For those who aren’t familiar with the narrative on deleveraging – the process of households paying down debts – as being crucial to our weak economy and high unemployment, they should check out Paul Krugman’s column today. He points out:
What we’ve been dealing with ever since is a painful process of “deleveraging”: highly indebted Americans not only can’t spend the way they used to, they’re having to pay down the debts they ran up in the bubble years. This would be fine if someone else were taking up the slack. But what’s actually happening is that some people are spending much less while nobody is spending more — and this translates into a depressed economy and high unemployment.
What the government should be doing in this situation is spending more while the private sector is spending less, supporting employment while those debts are paid down … It’s true that we’re making progress on deleveraging. Household debt is down to 118 percent of income, and a strong recovery would bring that number down further. But we’re still at least several years from the point at which households will be in good enough shape that the economy no longer needs government support.
The Federal Reserve just released the latest quarterly Fed Flow of Funds last week, and consumers continue to delever:
Back when this crisis first started, people understood that this was going to be an ugly, ugly process. And there were two ways of helping this process along. The first was modifying defects in the bankruptcy code to help with writing down mortgage debt, the so-called lien-stripping or cramdown bill. The second was a period of short sustained inflation, which was being recommended from all kinds of ideological places including Greg Mankiw and Kenneth Rogoff (Rogoff: “I’m advocating 6% inflation for at least a couple of years”).
That our current situation is the exact opposite of this happening would be an understatement. The cramdown bill failed and we’ve got a period of moral panic and hysteria around strategic defaulters, those evil-doers that nobody can actually quantify as actually existing. And we have Sarah Palin and the conservative base teaming up with the hard-money right to scream “Fire!” on Noah’s ark. They are going to try and make 2011 a year of seige against the Federal Reserve, stoking fears that we’ll have an inflation crisis any day now when we are actually disinflating.
The result is exactly what you’d expect: Our consumer de-leveraging is mostly taking place through defaults on loans, the most painful, externality-prone, and drawn-out mechanism we have for resolving bad debts. That savings rate reflects less our ability to pay off our debts and more our inability with an unemployment crisis and the collectors kicking in the door.
I need to compile my own evidence of this for future work, so I will summarize others' work while I learn the data. To start:
1) Mark Whitehouse, Wall Street Journal, September 18th, 2010, Defaults Account for Most of Pared Down Debt:
The sharp decline in U.S. household debt over the past couple years has conjured up images of people across the country tightening their belts in order to pay down their mortgages and credit-card balances. A closer look, though, suggests a different picture: Some are defaulting, while the rest aren’t making much of a dent in their debts at all.
There are two ways, though, that the debts can decline: Pay them or default. The total value of home-mortgage debt and consumer credit outstanding has fallen by about $610 billion, to $12.6 trillion, according to the Federal Reserve. Of that $610 billion, “banks and other lenders charged off a total of about $588 billion in mortgage and consumer loans.
2) CoreLogic (h/t Alphaville’s Cardiff Garcia):
CoreLogic reports that 10.8 million, or 22.5 percent, of all residential properties with mortgages were in negative equity at the end of the third quarter of 2010, down from 11.0 million and 23 percent in the second quarter. This is due primarily to foreclosures of severely negative equity properties rather than an increase in home values.
3) Karen Dynan, Brookings Institute, Household Deleveraging and the Economic Recovery:
But, a considerable share of the deleveraging can be accounted for by high rates of defaults on consumer loans and mortgages. While defaulting typically has other consequences that are undesirable, it is a way in which some of the most distressed households have been able to shed their debt.
Although credit supply conditions have been thawing, it seems very likely that we will see significant further deleveraging, particularly in the form of additional defaults on mortgage debt.
What to make of this? First off, I’m terrified at the idea that national wealth is roughly where it can pay for the servicing of debt -- but not necessarily pay off any actual debt. Our household sector is at the point where we can make the minimum payment on our metaphoric credit card without paying any of it down, and the only other choice is to not pay it at all.
Second, remember that your first mortgage payment is almost all interest, and your last mortgage payment is almost all principal. With that in mind, in a disinflation environment you could see eight years and above to pay to get a mortgage from an LTV of 130 to one at 100. Refinancing resets this problem. The mortgage structure isn’t set up to pay off principal quickly.
Third, foreclosures are mini-neutron bombs on property values and neighborhoods. The cynical implication that we are going to get out of this balance-sheet recession by destroying neighborhood after neighborhood in abandoned housing and wrecked communities when there are sensible alternatives in our bankruptcy code and monetary policy is immoral.
This will continue; foreclosures are expected to be at record highs for at least the next two years, and consumers have a lot of debt left to work off. What else am I missing? What are some other negative (or positive) aspects of a default-driven de-leveraging process?