Jubilee & Turbo-Deleveraging
A while back, when charts like this & this were making the rounds, I occasionally ran across a notion (*) I termed the “Jubilee Solution”. It basically proposed to restore economic growth via mass debt defaults, using this sort of economic logic:
1. Consumption spending contributes a lot to US GDP; and
2. An overleveraged private-sector is less able to spend on consumption, both because
a) overleveraging makes (additional) borrowing for (additional) consumption is impossible; and
b) private-sector deleveraging (sans default) necessitates increasing the share of income devoted towards debt service, thereby exerting downward pressure on consumption;
3. Hence, so long as we’re deleveraging, economic growth will remain depressed.
4. Ergo, the faster we bring down household debt to sustainable levels, the less we’ll have to wait for real (i.e., non-anemic) recovery.
5. Since private-sector processes take too long to deleverage, government should intervene to rapidly reduce debts en masse, via force majeure processes (e.g., mortgage cramdowns) or subsidies (e.g., HOLC redux).
Beyond eliminating drag of sustained deleveraging, the “Jubilee Solution” would also obviate the need for the government to run up massive debts via fiscal stimulus spending. However, I was never quite able to convince myself of the efficacy of this course of action. From the standpoint of property rights, they were basically a massive redistribution of wealth from creditors to debtors. While lenders were hardly blameless, neither were consumers; as such, I didn’t see much justice in robbing the former’s balance sheets to benefit the latter. More practically, not only would this involve massive moral hazard – with consumers’ takeaway message being, “If I, and enough others, get into debt over our heads, the government will bail us out,” – but it would also lead to permanently higher cost of credit, as loan prices added the risk of unanticipated government intervention to the risk of default. This, in turn, would depress consumption & investment (and hence growth) going forward.
(Had we ever seriously considered taking the “jubilee approach” to deleveraging, my preference would’ve been mass bankruptcies & foreclosures – as opposed to the free lunches espoused by Roubini & the like – so as to minimize the moral hazard aspect.)
Well, it turns out that jubilee, of a sort, may come to pass nevertheless, albeit via purely private-sector processes. Or, at least, it appears we might manage to deleverage more quickly than some (e.g., the Fed study Steve recently noted), according to a couple of Morgan Stanley analysts. Money quotes:
…[W]e establish what might be a sustainable level of consumer debt service in relation to income; a rough estimate is 11-12%, which might be associated with debt in relation to income of 80-100%. […] Under [optimistic, pessimistic, or intermediate] scenarios, we think the 11-12% debt-service and 80-100% debt-to-income ratios might be attainable by 2011. [Emphasis added]
They estimate that household debt will shrink by 8% annually from 2009 through 2011; mathematically, such a rate of decline would indeed result in the same ratio of household debt/GDP suggested in the aforementioned Fed paper, albeit several years sooner. They argue that consumers will be pushed to deleverage by 1) the damage to household balance sheets imposed by shrunken/stagnant housing wealth; 2) increased borrower & lender risk-aversion resulting from the recent financial crisis; and 3) reduced availability & increased cost of credit due to increased financial regulation. Meanwhile, deleveraging will also occur involuntarily, as consumers shed debt via foreclosure, bankruptcy, & other defaults, and banks charge off & write down the loans in question.
Tallying the costs & benefits of deleveraging, they conclude:
Leveraged losses will hurt both lenders and consumers, the latter as foreclosures and bankruptcies rise. Adjusting to a new austerity will be painful for many, even in recovery. But less leverage will leave lenders and consumers better able to withstand financial and economic shocks, promoting financial and economic stability. And by boosting domestic saving, the deleveraging process should over time further reduce America’s external imbalances, a critical need when global investors are fretting over America’s fiscal sustainability.
IMHO, we should hope for such a (relatively) painless outcome. Besides the obvious advantages of such an outcome to human welfare, a relatively rapid deleveraging would also eliminate the need for government to rack up massive debt for years on end – at non-trivial cost to its long-term solvency – via attempts to fiscally-stimulate a deleveraging economy. The specter of a prolonged “balance sheet recession” (and associated debt-deflation) would likewise fade.
(*) See, e.g., Wolf, Blodgett, Roubini, Ferguson, Dalio, Hussman. I neglect proposals – e.g., here – to basically shift private debts onto the government’s balance sheet, in view of the massive cost of doing so: E.g., reducing household debt (currently ~130% GDP) by a quarter, via this method, would increase government debt by approximately the same percentage of GDP.