Integrating finance and macro: the problem of modeling debt

So I have finally read Mian and Sufi’s House of Debt. They do an excellent job of setting forth an argument that has met with quite a bit of resistance within the economics profession: the growth of household debt before the crisis and the failure to reduce it after the crisis explains to a large degree the severity of the crisis. (House of Debt was written in 2014, so if you’re thinking: “But wait, that argument is mainstream now” you would be correct.) I actually read the whole book which can be taken as approval of both its structure and the quality of the writing. (On the “life is short” principle I typically don’t get through a book is poorly structured or poorly written.) The book is widely cited and almost universally acknowledged as one of the foremost expressions of the household balance sheet view of the 2007-09 financial crisis. Thus, I am going to take the book’s many excellent qualities as given and focus on the most important flaw that underlies the book, because that flaw also underlies most economic analysis of the way financial factors played a role in the crisis.

While it is wonderful that Mian and Sufi are talking about debt, the way they are talking about debt and in particular their underlying model of debt is very problematic. Furthermore, the errors in their underlying model of debt are so ubiquitous in economic theory that these errors function as a constraint preventing the development of models that can accurately represent the relationship between finance and the real economy. In short, while this post will focus on a critique of Mian and Sufi (2014), this book is really just standing in for all the economic works that make the same assumptions, some of which I will reference below.

Holmstrom (2014) presents the standard economists’ model of debt, which underlies Mian and Sufi’s discussion too, using this diagram:

Holmstrom debt

Debt is modeled as a promise to make a fixed payment that will only be met if the borrower has enough money at the time payment is due. This diagram treats the value of the borrower’s collateral as equal to her entire wealth, assumes that the value of the collateral may take on values ranging linearly from 0 to something well in excess of the amount to be repaid on the debt, and assumes that the lender can take the collateral if the debt is not paid. Thus, the lender’s payoff increases linearly until the value of the collateral exceeds the amount due on the debt at which point the payoff to the lender is fixed.

There is nothing wrong with this model as a first pass at modeling debt. It is widely used for good reason. But the basic model also dates back to the 1980s (I connect it with a paper by Hal Cole that I can’t locate, but am not entirely sure of its origins) and it is remarkable that the model has not in ensuing decades been amended to allow for the much greater complexity of real world debt. Treating this model as if it represents the general category of “debt” and not the specific simple case that is easiest to model is a huge mistake that permeates the economics profession.

So what’s wrong with this model?

1)   It is used to treat “debt” as homogeneous

The model assumes that all debt takes a single specific contractual form modeled on a mortgage. In fact, debt is broad term that encompasses a huge range of different contractual provisions. Debt can be structured to favor the borrower or it can be structured to favor the lender. A debt contract can be designed so that it is hardly distinguishable from equity or so that the lender bears virtually no risk of loss. Economists need to stop talking about “debt” as a homogeneous product and start talking about the specific kinds of debt they mean to address.

For much of the discussion in Mian and Sufi, the standard model is appropriate, because their main focus of inquiry is mortgages, and this is a reasonable model of mortgage debt. On the other hand, this model leads them to make generalizations about debt itself that are simply nonsense, e.g. “This is a fundamental feature of debt: it imposes enormous losses on exactly the households that have the least” (p. 23). If they simply replaced the term “debt” with the phrase “the current US mortgage system” there would be nothing wrong with this sentence. When, however, they generalize from the problems with US mortgages to “debt” itself, they misfire badly. As I note above, this problem is not in any way restricted to Mian and Sufi, this is a general problem that permeates and degrades much of the economic discussion of debt.

It is highly unlikely that the economics can make progress in its efforts to study the relationship between finance and the real economy so long as the profession’s vocabulary for discussing something as fundamental to finance as “debt” is so utterly impoverished.

2)   Failure to model uncollateralized debt

Uncollateralized debt has very different properties from collateralized debt. In economic theory models debt is almost always modeled to be collateralized and is therefore backward looking (see, e.g. Holmstrom 2014 or Gertler and Gilchrist 2018). An agent must already own something pledgeable in order to borrow. This ensures that wealthy agents can borrow more and grow more wealthy, whereas poor agents are likely to be constrained forever. This framing of debt is closely related to the inequality dynamics described by Mian and Sufi.

By contrast, when debt is uncollateralized, it can be forward looking. If I can convince a bank that after investing the proceeds of a loan of $50,000 today, my business will give me revenues of $100,000 in a year, the bank can fund the loan with nothing more than my personal promise to pay it back (and the knowledge that our legal and social system will impose significant costs on me for a failure to pay, e.g. a public judgment against me, and a defective credit report). As long as I am expected to have the funds to pay back the loan when the debt is due, there’s no reason at all for the loan to depend on my ownership of more than $50,000 in assets to be used as collateral. For relatively small amounts and short periods of time this type of unsecured lending is very common in practice and has been very common for centuries.

Effectively the habits of thought that economists adopt when they think about debt are unreasonably constraining their ability to model the relationship between finance and the real economy. And these same habits of thought tend to rule out by assumption the possibility of inequality-reducing debt.

3)   Inaccurate assumptions about the legal framework governing debt

“Debt leads to bubbles in part because it gives lenders a sense of security that they will be unaffected if the bubble bursts” (p. 114).

This is simply not a property of “debt.” In the event of a bubble that bursts there will be a rash of bankruptcies and the basic rule in bankruptcy in this situation is cramdown: the borrowers’ debt is written down to the post-crash value of the collateral. In short, the standard legal procedure governing debt addresses precisely the macroeconomic problem in question here. A lender who lends into a bubble is at risk of loss. As a general statement, Mian and Sufi’s claim is simply incorrect. It is, however, (1) an accurate description of the model of debt that they are working with and more importantly (2) an accurate description of the law governing US mortgages on first homes, because of the explicit exception for these loans in the bankruptcy code. (Interestingly enough, the rules for the treatment of second homes in bankruptcy do allow cramdown.)

Thus, when Mian and Sufi write “Our main argument is that a more even distribution of losses between debtors and creditors is not only fair, but makes more sense from a macroeconomic perspective” (p. 150), what they are missing is an acknowledgement that “debt” as a general category is usually subject to treatment in bankruptcy that addresses their macroeconomic concerns. “The inflexibility of debt contracts” (p. 168) about which Mian and Sufi complain exists in their model and in US mortgage markets, but is not in fact a property of “debt contracts” themselves under the current legal regime in the US.

What should economic models of private debt do?

Economic models that seek to integrate finance and macro need to be very conscious of the different kinds of private debt and make deliberate decisions about why a specific form of debt is being modeled. To assist in this project, I present here a simple hierarchy of different types of debt that are likely to have very different macroeconomic consequences and thus should be modeled differently. (It’s possible and even likely that I have omitted an important type of debt, so this hierarchy is open to revision.)

The types are ranked from those that are most favorable to the lender to those that are most favorable to the borrower. (Note (i) I use “mortgage” as a general term for a collateralized loan, and (ii) the listed term of the loan should be understood as typical and not as claim that these types of debt are restricted to this term.)

  • Repurchase agreement or margin loan: ultra-short-term, overcollateralization, marketable collateral, immediate right to seize the collateral if it falls in value (and isn’t increased).
    Comment 1: A vigilant lender cannot lose money on a repo.
    Comment 2: There has been significant work on repo since the crisis, e.g. Brunnermeier and Pedersen 2008, but as far as know there is no “workhorse” model comparable to the model of debt above. (Please correct me if I’m wrong.) My impression is that much of the work on repo has been empirical (e.g. Adrian and Shin 2010).
  • Mortgage with recourse: long-term, overcollateralization, a right to seize the collateral only after the borrower defaults, right to be paid in full if the collateral value at the time of default is deficient.
  • Mortgage without recourse: long-term, overcollateralization, a right to seize the collateral only after the borrower defaults, no right to further payment. (This is the type of debt that corresponds to the “standard” model of debt discussed above.)
  • Mortgage with cramdown: long-term, overcollateralization, a right to seize the collateral only after the borrower defaults, but subject to cramdown if the borrower declares bankruptcy.
  • Unsecured debt with bank guarantee (e.g. commercial paper): short-term, no collateral, lender relies on bank guarantee.
  • General unsecured debt: short-term or long-term, no collateral. Enforcement must be via long-term incentives (reputation) and/or penalties imposed by the legal system for failure to pay. Corporate bonds fall under this heading.

7 thoughts on “Integrating finance and macro: the problem of modeling debt”

  1. About repo’s: am I the only one to notice that a repo looks very, very much like a pawnshop loan? Or am I mistaken?

    1. The principle is pretty much the same. But a repo is cheaper — because the lender knows he can cash you out as soon as market prices drop.

  2. Looks like a good summary of debt from the perspective of the lender, but if you want to accurately model the whole economy you might want to have student debt and credit cards in separate categories. I mean, if I just had credit card debt, I would have declared bankruptcy years ago and would likely be well on my way towards living a decent life. Whereas in reality I had the good fortune of graduating with an Engineering degree from a state school in 2008 with $100k in a mix of public and private student loans and couldn’t find work in my field for 4 years. The 60 hour weeks I worked part time barely covered the minimum payments on the student debt so I had to rack up about $20k of living expenses on credit cards. The job I got paid $20k a year less than the average starting salary I was expecting while I was signing my loans. Because the federal loans didn’t care about other debt when calculating income based repayment switching to that would have increased my payments. After 4 years at the job I was finally making what I thought I would make right out of school and 75% of my income went straight to rent and minimum payments. At that point I realized that there was absolutely no chance I would ever earn enough to not live in poverty, much less afford a house, car, or family. That kicked in some intense depression and it wasn’t long until my performance at work suffered and I lost my job. That was 2 years ago. Every time I get over the depression long enough to apply for jobs the holes on my resume ensure the effort is futile.

    Long story short if our comically corrupt government hadn’t bridged the partisan divide to ensure my student debt was impossible to discharge, then blow up the economy and payed the wrecking crew for the privilege I would probably be a productive member of society. This miserable country has done nothing but throw roadblocks at me my whole life and I would be shocked if I was still alive in 4 years

    1. This blog post is really very abstract and academic, but I actually think that if economists start modeling debt more carefully they will quickly figure out what is implicit in Mian and Sufi: All debt should be subject to standard bankruptcy rules. There’s a reason the bankruptcy code evolved as it did and there are very high costs to designating debt that can’t be crammed down or that can’t be discharged in bankruptcy.

      In short, the special rules governing student debt are a mistake, not only from your personal perspective, but from a macroeconomic perspective. Good macroeconomic models of debt would be able to show that.

      I hear you. The way debt is structured in this country is very unfair — and that’s actually one of the motivations that drove Mian and Sufi to write their book too. Hang in there. People are really beginning to recognize the structural flaws in the economy. And that’s the first step to reforming them.

      1. I seriously doubt there is ever any help coming for me. When even socialist magazine’s and people who understand and advocate for MMT can’t get past the ‘moral hazard’ there is zero chance the general public will. This country is hopelessly brainwashed with individualism. They know how much work they put into paying off debt and therefore everyone who hasn’t is just a lazy loafer. It would be impossible for them to understand that just by not entering the workforce in 2008-10 they probably earned an extra $100k and that isn’t due to anything besides luck. This entire culture is built on the non-stop propaganda from the oligarchy that we live in a meritocracy, and anyone that isn’t filthy rich has no one to blame but themselves. Besides, I don’t think I will enjoy watching civilizational collapse and the agonizing death of billions due to a complete refusal by a handful of rich oil men to let something so insignificant as the continuation of the species get in the way of their profits. And as an Engineer I can assure you that is essentially locked in by this point unless every government on the planet did a greater than WWII level mobilization of their entire economy to build as many Nuclear, PV, and wind plants as fast as possible. Better odds on pigs growing wings.

  3. @userfriendlyyy

    My approach is to keep hoping, try and fix things, and at least work on being good to others in daily life. Sometimes just a smile and friendly hello, chat with a stranger can make the world a better place. The little things matter too. And it can’t hurt to keep work on the bigger problems too.

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