Delivering from De-Levering
The summer hasn't been kind to financial markets. Prices swing wildly once more, investors again seek ‘safe havens,' and people are muttering ‘double dip,' ‘Crisis 2.0,' and the like. What's this about?
Let's catch our breaths and recall that the nation has suffered a rapid succession of credit-fueled asset price bubbles and bursts. The last one, involving both real estate and stock like a nasty one way back in 1929, was particularly destructive. Credit markets everywhere seized up and simply ceased functioning. Financial firms right and left fell. Those that did not fall, nonetheless shaken, now will not lend. And it's more than financial firms that hold back: Companies everywhere sit upon mounds of retained earnings cash. They're no more willing than banks to invest. And this is so three years post- crash.
The pertinent upshot: our economy still lies idle, growth is now stagnant, productive capacity sits dormant and depreciates, and the employment-to-population ratio hovers below 60% – lower than at any time since the 1950s. Why's this still happening – or rather, not happening?
Widen the angle and you'll find your answer. Start with this bigger question, which turns out to be bigger than you might at first think: Why were there credit-fueled asset price bubbles and bursts in the first place? Here's why: For near thirty years by the time of the last bubble's burst, real incomes of all but the very top earners had stayed steady or steadily fallen. You can thank tax, trade and other policies for that. Wealth and income disparities in consequence reached measures not seen since full 80 years earlier: in 1929 – that year again – just prior to the last ‘great' price bubble and crash and depression.
Mind this gap – the gap that grew wider between richer and poorer. It bore two crucial consequences.
One such consequence was that the non-wealthy now had to consume less than before, hence relinquish the ‘American Dream;' or borrow more than before, hence mortgage that ‘Dream.' The other such consequence was that wealthy folk now had more money to play with. But since consumption diminishes as a proportion of income – how much utility would your seventh yacht yield? – and since the non-wealthy now had to consume less, one outlet was apt to draw most of the nation's new wealth: speculative, in lieu of productive, ‘investments.'
And so speculate we did. The wealthy spent massively on new ‘financial products' meant to appreciate rapidly. Many of these products derived from new forms of lending extended to non-wealthy citizens who suffered those aforementioned stagnating incomes. Well-to-do buyers bid up the prices of these products so fast and so high that before long, even non-wealthy folk sought to get in on the act, borrowing yet more to seek ‘capital gains.'
The beneficiaries of widening wealth and income gaps, in other words, lent more and more, at yet further profit, to the victims of those gaps. In this they were acting as rentiers always have done through the ages, from late-republican to imperial Rome, to feudal Europe, to the sharecropper south, to the ‘banana republics' and, more lately, to the ‘tea party's' rustbelt and sticksville.
In all of this, what's more, the well-to-do replicated and reflected, microcosmically within our increasingly porous nation, a great macrocosmic trend worldwide – a trend that itself, as it happens, fueled inequality here at home: Nations with unregulated product and labor markets, whose domestic income and wealth gaps accordingly presaged those destined to become our own, sold to us cheaply but didn't buy from us. The resultant surpluses they racked up then were lent back to us, just as our wealthy now lent to our poor.
That's right: These nations now exported to us both their internal poverty and inequality rates, and the debt peonage relations that always emerge between sides of these inequalities. But they didn't stop there. They macro-sized the dependency relation itself: Debt peonage came to subsist not only between poorer and wealthier citizens, but also between our nation and those nations themselves.
The funds that these nations lent to us per this relation lent further fuel to our credit-fueled asset price bubbles, just like those lent by our rich to our poor. So, finally, did policies pursued by our most renowned credit- and money-modulator, the central bank chairman of the day. For he was understandably keen to paper-over that long-looming threat of diminished consumer demand, rooted as it was in the worsening domestic income-inequality and foreign trade-inequality that he lacked the tools, the authority, and perhaps even the will to prevent.
And so: Speculative asset prices rose, and rose, for over ten years, until the credit that chased them at long last ran out. Then it all crashed. And you know the rest.
And so now we return to our question. Why do firms not now invest? Easy: The nation is now in the throes of dramatic ‘de-levering' – textbook debt deflation of the Irving Fisher variety. What we owe didn't collapse as did that which we bought. Hence the bubbles that borrowing brought, when they burst, left us with massive debt overhang. The poor owe the rich. We all owe our trading ‘partner.' The state that's endeavored to ‘backstop' and mop up the mess owes them both.
So we're all under water: the speculative stuff that we bought with our borrowings now is worth less than the debts that we owe. Until that overhang's lopped off, or offset by new asset price growth, individuals and firms will not spend – they just can't – in amounts that can prompt more production and healthy employment.
It is crucial to understand that individual persons and firms cannot change this. And this claim doesn't just happen to be true, it is structurally, logically true – true in the way that it's true we can't all be above or below average. Deflation's inherently macro, not micro, in character. It's a wholesale collective action problem just as inflation's a wholesale collective action problem.
You can't on your own stop the price of your bread from ascending. So the rational thing's to buy now, before it grows yet more expensive. And then everyone's acting thus rationally accelerates the harm' progress – prices rise further and faster. Deflation's the same, in reverse. You can't on your own reverse slackened demand for consumption. Nor can you lop off or offset economy-wide overhang. So the rational thing is to cut your own costs and expenditures. And then everyone's acting thus rationally idles both labor and other capacity market-wide. That is the ‘downward spiral' we all know as ‘depression' – ‘inflationary pressure' turned upside down.
‘Collective action problem,' I called it. Everyone says, ‘after you.' No one goes first. So no one goes. How do you solve problems like these? It's simpler than you might think.
To solve a collective action problem you first need a collective agent – someone who's authorized and able to act on behalf of us all. Hmm … that's what we call … ‘government.'
You then need that agent to see itself as such, and to act both accordingly and resourcefully. If we're now to de-lever economy-wide in an orderly manner, and thus to reverse that ongoing debt-deflation whose reversal awaits de-levering, we must first recognize it for the collective action problem that it is. Then we must address it forthrightly and resourcefully through our collective agent – our government. Starve that agent, call it a ‘beast,' and you starve and bestialize only yourself and your countrymen.
What will addressing our debt-deflation problem collectively, forthrightly, and resourcefully entail? Again, pretty simple. Debt overhang, again, must be lopped off, or offset, or both. You lop off by trimming, restructuring, or forgiving debt. You offset by growth – real asset price growth. (That's more than paper price growth – we'll come back to this presently.) There are of course fairer and less fair, better and worse ways to do either or both of these things.
A worse way to do debt-forgiveness – a way that evokes ‘moral hazard' precisely by dint of its unfairness – for example, is to forgive all debt tout court. Or, perhaps, to expropriate rentiers altogether by stealth, through inflation. Or to forgive debt procured via fraudulent means. Or, in some cases, to forgive debt contracted for purely speculative purposes – ‘house flipping,' for example. A fairer and presumably better way to do debt-forgiveness is first to consider it only or mainly for honestly procured and non-speculative debt, and second to afford it in what I'll call ‘Solomonic' measures.
If your house is now under water, and neither you nor your creditor had more reason to expect a ‘correction,' you both split the overhang. If instead one of you should have known better, or if one of you lied to the other, let him take the loss. If you both are at fault in a number of ways but unequally, apportion the loss per the familiar court calculus of comparative fault. Of course, if we're to do this with underwater homes, we'll have to include them in bankruptcy cases: our legislature must take up those bills that have languished in committee for over two years now.
Similar considerations should attend international debt-forgiveness. If creditors rack surplus upon surplus by violating labor or environmental protection standards, or by manipulating their trading ‘partners'' currencies, their assets have not been legitimately procured. Consider trimming accordingly. Or if you'd rather be prudent, pay them in kind, or in credits to purchase your own (higher quality) goods for a change. That also will help with the offset, as distinguished from the lop-off, approach to eliminating debt-overhang. Which takes us to … So how about that offset route mentioned above – offsetting overhang with asset price growth? There are better and worse ways to manage this too. We won't pull it off in the long run with targeted asset purchases done by our collective monetary-financial agent – i.e., QE by Fed – alone, crucial as this is right now, in the short run, to afford breathing room. In the long run we have to boost growth in the ‘real,' not just the monetary-financial economy. That means – with all due respect to the financially illiterate in their breeches and tricorner hats – fiscal policy.
Yep, our collective fiscal agent – the chief executive – has to spend real money. It must do so massively and strategically – much more massively and strategically than two years ago – to kick-start us into activity again. Then, and only then, should it look into slowing the growth of expenditures – after the pump has been primed, growth restored, and revenue's once again rising.
See, again, just as monetary-financial policy is inherently collective action, so is fiscal policy. Because it is individually irrational for each of us not to spend when prices are rising too quickly, it takes a collective monetary-financial agent (a central bank) and a collective fiscal agent (a chief executive) to slow economy-wide price rises by trimming back money, credit, and aggregate expenditure. And by the very same token, because it is individually irrational for any of us to spend more when our jobs are imperiled by deflation, it takes a collective monetary-financial agent and a collective fiscal agent to boost money, credit, and aggregate expenditure. It's what used to be called ‘countercyclicality.' It's high time we rediscovered that salutary, collective-action-attentive idea.
Our central bank has done wonders in advancing along its front of today's iteration of this ever-fought two-front war. That's what the masterfully improvised QEs have been all about. But our executive, apparently neutered by an overly cautious or courtly disposition on the hand and venal, bigoted, economically illiterate legislators on the other, has done little. That's got to change. Now.
What should be done? In the short to medium term, massive infrastructure-revitalization is by far the most promising avenue. Tax cuts alone just will not do the trick for the debt-deflationary present, when it's individually rational for recipients simply to hoard proceeds. The American Society of Civil Engineers has identified over $2 trillion in urgently needed transport, educational, and other public facilities repair. These are things that will have to be done anyway, and will only grow more expensive through cost-acceleration while we wait. Now, while demand is slack, capacity's idle, and public borrowing costs are near nil, is the time to do this. Not to act now is near literally to leave money on the table. Our largest trading ‘partner' seems to see this, investing as it does some 50% of its income in infrastructure and industrial capacity. Why don't we? Are we less able than they are, or simply more stupid?
In targeting infrastructure, the public's agent, the government, will be supplying inherently public goods – goods that the private sector, by dint of the structure of incentives, inherently under-provides. In so doing it will provide scores of thousands of well-paying jobs for years down the pike – those too amounting to public goods during slack times – as well as state-of-the art transport, educational, and other facilities that will pay off for decades. All of this will boost growth economy-wide not only directly, by boosting employment and aggregate demand, but also indirectly, by speeding up commerce, lowering energy waste, and bettering education. And as the economy grows, so will the value of real assets – eliminating much of our current debt overhang by offset as prescribed above.
In this latter connection, it's also important to see that public infrastructure investment will pay for much of itself in the form of enhanced tax revenue as growth reignites. Robert Frank, Laurence Seidman and I have quantified the effects, in a study we're soon to release to the press. The projects, in other words, boast the public sector equivalent of very large positive net present values. They're good long term investments. It's literally irrational, financially speaking, not to pursue them. Rationality might be too much to ask of the people who still dress in 18th century clothing. But it's not much to ask of Americans.
Speaking of that just mentioned longer term, three additional measures will be most important to take for the more distant future. One is to trim back, in time, the ratio of our national debt to our gross national product – a ratio that has not yet equaled its historic heights of the 1940s, but will at some point draw close. This trimming will occur largely on its own as the economy returns to growth, provided we limit the growth of expenditures as we did from the early-mid 1990s until 2001. It will be salutary for government credibly to commit to that longer term discipline even as it strategically boosts targeted infrastructure spending for the short to medium term now.
The second critical long term measure is to reverse three decades of relentless regression and restore progressivity to our tax code. Remember those gaps that I said to mind? Only nations with large middle classes and narrower wealth spreads sustainably prosper. That's what we were till the mid-1970s. Since then our tax code's become easily the most regressive in all of the developed world. It's more that of a banana republic, and so banana republic we've been becoming. And banana republics, we now know, are not only squalid, miserable, politically dysfunctional places: They're also the places you find most financial and monetary volatility – precisely for reasons we noted above.
Finally, the third long term measure that has to be taken is to restore balance to global trade relations. That likely means automatic currency adjustments that prevent long term net current account surplus or deficit status on the part of individual trading nations. A properly functioning global central bank or clearing arrangement – something like Keynes's original vision for what became the IMF – might be the answer, as I've argued elsewhere. For it would not only adjust currencies, but also prevent speculative attacks upon currencies, thereby preempting the self-insurance motive that prompts some foreign exchange hoarding. And if authorized to provide global liquidity, it would at last spare the dollar its unsustainable role as permanent-deficit-requiring global reserve currency.
Let us, then, return to our pre-banana-republican roots. Strategically target forgivable internal and external debt, restore public infrastructure and macroeconomic growth, render the tax code progressive again, and finally bring order to the global financial and trading ‘order.' Only then will we all be delivered from destructive de-levering. Only then will we once again be – US.
Robert Hockett is Professor of Law at Cornell University, where he teaches, researches, and writes in the fields of domestic and transnational financial law and economics.
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