"The Ongoing Debt Transformation"

Via Paul Krugman:

The Ongoing Debt Transformation, by Paul Krugman: A follow-up on my note about US deleveraging. It turns out that if you measure debt as a percentage of potential GDP (as estimated by the CBO) and use a stacked-area graph, you get a pretty clear picture. Here it is, using nonfinancial debt (for reasons explained in the previous post):

All data from FRED.

What we see here is that there was an explosion of total debt during the Bush years; since then debt has stabilized relative to potential output. But there has been a redistribution, with private debt falling while public debt rises.

Arguably, this is exactly what needs to happen: the federal deficit is sustaining the economy while balance-sheet constrained private actors deleverage. ...

Once balance sheets are sufficiently repaired, private demand should recover, and the federal government will no longer need deficit spending to keep the economy afloat.

Obviously (at least to me) we should have been stabilizing things at a higher level, with less unemployment. But this is a picture not of runaway borrowing, but of progress being made in dealing with an excessive level of private debt.

Let me just add one note. So long as household balance sheets are still being repaired, demand will be too low and the economy will struggle to recover. Restoring balance sheets takes time -- the fall in housing values and the crash of financial markets took their toll on household finances and the damage is still being repaired. One of the biggest threats to household balance sheets is the loss of a job. Losing a job devastates household finances, and balance sheet repair is all but impossible for the unemployed. Thus, job creation is the first problem that needed to be addressed, and we have not done nearly enough to help to create job opportunities. More jobs could have saved many, many household balance sheets from disaster, and helped other households repair the damage at a much faster rate (and it would have also avoided the permanent costs to individuals and the economy associated with long-term unemployment).

But job creation is not the only way the government could have helped household balance sheets, and this could have been accomplished without increasing total debt. Imagine, for example, that the federal government had done more to help households that are struggling to pay their mortgages and are in danger of foreclosure. Private sector debt reduction -- mortgage, student loan, or credit card writedowns -- would have made the blue area in the graph fall even faster, and the red area would have increased faster to compensate as the government took this debt onto its balance sheet. But, importantly, the total amount of debt need not have changed. This simply transfers debt from the private to the public sector. (Note: This says nothing about the optimal level of public debt -- more public debt used for job creation programs and private sector debt reduction would have helped the economy recover even faster -- this is about the best mix of public and private debt for a given level of total debt).

The transfer of private sector debt to the public sector increases the rate at which households repair their balance sheets, and thus helps households return to normal (non-bubble) patterns of consumption faster. This helps GDP to recover faster as well and, since income would be higher but debt the same, allows us to pay off the same total debt, both public and private, from a higher income base (one could argue that the increase in household confidence from balance sheet repair would be offset by a decrease in confidence from higher public debt, but there's little evidence to support the latter effect, especially since our overall debt doesn't change). Thus, even though households will ultimately pay off the public debt, transferring some of the debt to the public sector temporarily allows them to wait until their situation improves before the tax bills for the debt come due (and some of the burden can be redistributed across income classes if that is desirable). That allows households to devote more of their income to consumption rather than bill paying -- which is important for households who are barely getting by as it is -- and the extra demand this creates helps the economy recover faster making it easier to pay off both the public and private debt.

Higher income, higher employment, and no change in total debt seems like a deal we ought to take, but fear from the wealthy that they might be asked to pay a larger share of the bills than others, or any share for that matter, the insistence from moralists that people should not be allowed to escape their debts (even if their problems were caused by the popping of a bubble that the experts told them wouldn't pop, or by other factors that they had no control over), and ideological opposition from conservatives to government programs of any kind are standing in the way.