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 Mian/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 principle 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.
Source: Federal Reserve and BEA