Balance sheets and reality

Yesterday, I discussed how the central problem with “deleveraging” is that monetary policy fails to accommodate it, not that it’s inherently destructive on its own. One common reaction is the following: “how can monetary policy make a difference when consumers can’t borrow any more?” After all, monetary policy works through interest rates, right? If households are at their borrowing limits, how will anyone’s behavior change?

There are several answers. First, to talk about households in general as overleveraged and pinned up against credit constraints is to seriously exaggerate: some are, but many are not. In the aggregate, the assets of American households are still far higher than their liabilities—in fact, as a quick glance at the Federal Reserve Flow of Funds tables will demonstrate, the situation isn’t so much worse than it was pre-crash:

Bad? Of course. But just as in 2006, most of America’s wealth is held by households whose assets vastly exceed their liabilities.

And this is even after I’ve excluded plenty of assets*: in the Fed Funds table, I’ve taken out both lines 6-7 (nonprofits’ equipment and software and consumer durable goods) and lines 27-30 (life insurance reserves, pension reserves, equity in noncorporate business, and “miscellaneous assets”), because they’re arguably less liquid, while leaving liabilities the same—in other words, I’m counting car loans as liabilities while excluding cars as assets. Yet even this calculation, designed to provide the least favorable picture of household balance sheets possible, shows that aggregate net worth is still well above zero, and aggregate leverage isn’t as high as you might imagine.

This is not to deny that many households have negative net worth. There are, and that’s a problem. Presumably the positive net worth that shows up in these aggregate statistics is disproportionately held by the top 10% of families, and the other 90% is in far worse shape. But the top 10%’s disproportionate share of assets is matched by its disproportionate share of spending, and therefore disproportionate influence on the macroeconomy. Even if in the short term lower interest rates do nothing more than provoke a spending spree among the top 10%, they’ll be worthwhile from a macroeconomic perspective.

Of course, lower rates are more effective than that. Even households drowning in debt tend to have some assets: a house, and maybe a 401(k) or IRA. All else equal, low interest rates place upward pressure on home prices (since they bring down the cost of financing for those who can obtain it) and make both equities and long-term bonds much more valuable (since lower rates increase the discounted value of an asset’s payout). This can actually help fix household balance sheets: it brings them out from underwater on their mortgages (or, at least, makes them less underwater than they otherwise would be) and increases the value of their other financial assets. In this light, it’s entirely conceivable that crippled balance sheets make monetary policy more effective, not less. Although the “wealth effect” from higher equity and bond prices matters most for the richest Americans, it’s useful for a much broader group.

And why are we just talking about households? Household spending isn’t all that matters; cyclical swings in investment by businesses are also a very important part of any recession. The dominant form of business in the United States is corporate, and most corporations aren’t facing any serious credit constraints. If it was really necessary, many could pay for investment through retained earnings alone, and most have access to reasonably liquid public debt markets. Further decreases in their cost of capital, or equivalently increases in Tobin’s q, can only increase the incentive to invest.

And if these straightforward neoclassical incentives are too weak, there’s also the “financial accelerator” of Bernanke, Gertler, and Gilchrist. For corporations, this accelerator is simple: by increasing the company’s equity value, low interest rates decrease its leverage and allow it to more readily obtain cheap debt financing, which gives investment a further kick. Again, here it’s possible that balance sheet considerations actually increase the impact of monetary policy. In fact, that was the whole point of Bernanke et al.’s research agenda: empirically, simple neoclassical mechanisms couldn’t explain the magnitude of the response to monetary policy, and the “balance sheet channel” provided the most likely explanation.

All in all, there’s no reason why monetary policy should be any less effective now than ever before. Yes, life is much more difficult at the zero lower bound, but the Fed can still commit to lower rates in the near future, which if credible does nearly as much as lower rates today. (Increases real estate and equity values, improving household balance sheets? Check. Makes durable goods purchases more attractive? Check. Improves corporate incentives to invest by increasing equity values and decreasing the cost of debt financing? Check.) There’s nothing special about a “balance sheet recession” that negates the value of monetary policy—indeed, if we read our vintage Bernanke, we’ll understand that monetary policy may be more important than ever.


*I can’t exclude all assets of nonprofit organizations, which are bundled together with households in the Fed Funds data. This is fine for two reasons: (1) many nonprofit organizations have an economic function similar to households, acting as final buyers of goods and services and (2) back in 2000, when the Fed last published figures on nonprofits separately, their assets were insignificant compared to assets held by households; I see no evidence of a sufficiently dramatic upswing since then.



Filed under macro

10 responses to “Balance sheets and reality

  1. Matt:

    Unfortunately, the “balance sheet recession makes monetary policy ineffective” view is pervasive and is probably an important factor behind the external political constraints the Fed now faces.

    By the way, I made a similar argument here:

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  3. But the top 10%’s disproportionate share of assets is matched by its disproportionate share of spending
    Another thing that people forget that is related to this idea that misunderstand is that investments is spending. Someone gets the investment money right away when a stock or machinery or equipment is purchased. Putting the money in a bank right now is saving because the bank might not have borrowers to lend it to.

    Also lower interest rate can allow people to refinance and spend the money that would have gone into interest elsewhere.

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  5. although i am convinced by Richard Koo, i think your points have some merit — treating “the household” as a bloc rather than fragmented groups, some of whom will benefit, is indeed counterproductive conceptually even if the aggregate demand for credit remains negative. And I would agree that the only reason private sector investment (ex-housing) is doing reasonably well — in spite of deficiency of aggregate demand — is the very low cost of funds enabling equipment replacement even as capacity is not being expanded.

    But I also think much overlooked is the negative impact of ZIRP on the economy.

    As the US government refinances its debt to shorter maturities with ever lower coupons under ZIRP, a real income stream is being removed from the economy. So far FYOINT is down ~$60bn/year from peak. Moreover, the share of FYOINT that is being paid into the Fed (and not the private sector) has increased (though total Fed holdings are still a modest share of total government debt).

    This is real net private sector income that has gone missing under ZIRP, which makes net private sector balance sheet repair more difficult. We’re seeing the effect of it in rapidly declining NIM revenues at the banks (some of whom are simultaneously being squeezed by non-interest expenses as they repossess housing collateral, killing their cash flow).

    Moreover, much as some segments of the private sector benefit from low rates in order to maintain or increase leverage, many others — particularly unleveraged savers, such as the elderly — are being destroyed. Anecdotally, I’m hearing of many friends and relatives who are being forced to cut spending, even so far as vacating eldercare facilities to move in with children, because their income has been so profoundly impacted.

    So while I see the reason of your points, I think you’re also skewing your analysis positive and thereby making much more of the net effects of Fed policy than is really there.

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  8. wh10

    A fair response, I would say –

    My sense is that you two would agree on at least some levels. You say monetary policy isn’t less effective. Cullen agrees, in that it isn’t rendered *less* effective than it was before, but that it likely won’t be sufficient for our current ailments. On the latter point, I imagine you might disagree, if it was used differently or more aggressively.

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