Mike Konczal has a new paper discussing the evidence for the proposition that we are currently suffering the aftereffects of a balance sheet recession. Konczal says that economists have offered several explanations for the slow recovery from the Great Crash:
Some believe it is the result of structural issues within the economy, the composition of the unemployed, or uncertainty resulting from the Obama administration’s policies. Others believe it has to do with the nature of recessions that follow a financial crisis, citing historical relationships between the two.
These explanations are weak, as Konczal briefly shows. He then turns to an alternate explanation, the balance sheet recession. The idea is that consumers as a group over time try to maintain a fairly steady leverage ratio, the ratio of debt to assets. When debt increases relative to assets, at some point consumers are shocked into fear. They reduce consumption to pay down the debt, a process called deleveraging. That results in a tremendous decrease in consumer demand. Konczal writes:
A balance-sheet recession requires three conditions: (i) sufficient inequality so that creditors and debtors are two distinct groups, (ii) a negative shock to the assets of the debtors so that debtors start to pay down debts quickly in the form of deleveraging , and (iii) the inability of creditors to make up the difference in consumption, an inability usually triggered by a “zero lower bounds” on monetary policy.
He shows how each of these conditions existed at the start of the Great Crash or in its immediate aftermath. Then he discusses four papers examining the available evidence. These studies use huge samples of county-level data from CoreLogic about action in the housing market, individual data from Equifax on expenditures, consumer debt and credit, Census data on employment at the county level, hourly wage data from the American Community Survey, international databases, and others. These papers support the balance sheet recession explanation. Seeking Alpha offers a similar view.
I’d add that the data make it clear, as Konczal says, that the big drag on the balance sheets for almost all consumers is the huge drop in house values. The Federal Reserve Board gives a good picture in this paper discussing its 2010 Survey of Consumer Finances. The median net worth for homeowners fell 29.1% for homeowners, but only 5.6% for renters. That is a decisive number.
This is primarily a problem of the middle class. Housing is a relatively small part of the wealth of the rich. Their wealth is primarily in financial assets, which have more or less recovered. According to the Fed, about half the losses in the major stock indices were recovered by September 2010, and financial assets have continued to grow.
If we had an evidence-based approach to policy, we’d put all of Konczal’s ideas into practice. He suggests stimulus, principle reductions on underwater mortgages, and Federal Reserve action. Of these, only the Fed is actually making a visible effort, but monetary policy has little traction when everyone is paying down debt. Neither the executive nor the legislative branches is even willing to consider using fiscal policy, the only thing that would actually work.
The explanation for inaction can be found in the conditions necessary for a balance sheet recession: the requirement that the debtors and creditors are separated into distinct groups. The rich control the vast majority of financial assets. Of course, pension plans and 401(k)s have some money, and a few people outside the wealthiest Americans have some money set aside for retirement. But the vast bulk of financial assets are owned by the rich, directly, or through hedge funds, foreign bank accounts, banks, brokerage and insurance accounts, and of course, $2 trillion held by gigantic corporations. Included in these assets is the huge pile of consumer debt.
According to the Survey of Consumer Finances (primarily tabs 13.07 Alt and 13.10 Alt). the debtor class includes about 75% of all Americans; only about 25% of us are debt-free. Look at the net worth statistics. We can safely ignore the top 10% of households by net worth because their income should easily be sufficient to handle their debt. In 2010, about 69% of the bottom quartile by net worth had debt, with an average of $20,400. Compare that with 2007, when about 69% of that quartile had debt, with an average of $11,900. Their leverage ratio (the ratio of debt to assets) increased from 108.3 in 2007 to 128.7 in 2010. We hope they can pay, but their incomes are usually low, and the chances are poor.
The large group between the 25th and 90th percentiles is where the problem debt lies. About 80% of this group has debt, and their leverage has increased dramatically. In the third quartile by net worth, the ratio went from 56.4 to 64.5. The leverage ratio also increased in the second quartile and in the 75-90 percentile group, but by less. See Table 12 for other breakouts of leverage ratio. These are aggregate numbers and averages, and there are many people whose experience is much worse.
For this middle group, the threat of unemployment is a continuing problem, and wages are dropping. These people are hamstrung by the policies favored by the elites who run the country. They have every reason to fear that Medicare and Social Security won’t be there for them, and that makes them want to increase their savings which decreases demand. Too many of them will consume their savings trying to pay their debts, and then fall into bankruptcy or homelessness.
The solution to a balance sheet recession is to help individual Americans clean up their balance sheets. But. If we reduce the amount of debt that the average American owes, we reduce the amount of money going to the creditor class, the rich. The entire government operates on the principle it would be wrong to force the creditor class to eat any losses. It’s them against us, one on one.