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Home Publications Blogs CEPR Blog Inflation: How Do You Spell Debt Relief?

Inflation: How Do You Spell Debt Relief?

Written by Dean Baker   
Friday, 07 October 2011 05:25

In his column today, Paul Krugman picks up the suggestion from Richard Yeselson, that debt relief for working people would be a good demand for the Wall Street occupiers to pursue. While there is a good logic to this demand -- many people find themselves facing crushing mortgage, credit card or student loan debt -- there are also problems with going this route.

For example, suppose we go the route of making every underwater mortgage above water by writing off the extent to which the debt exceeds the value of the home. As of what date do we wipe out underwater debt, today, six months ago, six months from now? That it isn't a joke, home prices are still falling in many areas. So do we say that people who were smart enough to be underwater as of some prior debt benefit, but folks who waited to get underwater are screwed?

Do we have a limit on debt write-offs? There are a lot of people who were speculating in homes who took out zero-down mortgages on expensive properties in places like Las Vegas and Miami at the peak of the bubble. Say they borrowed $450k on a home that is worth $200k today. Is it important to ensure that these people have their mortgages brought above water.

There is also the question of the other side of these loans. Close to half would of the underwater mortgages would now be held by Fannie Mae or Freddie Mac, so the write off would be a loss of government money. We can argue over whether this is the best use of it. Some of the rest of the mortgages are held by banks, but most are in pools. The owners of these pools include some rich investors, but it also includes institutional investors like pension funds and individuals with 401(k) holdings.

This raises both a question of fairness and also dampens the economic impact -- which has been hugely overstated in any case. If we eliminate $900 billion in underwater mortgage debt (certainly a high estimate, since it implies that almost 10 cents of every mortgage dollar outstanding represents underwater debt), we should expect the additional wealth to generate around $54 billion of additional consumption a year (this assumes a 6 percent wealth effect)

However this would be in part offset by the loss of wealth on the other side. If we assume that half of the debt is held privately and a wealth effect of 4 percent for this group (they are likely wealthier on average), then we would lose $18 billion in annual consumption for a net gain in annual consumption of $36 billion or 0.2 percent of GDP. That's not trivial, but not exactly a game-changer in an economy that is operating 8 percent below potential.

Finally, there is the political side. Remember, the Tea Party got  kicked off over the misrepresentation of the HAMP. People were outraged over the idea that the government was going to pay their neighbor's mortgage. There is some logic to the complaint. For every underwater homeowner on the edge of foreclosure, there is someone next door who has struggled to meet their monthly payments.

There is another way to bring about debt relief that is both simpler and fairer, inflation. Economists from across the political spectrum have advocated that the Fed deliberately target a somewhat higher rate of inflation as a way of boosting the economy. This would both lower the real interest and provide the debt relief that is so badly needed.

Just to throw out some simple numbers, suppose the Fed targeted a 5-6 percent inflation rate over the next two years as advocated by Ken Rogoff, the former chief economist at the IMF. This would mean that most people's wages would be 10-12 percent higher in two years than they are now. That would substantially reduce the burden from mortgage or student loan debts.

In addition, if we assume that house prices rise more or less in step with inflation, then many currently underwater homeowners will come back up above water. Someone who owes $220,000 on a house that is today worth $200,000 will likely be back above water again in two years in the Rogoff scenario. The benefit of going this route however is that it doesn't just benefit underwater homeowners. The more thrifty neighbor who only owes $180,000 on their $200,000 home will also see their home rise in value to $220,000. As a result, she too can benefit from this policy.

Anyone who thinks that this sort of deliberate inflation policy requires more sophisticated analyses than can be expected from the Occupy Wall Street (OWS) crew need only look back to the Populists of the 19th century. Inflation, in the form of moving away from the gold standard, was the central theme of the populist movement, as typified by William Jennings Bryan's famous speech about being crucified on a cross of gold. There is no reason to believe that the OWS crowd is any less sophisticated than the populists of the 19th century. If they decide that debt relief is a good policy, they will be able to understand how inflation can accomplish this goal.

Tags: debt | housing bubble | inflation | Wall Street

Comments (4)Add Comment
Mark the Banks Assets to Market!
written by Elwood Anderson, October 07, 2011 11:28
Complicated half measures won't work. The first objective of Occupy Wall Street and other protests should be to demand that Wall Street bank assets be again marked to market. It would lead to all the "too big to fail" banks becoming insolvent so they could be nationalized temporarily and restructured, wiping out the large debt overhang which is the root cause of the current malaise. Good mortgages would end up in the restructured banks and bad ones would be forclosed immediately. The Keynesian measures taken so far have delayed the collapse, but shifted the debt from private holders to the public, and increased it. By doing so they probably have made the eventual collapse worse. The low interest rates essentially take money from savers and give it to insolvent banks to get well at the public's expense. The austerity proposals are even worse, in that they hasten the collapse. The only solution that will give us a fresh start is debt liquidation. The initiators of debt were the cause of the problem and have profited from the bubbles and their collapse, and continue to profit at the expense of the public at large. They must pay the price by absorbing the losses on the bad bets they made.
written by hapa, October 07, 2011 7:01
"This would mean that most people's wages would be 10-12 percent higher in two years than they are now"

hmm would it indeed
Inflation and wages
written by Dean, October 07, 2011 11:01
Yes it would Hapa. Most people's wages do rise with inflation -- not everywhere and always, but anyone who thinks they know of a policy that won't hurt anyone hasn't done enough thinking.
written by hapa, October 08, 2011 7:25
"Most people's wages do rise with inflation"

this is an extraordinary job market and it would be off-trend inflation.

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