'It's Not a Banking Problem"

In a column back in December on balance sheet recessions, I noted that:

... When combined with the loss of jobs due to the recession, and the fact the debts do not decline with the fall in asset values, the effect on balance sheets can be devastating – much larger than, say, the balance sheet impact of an oil price shock. Households have no choice but to set aside part of their income to both rebuild the asset side of the balance sheet and to pay down their debts.

This is one of the main reasons why recovery from these “balance sheet recessions” is notoriously slow. As households rebuild their balance sheets, resources are directed away from consumption, and the reduction in aggregate demand is a drag on the economy. It takes a long time for households to recover what is lost, and the recovery will be slow so long as this rebuilding process continues. Fiscal policy attempts to restore the lost aggregate demand, and that is important, but it does very little to directly address the household balance sheet issue.

The same cannot be said about bank balance sheets..., policy has done a good job of ... rebuilding financial sector balance sheets through the bank bailout and other means. But household balance sheets have not received as much attention. We could have helped households rebuild their balance sheets, and this would have helped banks by lowering the default rate on loans. Instead, we left households to mostly solve their problems on their own, and then helped banks when households could not repay what they owed. ...

One of the main points was that helping households rebuild their balance sheets will also shorten the recession. (This is one reason I changed my mind about tax cuts. If tax cuts are spent, they stimulate the economy immediately. If they are saved instead, then they restore balance sheets faster thereby bringing a quicker end to the recession. In the latter case we won't see much in the numbers until balance sheets have been rebuilt -- the saved funds will not stimulate output and employment -- but it would be a mistake to conclude that the policy was useless since the balance sheet rebuilding is an important component of recovery.)

As Paul Krugman writes more about this topic, I hope he picks up on some of these themes:

It’s Not A Banking Problem, by Paul Krugman: I’ll need to write more about this, but I thought I should put this up for now: one theme you still find running through many policy discussions, especially about things like taking action on foreclosures, is the constant warning that you mustn’t be mean to the banks — because things are fragile, you know, and we don’t want another financial crisis.

So I thought it might be worth pointing out that this long ago ceased being a banking problem.

The St. Louis Fed has an indicator of financial stress (it’s the first principal component of a vector of different financial measures; aren’t you sorry you asked?). It looks like this:

You can clearly see the oh-God-we’re-gonna-die period following Lehman’s fall; you can also see that it’s over, and stress is more or less back to normal.

So what’s holding back the recovery? Housing and household debt.

And so the priority in financial policies should be helping to clear up the housing mess and helping arrange debt relief. This is not the time to worry a lot about the banks — and especially not to worry about what bankers say.