Tag Archives: deleveraging

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

Deleveraging and monetary policy

Few popular terms irritate me as much as “deleveraging”.

Yes, the concept is important. In fact, it’s probably central to understanding why we’re in such a rut. But almost everyone talking about it fails to understand why it matters, and why it’s intimately related to monetary policy.

Sure, most people know the basic idea: during the crisis, consumers and businesses experienced an enormous hit to net worth, and now they want to improve their balance sheets. To do so, they spend less—but since lower spending means lower income somewhere else in the economy, in the aggregate balance sheets barely improve at all. The economy is depressed as it gradually returns to the correct level of leverage, and we experience the  “long, painful” process of deleveraging. (In the words of, well, every blogger and amateur econ pundit in the world.)

Great story. Too bad it ignores everything else we know about macroeconomics.

After all, why should the desire to spend less and save more hurt the economy? If I want to save, I hand my money over to someone who wants to borrow or invest it. Net saving is channeled into productive investment. If consumers want to save more, we’ll see lower consumption but an investment boom—hardly a disaster for the economy.

Sure, you say, but maybe no one wants to invest this money. Won’t an increase in savings then mean that the economy crashes? After all, the money isn’t being spent on consumption, and it has nowhere else to go.

Although this sounds plausible, it doesn’t really make sense. At the micro level, economists don’t worry about weak demand causing a supply glut: instead, they correctly say that prices will adjust to clear the market. The same is true for macro as well. There’s a price—the real interest rate—that determines willingness to save and invest. Like all prices, this price has a market-clearing level: at a sufficiently low real interest rate, the supply and demand for savings will equate, and consumers’ desire to save will translate into an investment boom, not an economic downturn.

The hitch is that the “market” doesn’t quite control interest rates: the Fed does. It controls both nominal interest rates (by setting them) and real interest rates (by shaping inflation expectations). Worse, nominal interest rates can’t go below zero. And if a real interest rate of -X% (0% nominal minus X% inflation) isn’t enough to clear the market and channel money from savers to investment, we’ll see a downturn after all.

So yes, deleveraging can be very bad for the economy. But this is only because monetary policy doesn’t adjust enough to match the market.

In failing to understand this core logic, most commentary about “deleveraging” is rather bizarre. At some level, it’s the same cluelessness that we once saw from central planners: they’d trip over themselves in the complexity of fixing a shortage in one market or a glut in another, never quite realizing that the price mechanism would do their work for them. Right now, historically low inflation expectations and below-potential output are prima facie evidence that real interest rates are too high. That’s what every macro model tells us is associated with contractionary policy by the Fed. Yet we see pundits lost in all kinds of complicated, small-bore proposals to stimulate the economy—when the fundamental, overriding dilemma is getting the price (in this case, the interest rate) right.

This isn’t to say that non-monetary proposals should be abandoned entirely. Monetary policy doesn’t stop working at the zero lower bound, but it is a lot harder. Even an ideal Fed would probably find itself constrained. This means that we should be open to other policies that affect demand—possibly via government spending, transfers, or tax incentives. But once we recognize that the fundamental problem is monetary, the issues become much clearer. The Fed’s failure to use all the tools at its disposal—in particular, its failure to make a conditional commitment like the one proposed by Chicago Fed President Charles Evans—is by far the most serious failure of economic policy today.


Note: High on the list of people who do understand deleveraging are Gauti Eggertsson and Paul Krugman. It’s even obvious from the title of their paper: “deleveraging” comes right before “the liquidity trap”, i.e. the zero lower bound making it difficult for the Fed to properly accommodate the effects of deleveraging.


Filed under macro