The standard tools of stabilization policy are countercyclical monetary and fiscal policy. Both approaches seek to offset fluctuations in spending and income and each derives from the observed correlation between money income and expenditure. These approaches reflect two possible interpretations of the causes of economic downturns: Either it is caused by a drop in spending (which precipitates a decline in money income), or it is caused by a drop in money income (which precipitates a decline in spending).Keynesians view recessions as caused by autonomous declines in private spending (usually investment), interacting with market frictions that impede speedy adjustment; the cure is to raise public spending and deficits to increase aggregate demand.
Monetarist policy derives from Milton Friedman’s observation that nominal income has historically correlated with the broad money supply; the approach is to offset a reduction in the velocity of money – which accompanies all recessions - with an increase of base money. Probably because it is so difficult to disentangle causality between variables that are so highly correlated, neither view has been able to conclusively prevail over the other. It is therefore not surprising the US government reacted to the recent threat of economic meltdown with massive injections of both monetary and fiscal stimulus.
Economists will long debate the efficacy of this policy response but, whatever the results so far, there are constraints that place severe limitations on the effectiveness of traditional policy going forward. The US deficit and the trajectory of US spending is unsustainably high and, as the late economist Herbert Stein famously observed, “what cannot last, will not do so”. Any further fiscal stimulus risks pushing US finances past the tipping point, which would be a reckless gamble. At near zero short term interest rates, traditional monetary policy has become impotent, QE has been ineffective and the Fed has entered uncharted waters with its massive increase in the monetary base, risking inflation once private sector deleveraging ceases and velocity picks up. So neither traditional remedy is available any longer.
Turning to a Neglected Tradition: Irving Fisher and ‘Debt-Deflation’ Dynamics
With US unemployment lodged stubbornly above 9%, what is to be done? Our policymakers, economists and commentators appear trapped in the confines of a paradigm that is no longer viable. Is there any other policy that might help spur recovery, or must we become resigned to waiting it out? The great Yale economist Irving Fisher charted the dynamics of the Great Depression as a downward spiral of declining asset prices triggering margin calls and bankruptcies, begetting further illiquidity, asset price declines and so on. Fisher’s “debt -deflation” theory emphasized the debilitating effects of the interaction of an economy with high leverage confronted with a shock that causes a downward revision in the valuation of key assets. In Fisher’s analysis, the key obstacle to recovery was a high level of nominally contracted debt. In such an economy, shrinking balance sheets force all of the economic actors to reduce spending. Causality runs in a direction opposite that assumed by Keynesians and Monetarists; it is balance sheet constraints that force reductions in spending and income, rather than the other way round.
There has been recent academic work theorizing and documenting a debt –deflation process initiated by the shock of the subprime mortgage meltdown, and various initiatives by the US Treasury and Fed have indirectly, and ineffectively, confronted this problem by attempting to boost asset prices through purchases of toxic assets and illiquid bonds. It is likely the US is embroiled in a Fisherian process, as leverage in the consumer and financial sector skyrocketed in the decade prior to the subprime meltdown.
But so far, there has been little discussion, and no policy action, to address the root cause of the debt-deflation dynamic – the debt contracts themselves. One might suppose this cannot be directly addressed, other than through inflation, because doing so would violate property rights. But this is not correct in all instances.
A New Economic Policy Framework
The two most indebted areas of the US economy are the financial and the residential mortgage sectors. Banks, which bore the brunt of the subprime collapse, have contracted lending for the first time since the Great Depression, as they hoard liquidity to hedge anticipated losses. This credit contraction has not been caused by a lack of borrower demand, as credit expansion has been robust in those areas where credit is available, like the corporate bond market and the non-bank finance market. The US has refrained from requiring banks to recapitalize, presumably out of fear that widespread bond defaults would trigger a capital flight from banks. But banks could restructure their debt, including conversion of debt to equity, to achieve a much lower level of leverage, without requiring infusions of outside capital, and it is within the legal purview of regulators to require such restructuring. Likewise, since the US government, through its ownership of Freddie Mac and Fannie Mae, now owns over half of US residential mortgage debt, it can, directly and indirectly through its ability to set regulatory capital rules for banks, restructure the debt of the residential mortgage market by offering homeowners the option to partially convert their mortgage debt into shared equity. If structured intelligently, such a conversion could actually increase the value of the claims owned by the US and its banks. These policies would spur credit expansion and consumer spending without placing further strain on public finances. So there is a constructive role for policy, within the framework laid out by Irving Fisher. The 1990’s Japanese “lost decade” was ended when the Koizumi government forced its banks to realize losses and recapitalize. A balance sheet recession requires a policy to effectuate a speedy reduction in leverage.