What Matters More: the ZLB or Debt Deleveraging?

Must private-sector debt crisis necessarily lead to sharp recessions? Are impaired household balance sheets the reason for the Great Depression, the Great Recession, and the Eurozone crisis? For many observers the answer is an unequivocal yes. People acquired mortgages based on unrealistic expectations about future income streams from housing. They, therefore, overestimated the present value of their homes and took on too much debt. When these expectations failed them, they were forced to deleverage and the resulting drop in aggregate spending ushered in the Great Recession. This view is both intuitive and widely held. But is it complete? Or does it miss a deeper, more important story?

These are the questions I discuss in my review of Atif Mian and Amir Sufi's new book, House of Debt, in the July 7 print edition of the National Review. Here is an excerpt:

Why should the decline in debtors' spending necessarily cause a recession?

Recall that for every debtor there is a creditor. That is, for every debtor who is cutting back on spending to pay down his debt, there is a creditor receiving more funds. The creditors could in principle provide an increase in spending to offset the decrease in debtors' spending. But in the recent crisis, they did not. Instead, households and non-financial firms that were creditors increased their holdings of safe, liquid assets. This increased the demand for money. This problem was exacerbated by the actions of banks and other financial firms. When a debtor paid down a loan owed to a bank, both loans and deposits fell. Since there were fewer new loans being made during this time, there was a net decline in deposits [and thus] in the money supply. This decline can be seen in broad money measures such as the Divisia M4 measure. These developments—increase in money demand and a decrease in money supply—imply that an excess money-demand problem was at work during the crisis.

The problem, then, is as much about the excess demand for money by creditors as it is about the deleveraging of debtors. Why did creditors increase their money holdings rather than provide more spending to offset the debtors? ...Mian and Sufi do briefly bring up a potential answer: the zero percent lower bound (ZLB) on nominal interest rates.

The ZLB is a floor beneath which interest rates cannot go. This is because creditors would rather hold money at zero percent than lend it out at a negative interest rate. This creates a big problem, because market clearing depends on interest rates' adjusting to reflect changes in the economy. In a depressed economy, firms sitting on cash would start investing their funds in tools, machines, and factories if interest rates fell low enough to make the expected return on such investments exceed the expected return to holding money. Even if the weak economy means the expected return to holding capital is low, falling interest rates at some point would still make it more profitable to invest in capital than to hold money. Similarly, households holding large amounts of money assets would start spending more if the return on holding money fell low enough to make household spending worthwhile. This is a natural market-healing process that occurs all the time. It breaks down when there is an increase in precautionary saving and a decrease in credit demand large enough to push interest rates to zero percent. If interest rates need to adjust below zero percent to spur creditors into providing the offsetting spending, this process will be thwarted by the ZLB.

It is the ZLB problem, then, rather than the debt deleveraging, that is the deeper reason for the Great Recession.

Here is another way of seeing the importance of the ZLB problem. The present value of housing is affected by both the expected income streams it will earn as well as the interest rate at which they get discounted. The debt deleveraging story focuses on the fall in the expected income stream, the numerator. The ZLB problem focuses on the lack of offsetting fall in the interest rate, the denominator. Had the interest rates been allowed to reach their negative market clearing (or 'natural') interest rate level, then the present value of housing would not have fallen as much. Household balance sheets would not have been impaired so badly and there would have been less need for deleveraging. In short, there would been no Great Recession but only a ordinary, mild one. So again, the ZLB really is the deeper story here.

P.S. There are ways for policymakers to get around the ZLB and hit the natural interest rate level. So even though it was the deeper story, it is not insurmountable. But these approaches are politically difficult, especially for a central bank that has exhausted its political capital on bank bailouts and make-it-up as go along QE programs. If only the Fed had spent more of its capital on one of these approaches early on.

Tinkering on the Margins: ECB Edition

Has the ECB finally ended its hard-money ways? You know the kind that raises interest rates twice during the crisis, allows aggregate demand in the periphery to stall, and fosters below-trend growth in money supply and money velocity. On Thursday, the ECB said it would be taking bold steps to stabilize the economy. It would start charging banks for the privilege of depositing their funds at the ECB, commence a new long-term lending program of €400 billion, quit sterilizing its bond purchases, and begin preparing for a QE program. That is quite a list, right? Many commentators are making much ado about the first item since it means a major central bank will begin targeting a negative nominal interest rate. Finally, a central bank who does not fear the zero lower bound!

So does this mean the ECB has finally gone all-Abenomics on us and unleashed both barrels of the gun? Sadly, the answer is no. Its new actions will not fundamentally alter the path of aggregate demand in the Eurozone for one key reason: there has been no regime change. The ECB did not change its inflation target. Should the ECB's new programs threaten to push inflation a tad too high expect it to tighten policy like it did in 2011. This point was made very clear by Mario Draghi in the ECB press conference :

“Meanwhile, inflation expectations for the euro area over the medium to long term continue to be firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2%. Looking ahead, the Governing Council is strongly determined to safeguard this anchoring."(HT Lars Christensen)

In other words, these policies at best raise inflation from its current low level to somewhere between 1% and 2%. That is not enough to close the aggregate demand shortfall. This is an important point. It means that even if there were further fiscal integration in the Eurozone and more active fiscal policy, such as helicopter drops, it would have little effect on the economy. The ECB would quickly offset any program that began to meaningfully raise inflation. It would cut short any robust recovery.

There has to be, however, a period of catch-up aggregate demand growth and by implication, temporarily higher inflation for a recovery to take hold in the Eurozone. This requires a commitment by the ECB to a permanent, non-sterilized monetary injection, the kind done by Japan under Abenomics and by Israel under Stanley Fisher. (No, the kind done under Ben Bernanke is not expected to be permanent and is a key reason for the sluggish recovery.)

The Germans should understand that were the ECB to allow a temporary period of catch-up inflation it does not mean long-run inflation expectations have to become unmoored. It does mean, though, the ECB would need to do something like a price-level or NGDP-level targeting. Level targeting is the kind of regime change that would fundamentally change the path of Eurozone aggregate demand since it allows for catch-up growth. It seemed to have worked for Israel during the crisis and should do wonders if tried in Europe.

In terms of the specific proposals, it is interesting to see the ECB try negative interest rates. In theory, it makes sense: move market interest rates closer to the negative natural interest rate and markets will begin clearing. And contrary to many observers claims, the mechanism for this process is not just about forcing banks to lend. It is more about incentivizing depositors on the margin to spend their money balance instead of holding them in the bank. The idea is that the banks will pass the ECB's charge on to their customers and spur a recovery in nominal spending.  

That is a compelling theory except for this problem:

Currency holdings have grown dramatically in the Eurozone and would grow even more if individuals started getting charged for their deposits. This is the zero lower bound (ZLB) problem: individuals would rather hold cash and earn 0% than hold bank accounts and earn a negative interest rate. So for all the buzz about the ECB targeting a nominal interest rate, it still has failed to solve the ZLB problem. There are ways to solve this problem without getting rid of currency. But so far the ECB has not been willing to try them.

In short, the ECB's new programs amount to nothing more than tinkering on the margins. Unfortunately, this means more sluggish aggregate demand growth and more human suffering.

P.S. Below is a figure showing currency as a percent of M3 less currency. It reveals a sharp drop in the currency holdings during the transition to the Euro that later returns to trend. Once the Euro crisis starts the ratio starts rising. Expect it to rise more.

Is It Time To Eliminate Paper Currency?

The answer is yes according to Ken Rogoff:

Has the time come to consider phasing out anonymous paper currency, starting with large denomination notes? Getting rid of physical currency, and replacing it with electronic money, would kill two birds with one stone.

First, it would eliminate the zero bound on policy interest rates that has handcuffed central banks since the financial crisis. At present, if central banks try setting rates too far below zero, people will start bailing out into cash. Second, phasing out currency would address the concern that a significant fraction, particularly of large denomination notes, appears to be used to facilitate tax evasion and illegal activity.

Not so fast. One can solve the zero lower bound (ZLB) problem without eliminating paper currency. All that is needed is to either (1) allow the exchange rate between deposits and paper currency to fluctuate or (2) have a systematic approach to monetary policy that is very aggressive when the treat of the ZLB is looming. The former would create a discount on paper notes during slumps so that the Fed could impose a negative nominal interest rate on deposits and get away with it. The latter would use a nominal GDP level target which would both raise money velocity via expectation management and commit the Fed to do whatever is necessary to hit the level target. Both approaches should take care of the ZLB problem. Miles Kimball has written extensively about the first approach and Scott Sumner done the same for second one. Read here for the details of these plans.

How to Get What Paul Krugman Really Wants

Paul Krugman called for a higher inflation rate at a ECB conference this week. His plea for more inflation is understandable given the failure of the ECB's 2% inflation target to shore up the faltering Eurozone economy. He believes raising the inflation target to 4% will do the trick. But is higher inflation really what he is after?

The answer is no. What he really wants is a foolproof way to ensure there is enough aggregate demand to keep the economy at its full-employment level. He sees a higher inflation target as the way to accomplish this objective. There is another way, though, to achieve his goal without raising the inflation target. To see how it works, let us turn to Israel who was able to keep the growth path of aggregate demand stable during the crisis without changing its inflation target.The figure below shows how the Bank of Israel accomplished this task. It reveals that the central bank temporarily allowed inflation to rise above target when real GDP started falling during the crisis:

By doing this, the Bank of Israel kept total Shekel spending stable as seen in the next figure:

So the Bank of Israel used temporarily higher inflation to offset the decline in real GDP as a way to keep aggregate demand stable. This arguably prevented the Israeli economy from going through the prolonged slumps experienced by the U.S. and Eurozone where this approach was not tried. This nominal stability is what Paul Krugman really wants and it does not require a permanent rise in the inflation rate. It only requires a willingness by the central bank to allow temporary movements in the inflation rate to offset changes in real GDP.

Now the skeptic may question whether the central bank has the ability to do this on a consistent basis. Can a central bank really move the inflation rate in such a timely manner? Maybe the Bank of Israel got lucky. That is a fair point. Fortunately, there is a relatively easy way for a central bank to accomplish this task: target the path of nominal GDP. By doing this the central bank will by default allow temporarily higher inflation when real economic growth slows down and vice versa. This approach will not require the central bank to micromanage the inflation rate--it will automatically adjust. Moreover, by stabilizing total money spending it will also by default be promoting a stable monetary environment where shocks to money demand (or velocity) are offset by changes in money supply and vice versa. This can be seen in the figure below which shows the deviation from trend of velocity and the money supply for Israel:

In short, Paul Krugman can get what he wants without raising the average rate of inflation. Central banks simply have to commit to stabilizing the path of total money spending or nominal GDP. And that is what the Bank of Israels appears to effectively have done over the crisis. The Fed and ECB should take note.

P.S. Evan Soltas was the first person to recognize the Bank of Israel appears to be doing defacto NGDP level targeting

NGDP Targeting as a Fashion Statement

It is hard to believe, but it has been almost four years since William Luther turned nominal GDP targeting into a fashion statement. Below is my attempt to further his effort. I plan to wear this shirt around my neck of the woods. I will report back how my Tennessee and Kentucky neighbors respond to it. The back of the shirt is my trump card if they start calling me a socialist.

P.S. Yes, you too can order the shirt here.

Risk Sharing as a Way to Improve Financial Stability

There have been many proposals to improve financial stability going forward. Some of them are bound to disappoint, while others have great potential. A great example of the former are proposals for macroprudential regulation. These proposals would have central bankers regulate financial firms based on systemic risks rather than firm-specific risks. The idea is to dampen the inherit procyclicality of the financial system and make it more resilient to shocks. This includes adjusting capital requirements, allowable leverage, and other risk-preventing measures based on the state of the business cycle. A big problem with this approach is that it assumes regulators are omniscient in their knowledge and can outsmart markets. It also assume financial regulators will be uncorrupted and benevolent dictators in the adminstration of the duties. If you believe both of these assumption will hold then you have not been paying attention to financial markets over the past decade.

A better way to foster financial stability is to create mechanisms that do not depend on regulators getting it right. Two recent proposals that do that are ones based around automatic risk sharing for debt contracts. The idea is to automatically make lenders share in both the risk and return that individuals and firms face when they borrow. This is akin to making debt contracts more equity-like in nature.

The first risk-sharing proposal comes from Amir Sufi and Atif Mian in their new book. In it, they call for a risk sharing mortgage. Here is the Wall Street Journal's discussion of their proposal:

With such instruments, if a home’s value rose, the lender would share in the gain; if it fell, so would the principal balance as well as the interest payment. That way, both parties to the contract—and not just the homeowner—would have potential upside as well as downside... Adopting shared-risk mortgages would mean shifting the focus of both government and the financial system to equity from debt. Right now, Mr. Sufi said, the government tacitly backs debt through the mortgage-interest deduction, federal deposit insurance and support of highly rated assets. But if those implicit subsidies were removed or eased—admittedly a tall order—shared-risk mortgages might appeal more to potential lenders. The United Kingdom has been offering a form of such equity loans. Under the U.K.’s “Help to Buy” program, home buyers can put down 5%, receive an equity loan for 20% of the property’s value, and take out a traditional mortgage for the rest.

Lenders probably would not be thrilled about it, but it nicely align incentives up front. That is, lenders would be more careful to whom they lent and this would minimize the chances of downward equity adjustments occurring in the first place. Given how important mortgage financing is to the U.S. economy, this proposal by itself should make a big difference.

The second recent risk-sharing proposal was made by Kevin Sheedy at the Brookings Papers on Economic Activity conference. There, he presented a paper where he makes the argument for risk-sharing via a nominal income target:

Financial markets are incomplete, thus for many households borrowing is possible only by accepting a financial contract that specifies a fixed repayment. However, the future income that will repay this debt is uncertain, so risk can be inefficiently distributed. This paper argues that a monetary policy of nominal GDP targeting can improve the functioning of incomplete financial markets when incomplete contracts are written in terms of money. By insulating households' nominal incomes from aggregate real shocks, this policy effectively completes financial markets by stabilizing the ratio of debt to income. The paper argues the objective of replicating complete financial markets should receive substantial weight even in an environment with other frictions that have been used to justify a policy of strict inflation targeting.

As a long-time advocate of nominal GDP targeting, this risk sharing proposal is near-and-dear to my heart. As Sheedy notes, it is not a new argument for a NGDP target (see Selgin, 1997), but it is an often overlooked one.

It would be great to see these proposals adopted before the next crisis hits. Unfortunately, it is more likely less effective approaches to financial stability like macroprudential regulation will be widely implemented.

What Caused the Great Recession: Household Deleveraging or the Zero Lower Bound?

Today I got into a discussion with Amir Sufi on Twitter about what really caused the Great Recession. Was it the vast amount of household deleveraging or the economy being constrained by Zero Lower Bound (ZLB)? Amir Sufi and his coauthor Atif Mian have a new book where they make the argument the key catalyst was household deleveraging.

For example, in a new article they argue the 2001 recession was far milder than the 2007-2009 recession because the related the stock market crash affected mostly rich individuals who had very little debt. On the other hand, during the Great Recession it was a housing market that collapsed and this affected middle and lower-class individuals who were highly indebted. This key difference in debt, they argue, is why the economy contracted so much more in 2007-2009. 

While it is true there was far more U.S. household debt leading up to the Great Recession and that cross country evidence shows that countries with more debt were generally hit harder during the crisis, I think they are confusing a symptom with the cause. In my view, the underlying cause was interest-rate targeting central banks running up against the ZLB. (Yes, there are ways around it for a determined central bank but most did not fully explore these options.) The failure by central banks to get around the ZLB caused most of the household deleveraging, not the other way around. Monetary policy, in other words, was too tight during the crisis.

I have embedded an annotated version of our twitter discussion below the fold: