… at least as long as the goal is to assess the effect of the activity on the macroeconomy today.
Rortybomb directs us to Matt Rognlie‘s critique of “deleveraging.” Rortybomb correctly points out Rognlie’s error in using aggregate data to discuss consumer behavior and links to a year-old analysis explaining that it’s the middle class that’s overleveraged. I have a different bone to pick.
While Rognlie nominally acknowledges that the deleveraging problem is specific to the aftermath of an asset bubble (“consumers and businesses experienced an enormous hit to net worth”), he restates the problem as something that is not precisely the same, that consumers desire to spend less and save more.
The aftermath of an asset bubble implies that many economic participants owe more than the value of the assets securing the loan. This has the immediate implication that either (i) defaults must take place, transferring full ownership of the assets to the lenders or (ii) assets are “locked in” and those who hold title to the assets cannot sell them (because the assets undersecure a lien, so in some sense this title is only nominal) or (iii) some combination of (i) and (ii).
The theory to which Rognlie refers tends to assume that (i) takes place instantaneously: After a bad economic realization, borrowers who owe more than the asset is worth strategically default, and losses are immediately recognized as lenders sell the foreclosed assets off to the highest bidder == highest value user. Economic recovery takes place quickly because the model doesn’t allow for assets to be held and used by low value users.
As I understand his argument, Richard Koo sees solution (i) as so full of costs that typical economic models don’t recognize that it can be rejected out of hand. And indeed most policy-makers seem to agree with him. Banks are not asked to recognize their losses, borrowers are induced through temporary payment reduction plans like HAMP to continue making payments on loans that would lead to strategic default in an economic model, etc.
The balance sheet recession theory focuses on a world, like the one we are experiencing now, where strategic default does not take place on a large scale, and assets continue to be held by entities that are paying more money for them then they are worth on the market. Such debtors have the use of the asset, but cannot sell it because the market value is insufficient to pay off the debt. They are “locked in” at least until such time as they choose to default and transfer ownership to the lender. This implies that we are now are in a world where assets are not as easily transferred to their highest value use (whether due to policy decisions, social pressures, or other concerns) as economic models tend to assume.
Observe, in addition, that spending less in order to have the means to make a debt payment on an underwater loan to a financial institution is very different in macroeconomic terms than spending less in order to invest the money in some asset. The reason for this is a simple matter of accounting: banks assume when they lend that the debt will be repaid (at least until such time as there is a significant default and they transfer the loan to an impaired asset category). Thus the payment of debt has already been accounted for by the bank in its assets and adds nothing to the economy’s capacity to lend. Savings/investment are a very different matter, because these are sums that an entity sets aside to provide itself with future income, but there aren’t many realistic future housing market scenarios in which reducing the negative equity in your home from 50% to 49% by making a year’s worth of payments is going to result in future income within the next decade or two.
Thus, it’s not true that all the two-earner households who have become one-earner households and are now cutting back on consumption in order to make their mortgage payments on underwater homes are “saving” in a meaningful macroeconomic sense — because many of these households don’t expect these payments to result in home equity for at least a decade (and since they are likely to lose the house in the end anyhow, they are really just renting == consuming housing services), and the banks’ current balance sheets are founded on the assumption that these payments will be made. These households are cutting back on their economic activity, but the “savings” from doing so added to economic activity in the year in which they took out the loan and bought the house, not now. Only if you want to argue that when banks don’t have to recognize losses on the bad loans they made, that also constitutes savings for macroeconomic purpose, can you claim that the vast amounts currently being paid on underwater mortgages are savings. This is, however, at best a disputable position.
In short, in order for Rognlie’s theory to apply to our current situation he needs to consider the effectiveness of monetary policy in an environment where a principal goal of policy-making is to protect financial institutions from experiencing (or at least realizing) losses and where the policy is implemented at the cost of obscuring the valuation information available to shareholders and of encouraging deeply underwater consumer-mortgagors to continue making payments on their loans (e.g. HAMP). Confusing the macroeconomic effects of paying off debt for the purpose of incrementally reducing negative equity (and in many cases insolvency) with the macroeconomic effects of saving is a serious error, but one that is easily made by those who work with models that don’t take insolvency and the bankruptcy process into account.
Synthetic Assets 
“Savings/investment are a very different matter, because these are sums that an entity sets aside to provide itself with future income, but there aren’t many realistic future housing market scenarios in which reducing the negative equity in your home from 50% to 49% by making a year’s worth of payments is going to result in future income within the next decade or two.”
I really don’t understand this argument. Or rather, I don’t understand why it isn’t always true of anyone paying down a mortgage. There’s nothing special about 0. So why does reducing the negative equity in your home — that is, increasing the equity in your home — by 1% today count less as “savings” than reducing the bank’s share of equity in your home by 1% five years ago. In fact, whatever future housing market scenario you consider, putting money into a house today has to be considered a better investment than putting money into a house five years ago, since the trajectory of home prices over the next decade is almost certain to be better (even if it’s not good) than the trajectory of home prices over the past five years.
Now, you can say, the whole point of negative equity is that people are paying far more for the asset than it’s now worth. But this is true of auto loans, most obviously — the vast majority of people driving around in cars that they bought new are paying more for the car than it’s actually worth. Yet there don’t seem to be disastrous consequences for the macroeconomy from this.
The bigger point is that there’s little evidence in the data to suggest that the debt overhang is seriously affecting the economy as a whole. Consumption as a percentage of income is completely in line (actually, higher than) pre-bubble averages. Debt-service costs as a percentage of income are as low as they’ve been in twenty years. If massive deleveraging is the cause of our problems, why can’t you see it in the numbers?
The difference between negative equity and positive equity is foreclosure. You get money back when your house is foreclosed and you have equity, you don’t get anything back if you negative equity, no matter how much negative equity you’ve paid down.
If you assume that no one paying down negative equity is at risk of foreclosure, you would be correct.
“Consumption as a percentage of income” hasn’t fallen. Why would you expect it to? My point is that some significant portion of what the macro data calls savings (paying down negative equity) does not play the traditional role of savings in the macroeconomy.
Additional notes:
“putting money into a house today has to be considered a better investment than putting money into a house five years ago, since the trajectory of home prices over the next decade is almost certain to be better (even if it’s not good) than the trajectory of home prices over the past five years”
That’s a remarkably low standard you’re setting. I suggest you consider comparing the investment to cash.
“the vast majority of people driving around in cars that they bought new are paying more for the car than it’s actually worth”
I live in California, and can’t say that I know anybody who makes payments on a new car with the goal of owning if for the long-term. People lease because they want a multi-year rental, and people who buy pay significant down-payments or cash. Maybe the car market you’re familiar with has a different structure.
“My point is that some significant portion of what the macro data calls savings (paying down negative equity) does not play the traditional role of savings in the macroeconomy.”
What’s the traditional role of savings in the macroeconomy? Presumably to channel capital from investors/savers to businesses/borrowers. The money that’s being used to pay down negative equity is still doing that, or would be if the banks were re-lending it. To the extent they’re not, it’s not because of deleveraging. It’s because the bursting of the housing bubble eliminated $500 billion or so in consumer demand as a result of the negative wealth effect (totally independent of the amount of debt), and until we find a way to replace that, we’re in trouble.
For the individual, savings plays a role of building a nest egg for the future. But insofar as that has an impact on current spending, and therefore the current state of the macroeconomy, it has to show up in the data. That’s why it matters that consumption as a percentage of income hasn’t dropped significantly. If, in fact, deleveraging, or the negative-equity problem, were having a massive effect on consumers, we’d see a much sharper decline in consumption, as individuals tried to save more. We’re not seeing it.
“I live in California, and can’t say that I know anybody who makes payments on a new car with the goal of owning if for the long-term. People lease because they want a multi-year rental, and people who buy pay significant down-payments or cash. Maybe the car market you’re familiar with has a different structure.”
The U.S. car market has a very different structure: there are 3.5 times as many new vehicle sales a year as new leases. And the average car loan, at least pre-recession, was around 90% of the car’s value. So the vast majority of American drivers have significant negative equity in their cars, literally as soon as they drive the car off the lot. I don’t see any disastrous consequences as a result.
“The money that’s being used to pay down negative equity is still doing that, or would be if the banks were re-lending it.”
Did you read what I wrote? It’s a simple matter of accounting that paying down a loan does not free any resources for a bank to lend. Accrual accounting assumed the payment would be made when the loan was made.
“savings plays a role of building a nest egg for the future. But insofar as that has an impact on current spending, and therefore the current state of the macroeconomy, it has to show up in the data.”
My understanding of the data on the wealth effect is that it’s often very weak, depends on the form in which the wealth is held and really should be modeled as an access to credit effect.
“we’d see a much sharper decline in consumption”
The savings rate doubled from about 2.5% in 1998 to 2008 to about 5% now. http://research.stlouisfed.org/fred2/series/PSAVERT?cid=112
What else are you looking for? Are you sure that your consumption data is consumption as a fraction of disposable personal income?
“the average car loan”: Clearly this is not the relevant data point. We need to know the average new car loan. Nobody’s questioning that people who buy used cars (which I believe make up the vast majority of car purchases in this country — precisely for the reasons you are indicating) make regular payments to own the car.
Regarding the car market, what fraction of your new vehicle sales are to corporations and not to individuals and what fraction of you average car loan data is to corporations and not to individuals. If you’re not going to provide links to your data, it becomes very difficult to have a coherent exchange.
“The savings rate doubled from about 2.5% in 1998 to 2008 to about 5% now. http://research.stlouisfed.org/fred2/series/PSAVERT?cid=112
What else are you looking for? Are you sure that your consumption data is consumption as a fraction of disposable personal income”
This is exactly the point. You’re taking the bubble era — that is, a period of time in which people’s wealth was illusorily inflated by bubble-driven asset growth, thereby leading them to spend more relative to income than they otherwise would — as the baseline. This makes no sense. The historical average during the pre-bubble era was around 8%, which tells you that people are not, in fact, reducing spending in an unusual way.
That data on car down payments is for new cars: http://www.usatoday.com/money/autos/2008-10-16-automakers-down-payment-credit_N.htm. Again, hard to see that negative equity in automobiles has some uniquely bad characteristics.
More important, your responses have confused me further. If you don’t believe in the wealth effect, and you don’t think paying off a loan has any effect on banks’ willingness to lend, then what, precisely, is the macroeconomic effect that savings typically have, and that they’re not having now. In other words, what, exactly, are the negative consequences from having people paying off negative equity?
Did you read the car article that you linked to? There is nothing in the text to tell us whether the loan data is for new cars or all cars — only the title indicates that the article is about new cars, and given newspaper methods for choosing titles that is not evidence at all. Furthermore who is to say that a buyer doesn’t use something structured as a purchase loan to own car for only a few years before replacing it and therefore has no interest in “equity” in the car.
“what, precisely, is the macroeconomic effect that savings typically have,”
You answered your question yourself: “Presumably to channel capital from investors/savers to businesses/borrowers. ”
“This makes no sense.”
You lost me there. You need a better defense of why the increase in saving is not an increase in saving. Remember that there are vast structural changes in the economy from the 1950s and 1980s to the 2010s.(And the housing bubble with its wealth effect didn’t start til 2003, so I have no idea why data from 2000 can be ignored.)
I’m beginning to think that your goal is to waste my time, and I do have other work to do.
Well, I don’t want to waste your time, so I’ll make just three quick comments and then leave you to your work.
1) The housing bubble did not start in 2003. It started in the late 1990s, as any graph of historical housing prices will show. See Dean Baker here: http://www.cepr.net/documents/publications/housing_fact_2005_07.pdf. The wealth effect from housing was already having a substantial impact on the economy in the early part of the past decade, while obviously the wealth effect from stocks was having a major impact on the economy in the late 1990s. This encouraged people to spend more of their income than they historically had, because they believed the stock market/housing market were doing their savings for them. This was not sustainable. When the housing bubble burst, we were going to get a rise in savings and a decline in spending, independent of how much debt or equity people had in their homes.
2) Whether people have interest in “equity” in the car or not is irrelevant. Your point about paying down negative equity, to the extent that I can discern it, is that having people paying an inflated price for an asset whose value has substantially decreased is bad for the economy because “we are now are in a world where assets are not as easily transferred to their highest value use.” I don’t know what the “highest value use” for a home is, other than having someone live there, but in any case the point about the auto market is that there are tens of millions of people driving around in cars and “paying more money for them then they are worth on the market.” There is no evidence that this is inherently bad for the economy.
3) Finally, your argument about negative equity not being “real” savings seems to be that because households aren’t “really” saving, money isn’t going, as it should, from investors to businesses/borrowers. But this makes no sense as a diagnosis of our current economic problems. There’s no dearth of capital available for creditworthy businesses — in fact, they can borrow it at remarkably low interest rates. But they aren’t using that capital, because the problem we face is one of insufficient demand, not a lack of “real” savings.
Thank you for more careful replies.
“The housing bubble did not start in 2003. It started in the late 1990s, as any graph of historical housing prices will show.”
As Fed chairman have been saying for a decade there’s plenty of room for dispute about when a bubble starts, but it’s extremely clear from looking at a housing price chart like this one ( http://cr4re.com/charts/chart-images/RealHousePricesJuly2011.jpg ) that a trend growth line from Jan 1976 to the early years of the ’00s would leave the late ’90’s below or at the line. So I just don’t see how the housing bubble starts then. I will agree that it is arguable that the date can be moved a year or two earlier than 2003.
Also I admit that I only skimmed the Baker article, but I didn’t see where he claimed that the bubble started in the 90s. Quote please.
“obviously the wealth effect from stocks was having a major impact on the economy in the late 1990s.”
The stock market wealth effect has rarely been measured to have a “major impact” see e.g. http://urbanpolicy.berkeley.edu/pdf/cqsadvmacro2005web.pdf
“tens of millions of people driving around in cars and “paying more money for them then they are worth on the market.””
They’re not paying more for them than they’re worth on the market, if the payers think of their payments as rental or paying for temporary use of the vehicle. This article makes it clear that low-cost loans are targeted to people who would be interested in leasing, so I’m not sure that loans mean people aren’t effectively “renting” their cars. http://www.cars.com/go/advice/Story.jsp?section=lease&subject=buy_lease&story=buyLease (“leasing has diminished in popularity as automakers have offered low-interest financing and cash-back offers to buyers … When interest rates are low, lease payments aren’t that much lower than financing. But “when rates start going up, leasing will become more popular again,” he says.”)
In short, it’s clear that the macroeconomic effects of equity in the car market is not really comparable to those of home equity. When did you last hear of a bank credit line secured by your car? Since cars aren’t worth much compared to houses and almost never increase in value, they’re not relevant, because it’s very difficult or impossible to build equity in a car. They’re basically consumption goods — and payment plans for consumption goods don’t seem important to me macroeconomically. (Try to convince me if you want.)
“because households aren’t “really” saving, money isn’t going, as it should, from investors to businesses/borrowers. … There’s no dearth of capital available for creditworthy businesses”
My argument is that when payments on deeply underwater homes are counted in macro data as savings, they fail to play the traditional role of savings, because (i) homeowners have little expectation of earning a future return on these “savings” as they’re very likely to be lost in a future foreclosure over the next two decades and (ii) the payments shore up bank balance sheets rather than freeing resources for new loans. Of course, I agree that there’s a demand problem and that’s affecting business demand for loans, but it seems clear that this is due to (1) failure of average income to increase and (2) the effect of doubling the savings rate on that stagnant income. How could these factors fail to cause a recession?
Why is the recession as bad as it is? I would argue that it’s because too much of what we’re counting as savings is not leading to meaningful investment. Obviously the negative equity problem isn’t the cause of our economic problems. It’s just a very important aggravating factor that makes the problem particularly difficult to solve.
Wow. I thought it was a good idea before reading this.