Anniversaries are typically met by a joyous celebration of a milestone. Not so with the commemoration of the financial meltdown’s third anniversary that evokes a sense of endless malaise. No longer do even the optimists or the naïve benchmark economic recovery based on previous recessions or the ability of the policymakers to engineer a way out. Despite the doom and gloom hanging heavy in the air there is a ray of hope amounting to no more than a rumor that some very effective help might be on the way.
First let me summarize where we are in terms of policy fixes for the Great Recession. Following the financial meltdown of 2007-2008 that took down the banks and in turn the economy, what followed was a host of borrow and spend policy fixes that amount to the conventional wisdom of post WW II policymaking. We have tried epic government support consisting of public spending, housing and auto tax credits, tax rebates, central bank monetary base expansions, quantitative easing, capital injections to financial institutions, and guarantees of financial institution debt, subsidies for Fannie and Freddie. I am sure I am leaving out some. The GM bailout qualifies.
Despite these doses of the conventional and semi-conventional government assistance, the economy is drifting close to the GDP level it was at three years ago and unemployment would have reached the 10% high water mark had not over a million workers dropped out of looking for jobs in the last three months. With or without a double dip recession the CBO has estimated that there are 3,000 banks that will ultimately fail forcing the recognition of Trillions of dollars of FDIC contingent liability. This of course has raised the question of whether conventional fiscal policy merely heaps on larger doses of government debt than it raises income. As such it raises the debt to income ratio which compromises future growth and also raises the ugly Greek question of will the government debt find willing buyers. That is the problem of the Debt Satiation Economy in which debt levels relative to the income base to support the debt does not allow recovery as income is applied to debt service and debt reduction rather than consumption. The Spellman Report has addressed these issues in numerous places and my Lacy Hunt interview in particular articulated why neither monetary nor fiscal stimulus at this point are effective.
As a policy alternative, being more mindful of the fiscal policy constraint that government debt must indeed meet the market test, all other members of the G-20 embarked on the opposite course at least for fiscal policy. Reductions in fiscal deficits via higher taxes and lower spending called the austerity policy have become priority number one as these governments have already been taken to task by the bond market. Unfortunately if deficit reduction were to be achieved by anti-growth incentives of higher tax rates associated with economic success it has been found to reduce investment incentives and is also found to be counter to the prospects for economic growth. It is little wonder that Christina Romer last week left her position as Chairwoman of the Council of Economic Advisors as she would not be able to support such policies being contemplated here which fly in the face of her recently published scholarly work that tax rate increases for the rich (in the political rhetoric of the day) reduce GDP with a large multiplier. Ironically, the austerity policy option also raises the debt to income ratio by reducing the income growth rate while still piling on debt at a faster rate than income growth.
There is a third policy way however that I have been advocating for some time and let us hope the third way is the charm. In a debt satiation economy there is too much debt relative to income which reduces net income flows after debt service and redirects income flows to deleveraging rather than spending. Furthermore since the consumer debt load is not being fully serviced when (9% of mortgages are in delinquency) the banking system is de facto insolvent (not meeting minimum capital requirements) as reflected in the continued reduction in bank lending to the private sector which in turn takes down borrowers who are shut off from credit.
The third policy way has appeared in the rumor mill as an announcement is expected camouflaged behind a discussion of the future of Fannie and Freddie (See An August Surprise from Obama?). The speculation is that the government will assume the underwater portion of residential mortgages which amounts to an $800 billion private debt forgiveness program and if the consumer mortgage debt is assumed by the government, this raises Federal government debt by about 6%. This policy approach is a direct targeting of the economy’s debt satiation problem.
While this is a private debt forgiveness program with underwater homeowner mortgage debt being refinanced via the Home Affordability Refinance Program with the debt in excess of the current house value being assumed by Freddie and Fannie. In judging the merits of this one must realize that this is merely the recognition of the contingent government’s FDIC liability when private debt defaults in large amounts and banks fail.
As far as society is concerned the shifting of the debt burden from private balance sheets to the government balance sheet is a wash and does not change society’s overall debt satiation, but it has the advantage of eliminating years and the cost of bankruptcy proceedings, the costs of foreclosure to both individuals and the banks and reduces substantially the damage from holding the housing market hostage to excess supplies of depreciated foreclosed properties being dumped on the housing market. There are then secondary benefits from the strengthening of the housing market that adds value to the collateral behind probably half of commercial bank assets as well as adding to consumer wealth.
Viewed in this context it contains the collateral damage of further bank meltdown, it is a behavior changer for those unburdened with debt and brings back to life a banking system without the time and cost of years of bank seizure, bank assets sales and the chartering and start up cost of new banks with fresh capital. With banks back to a more normal state as far as meeting their capital requirements, it reactivates the ability of the Federal Reserve to get a positive response from expansionary monetary policy as banks can lend again.
Yes, private debt forgiveness is politically motivated with mid-term elections less than 90 days away to aid millions of underwater consumers. I also view this proposal as an indirect public recapitalizing of the banking system (without the messy TARP perceptions of subsidy and nationalization) but regrettably without the government (people) getting a stake in the de facto recapitalized banks as did the TARP program.
In my view this is one of the best investments that the federal government can make at this juncture as the problem with our economic malaise and resistance to both expansionary monetary and fiscal policy is the debt overhang of the consumer sector and the associated zombie banking system which is a road block to consumer and commercial loan rollover and the origination of credit.
Despite these benefits, there no doubt will be loud screams of “unfair, unfair.” “I worked hard and paid off my mortgage and my irresponsible neighbors get a partial free ride.” Yes it is unfair but remember rule number one:”Life is Unfair.” This is certainly not first best policy but it’s the best we have under the circumstances. We will need to get over it and if it were not to occur the collateral damage of a debt satiated consumer sector is much worse. Another way to get over it quickly is to make a judgment as to which publicly traded banks will benefit most and purchase its stock or bonds. Thus such a program also provides incentives for further private recapitalization of banks .