Tuesday, September 14, 2010

Head Winds to Growth

One of the main arguments for the possibility of a double-dip recession is the amount of astounding debt that is floating around out there. Felix Salmon highlights that credit card interest rates are rising, while consumers are still racking up the debt:
But two years after Lehman Brothers collapsed, credit card default rates are still high — in fact, at 10.8% in the second quarter of 2010, the charge-off rate is hitting new highs and rising alarmingly. (It was 9.8% in the same quarter of 2009, and 10.1% in the first quarter of 2010.) Consumers are continuing to rack up new credit-card debt: far from paying down their balances at all, they’re charging new stuff every month. Yes, the total amount of credit-card debt outstanding is falling — but that’s only because the banks have given up on collecting an enormous amount of it — they wrote off $81.6 billion in 2009, and another $43.5 billion in the first half of 2010.
A rise in interest rates is not a good sign. It shows that financial institutions are lending less, hoping to try and make up for losses in their balance sheets. This issue should be no surprise to people that understand the dynamics of a financial crisis versus more vanilla-type recessions. In most recessions, a shock to aggregate demand occurs, via supply shocks, decrease in money supply, or demand-related impacts, such as loss of confidence. In these recession people to have less money in there pocket, causing them to pull back spending in order to offset the loss they have incurred from price increases or job loss. Now these types of recession presume that people's balance sheets are overall healthy, i.e. people are living within their means, it's just that price increases or lost wealth, in the context of job losses, are offset by people recalibrating their budgets to live within these new means.

Now what happens if people are living beyond their means when a recession strikes? Not only do people have to recalibrate their balance sheets in regards to lost wealth, they also are forced to pay back all that outstanding debt they had when the crisis started. This occurs because financial institutions, who were also living beyond their means, have the same balance-sheet issue. Asset-values have dropped significantly, causing these institutions to go from the black to the red, and they have to pull back on lending, calling back loans and increasing interest rates on any new loans that they give out.

This dual balance-sheet issue has two implications. First, it means the recession will be starkly longer then normal crisis. People are starting deeply in the red with debts, and therefore need to increase greatly the amount of money they save. But since job-creation is slowed down and new lending will not help pick it back up, people are going deeper into the whole, forced to take out more debt at higher interest rates to pay back the debt they already owe. Second, and this is the most important, the ways to tackle this sort of recession changes the normal dynamics of fiscal policy. Normally, tax cuts are targeted to try and induce as much spending as possible. Because normal recessions have the sole issue of inadequate demand, tax cuts/stimulus that induces greater spending on the part of the consumer is considered optimal. However, our economy is not just facing an aggregate demand problem, but also a balance sheet issue. Here is where Mark Thoma has some interesting analysis:

Initially I was critical of how the tax cuts were targeted since so much ended up going to saving rather than consumption. This is the part I am rethinking.

There are different types of recessions, and this one can be termed “a balance sheet” recession. It had a big impact not just on bank balance sheets, but on household (and, for that matter firm) balance sheets as well. Households were particularly hard hit due to declines in stock prices and declines in the value of housing. These losses were large, they upset plans for things such as retirement, and households needed to refill the holes in their balance sheets that had been created (this includes paying off debt).

How do they refill their balance sheets? By saving more and consuming less (paying off debt is a form of saving). Thus, as the recession took hold, we saw a large increase in the saving rate and a corresponding fall in consumption. The tax cuts were an attempt to reverse the decline in consumption, but instead they mostly raised the amount that went into saving.

Since consumers need to get back to square one to start consuming again, tax cuts that induce saving are not the sub-optimal policy anymore. If consumers are able to restore confidence in paying back loans, interest rates can go down, causing an increase in lending generally. Now this raises issues of normal multipliers. Is it better to increase aggregate demand now, which may seem to indicate that tax cuts for those who don't have much debt, i.e. those in the top brackets, could be beneficial, or is it better to try and recalibrate balance sheets with demand picking up once this occurs, i.e. tax cuts to middle to lower income individuals. It seems a question with a thousand answers.

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