written by Russ Abbott, September 15, 2012 5:22

You wrote, "Now let's have the great god of economic correctness clap her hands and eliminate the $5 trillion in excessive debt." Then you asked if that would increase consumption.

In answering that it wouldn't you wrote, "Our god just destroyed $5 trillion in wealth." But that's not true. The assumption was the god destroyed debt, not wealth. Consumers who are no longer devoting the income to paying down their debt have more money to spend on other things. I don't see what's wrong with that conclusion.

VP for Economic Policy
written by Michael Ettlinger, September 15, 2012 5:24

Those who are the lenders, by definition, have chosen to "save" the amount they are lending instead of consume it--their propensity to consume this and the income stream from it is extremely, extremely low. Those who have borrowed and are underwater are almost certainly in the income and demographic sweet spot of consumption. I expect there's a pretty big difference.

I don't disagree with your conclusion about where the answer has to come from in the short run. But from a business perspective, trying to figure out the medium term, the fact that middle-class consumers are constrained, and will be for some time, is a concern and affecting behavior. What you're implicitly suggesting is that the only way out is for the businesses that depend on the US consumer be replaced in the economy by exporters and, in the short run, government contractors.

One would note, BTW, on the government front, that its money has to come from somewhere too. If it's coming from within the US, you've still got a propensity-to-consume issue. Though we do know, presumably, that the propensity is 100% for the government but it only works completely if the funds are coming from outside the country.

Great Idea - Let's Do Nothing About Unemployment
written by Paul, September 15, 2012 6:31

The reality is that we need some new source of demand to replace the demand generated by the housing bubble. In the short-run, this can only be the government.

Last time I checked (5 minutes ago) all action by the government, federal or state, is still being blocked by the GOP as it has been continuously for the past 2 years since the Tea Party took control of Congress.

So the bottom line is that nothing can be done or will be done to increase demand and therefore jobs. No wonder starting an international trade war seems like a better option. Even Mitt wants to go after China on trade so maybe the GOP will go along.

Right, but...
written by Amileoj, September 15, 2012 6:52

Why does the needed source of new demand have to change from government to net exports? Surely this is up to our trading partners? As long as they are willing to keep sending us more stuff than we send them, so as to have more growth than their domestic consumption can support on its own, I see no reason not to indulge them. Our own demand deficit can be made up by government spending in excess of tax revenue as long as we wish, with interest rates set wherever the Fed chooses to set them. If this eventually leads our trading partners to rethink their desire to accumulate dollar denominated financial assets then so be it, but why rush them?

Gadfly
written by Alan, September 15, 2012 7:51

Or we could admit that some portion of the previous aggregate demand was artificially generated by low interest rates and loose lending standards and that government attempts to reflate would be artificial and unsustainable as well. Perhaps we should look for the sustainable level of demand and get used to it.

No PHD for me..........

-2

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written by urban legend, September 15, 2012 8:02

Why would the difference in propensity to spend be less than 2%? The consumers now holding $5 trillion in additional net wealth (offsetting the loss of $5 trillion in wealth for lenders) has no need for profits, a portion of which will be ex-patriated to lenders based abroad. Sizable portions of gross profits for all lenders will go to compensation for executives who themselves have less propensity to spend.

Debt Overhang
written by Aaron, September 15, 2012 8:49

Although I've heard some argument that "helicopter Ben" should drop his "free cash" on the masses instead of directing federal assistance to financial institutions, the more typical argument is that we would benefit from a number of years of sustained, moderate inflation - increasing house values and returns on retirement savings.

Without getting into the desirability of debt-driven consumer spending, it's difficult to avoid seeing how a reduction in the availability of credit to consumers affects their ability to consume in excess of their income.

Propensity to Spend
written by ellen1910, September 16, 2012 1:40

The owners of consumers' debt (single family residential mortgages, credit card balances, student loans) are the Federal Reserve Bank, foreign investors, commercial banks, insurance companies, pension funds, hedge funds, and perhaps, to a small degree, individual 401(k)s.

To baldly assert that these lenders' (and their beneficiaries/principals') propensity to consume is only 2% less than the debtors propensity seems cavalier and to fly in the face of common sense.

...
written by QP, September 16, 2012 3:22

The lenders have not been lending savers money, the bubble fuelling lending has been created out of nothing. There has been a clear expansion of debt beyond what the productive economy can support. And as has been pointed out this debt is not wealth, wealth might be measured in $ but it is really ownership and control of resources (in this case the lenders have an overvalued claim on borrowers earnings - its a fraud is essence). Debt write downs are the only sustainable way foward.

A Plausible Interpretation of Debt Overhang
written by Last Mover, September 16, 2012 8:16

If $5T in debt vanished absent the bubble then aggregate demand by homeowners would be higher given higher housing equity, which translates into higher MPC from more net wealth retained by debtors than lost by lenders. Therefore the negative MPC of lenders is not sufficient to offset entirely the increased MPC of debtors.

The point is to demonstrate that in isolation from a bubble, debt overhang per se doesn't cause significant insufficient demand since removing it only increases net MPC slightly. Given the bubble, housing equity was much lower and debt was much higher, therefore reducing debt by $5T would result in even lower net MPC compared to the absence of a bubble.

A broader scenario would include displacement of aggregate demand from reduced wages by the bubble which also financed increased spending for more imports via a trade deficit. (The economy as a whole was not producing beyond its capacity during the bubble.)

After the bubble burst there is no signficant demand to replace it in the short run absent accelerated deleveraging of the debt overhang which is not going to happen anytime soon, given the offsetting effects between debtors and lenders coupled with the liquidity trap.

As Baker demonstrates, the only plausible solution is direct fiscal stimulus to break out of the stalemate circle. Also recent actions by the Fed to assure reduced long term interest rates does tend to accelerate deleveraging by increasing the value of current wealth compared to future wealth.

Debt - The Housing Bubble Debt is Only One Element
written by Ron Alley, September 16, 2012 9:03

Debt is a serious problem that is a natural consequence of the preferred position the financial industry has gained in our political and economic system over the last 30 years. Congress and both wings of the Corporate Party of America have rewarded the financial sector at the expense of consumers and other sectors of the economy. Real estate mortgages are only a portion of the debt burden that is strangling demand. Education loans have replaced government's commitment to higher education and represent the most serious suppression of demand.

alternate timeline
written by Peter K., September 16, 2012 10:12

Imagine and alternate timeline, one where there wasn't a housing bubble.

What if in an alternate timeline, all the money that was bet on the housing bubble instead was invested in more productive, sustainable ventures. That wouldn't be the same as 5 trillion vanishing, no?

...
written by skeptonomist, September 16, 2012 10:49

There is over $800B in revolving credit debt (FRED: REVOLSL) which I assume is mostly credit cards or similar. The part that revolves beyond a month is subject to ridiculous interest rates which neither the Fed nor anyone else but banks seems to affect. Without necessarily calling in a godess, this debt could be handled in a more constructive way. I have suggested before that since credit cards are money, they should be under the control of the government or some responsible agency which has the collective good in mind, rather than big banks (but not Alan Greenspan).

Awkward
written by Lord, September 17, 2012 1:23

God has already clapped her hands and made that much wealth disappear, the debt remaining from it is unbacked so represents only a liability to borrower and only a fleeting asset to the lender who will more than likely face losses in the future if not already. There are a few ways of eliminating the debt though. Declaring it null and void would help borrowers who would not have to repay it and harm lenders who would have to face their losses immediately. Defaulting would free borrowers from having to repay but place the reduced value asset in the hands of borrower who would have to sell or rent it but still face the loss either immediately or over time. Liquidating it free borrowers from servicing it but impoverish the one paying for it and leave the value in the hands of lenders to reinvest. Our presumed wealth is gone, the debt is just the desiccated corpse of it. On the rest of it you are correct.

...
written by J. MIner, September 18, 2012 12:02

In the longer-term wouldn't private domestic investment be a potential source of additional demand with Fed policy of low interest rates and a relatively high inflation target?

Krugman and debt overhang
written by paul, September 24, 2012 9:31

Krugman mentioned it today in his op-ed (9/23). So DB, the basic story is that debt overhang is a problem because of the lost demand from the wealth effect (borrowers propensity vs lenders) and it just isn't that big (especially when considering actual spending against the historic trend). Hence the problem is lack of government supplied demand. What's Krugman's deal?

The Non-Debt Overhang: Economics and Arithmetic #5467

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