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Sunday, January 30, 2011

"Do for Households What the Fed Sought for the Banks"

Vernon Smith, who is not a fan of government intervention, makes familiar arguments about how to escape from balance sheet recessions:

Mired in Disequilibrium, by Vernon Smith, Newsweek: ...Some 23 percent of homeowners owe more than their home is worth on the market, and their demand for goods is restrained by the need to pay down debt. This is the essence of a balance-sheet recession, and is what underlies the so-called Keynesian liquidity trap. ...
There are three routes to restoring equilibrium:
• Inflate the prices of all other goods, including labor, while housing demand remains stuck in its negative equity loop. Fed policy has been consistent with this objective since 2008 with no evidence of success, as is typical in severe balance-sheet recessions.
• Allow the household deleveraging process to grind through an extended period of low GDP growth and high unemployment until we gradually recover. This option will surely succeed in due course, but not without high annual opportunity cost in terms of lost wealth creation. This was the path followed in the Depression.
• Do for households what the Fed sought for the banks: the Treasury (facilitated by Fed monetary ease and bank capital requirements) finances the banks to restate the principal on current negative-equity mortgage loans, restoring them to new mark-to-market zero-equity baselines.
The last option, in principle, seeks to reboot homeowners’ damaged balance sheets in an effort to arrest a prolonged deleveraging process and more quickly restore household demand to levels no longer dominated by negative home equity. It is analogous to a mortgage “margin call” with public funding of the restored household balance sheets.
I regard the third option as far better than the stimulus, while recognizing that forgiving debt—whether bank or household debt—is never good policy. But please keep in mind that we have had no good options. (Since total negative equity is now about $700 billion, it is cheaper than was the stimulus.) ...

Where we differ is that I would do this in addition to fiscal policy, rather than dropping fiscal stimulus and doing this instead. That is, I see this as a complement rather than a substitute for other policies.

One more note. I have made similar arguments, but I've come to believe that household relief must be broad based in order to receive the public support it needs (the proposal above addresses all households that are in a negative equity position, not just those near or at default, so it is broader based than many competing proposals along these lines). If we only bail out the households who made the worst choices and are in danger of default, and do nothing for the households who have taken large losses through no fault of their own, but are still surviving and making payments, the public resentment will undermine the policy.

    Posted by on Sunday, January 30, 2011 at 10:08 AM in Economics, Fiscal Policy, Housing | Permalink  Comments (39)


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