Right Reason

Deleveraging: A Matter of Coordination

 

A trifling debt makes a man your debtor; a large one makes him an enemy.

-Seneca the Younger

 

 

Yesterday, the, dare I say, always-worth-reading Paul Krugman wrote on the on the hazards of deliberating in “Nobody Understands Debt”: “Why is deleveraging a problem? Because my spending is your income, and your spending is my income, so if everyone slashes spending at the same time, incomes go down around the world.” Mr. Krugman provides the orthodox Keynesian diagnosis of deleveraging in terms of aggregate demand and it doing so reveals the flaws of the aggregate-demand approach: It ignores the ecological qualities of the markets. 

 

To really understand whether people’s spending reflects the wealth of the nation, we have to understand the context in which people are trucking, bartering and exchanging. The economy is a coordination problem where profits are to be had by bringing people’s future plans into greater coordination with each other. Wealth, in turn, is fit order that correctly anticipates people’s future appetites and is thereby coordinated with them.

Any process of deleveraging therefore needs to be understood in a coordination perspective. Such a process, however painful, can be necessary if there is widespread mal-coordination within the economy. In a 2010 study, “Debt and Deleveraging: The global credit bubble and its economic consequences,” the authors, Roxburg et al., addressed such mistaken activity when it wrote about how the level of debt in most mature countries aggressively expanded after 2000 due to “unusually low interest rates and risk spreads…” (Roxburgh et al. 2010: 10). Later in the study, Roxburgh et al. specifically point to the leverage of households as being an economic problem post-2008:

Taking a more granular view of leverage within sectors of the economy, we find that households increased their borrowing substantially, particularly through home mortgages. Rising housing prices meant that the ratio of household debt to assets appeared stable in the years prior to the crisis. But household debt compared with disposable income increased significantly, which should have raised a red flag long before the crisis. (Ibid)

Leverage just isn’t a data point; rather, it’s the manifestation of economic life. Whether it’s a manifestation that adequately corresponds with the demands of life is another matter. The markets can and do lead to situations where the patterns of specialization and trade that have hitherto evolved are, for one reason for another, unsuited to the demands of life. Roxburgh et al. write of a credit bubble that led to households holding an unsustainable level of debt, compared to their income, once economic reality reasserted itself. 

 

Mr. Krugman is correct in asserting that debt per se is nothing, “it does not directly make the economy poorer (and paying it off doesn’t make us richer)” What makes us poorer or richer is how our economic life, the patterns of specialization and The moment that people realize the departure of the two is, like most sudden revelations, a moment of crisis—the crash of the housing market was certainly devastating for those who had based their economic life on it.

 Once such bubbles have burst, spending needs to go down so that people can figure out the most profitable ways of doing business with one another. Deleveraging can be a necessary part of that natural process. The way forward isn’t to deny that people borrowed too much, it’s to accept that people have to adapt themselves to the demands of economic life and deleveraging, as described by Roxburgh et al., can be a necessary part of that process. Economic life, after all, is a coordination problem. Even if that coordination problem may be somewhat of a mass hallucination, it is still a mass hallucination that people have to adapt to if they desire to flourishing.

 

Insofar as deleveraging reflects the aftermath of the extinction of unprofitable patterns of specialization and trade, it reflects an event that enhances the wealth of the nation by bringing people’s economic decisions into better coordination with one another. It is bad when it doesn’t it doesn’t enhance that coordination, which can be the case when there are monetary disturbances—but that’s a topic for another day. The connections created between people through business are complex and ecological, not simple and hydraulic. 

Mr. Krugman’s repetition of the tired line that “We owe debt to ourselves” encapsulates the latter perspective. People don’t owe money to themselves; rather, different people in their own distinct stations of life owe money to different people. There’s a politically pertinent reason for not wanting to look at loans in such simplistic terms: The adage that he who holds the purse holds the power is all too true. 

The fall of Prime Minister Silvio Berlusconi’s government in Italy following pressure from the bond markets on his government’s finances in 2011 and the rise of Mario Monti’s government of unelected technocrats, just a week after Monti had been appointed a senator for life by President Giorgio Napolitano, should be a lesson in the power of the bond markets as a faction. A modern government cannot operate without access to well-functioning bond markets, which means that bond-holders are a potential faction that can override an otherwise democratic government’s wishes. As long as people have different appetites and different ways of life, then the slogan “We owe it to ourselves” is a delusion. There is no ‘us.’ There’s only a heterogenous population of different people all with their own ends in life, and only a fool bets that people will be publicly spirited when crisis is around the corner.  

We're Not as Rich as We Think We Are: Deleveraging Edition

From MEP Daniel Hannan at The Telegraph :

I recently spent a long weekend with friends in Valladolid, and the signs of a downturn were everywhere. Council services were being cancelled, employees laid off. The handwritten notes that you used to see in every other Spanish shop window in August – ‘closed until September’ – have disappeared, because no one can afford to spend three weeks at the beach any more. Bars and restaurants are empty, shopkeepers painfully grateful for your custom. Worst of all, no one sees any way out. Although Spaniards have finally woken up to the idea that the EU is the problem rather than the solution, they are a long way from wanting the peseta back. (I'm doing my best – see clip below – to suggest alternatives to the present policy.)

Because journalists deal in drama, they like to frame the euro crisis as a choice between ‘a solution’ and a catastrophic breakdown. But surely there is a third option, namely that people carry on getting gradually poorer.

Imagine that you lost your main source of income tomorrow. At first, not much would change. You’d still be driving the same car, sleeping in the same bed. Only as things broke, and went unreplaced, would your poverty become visible. Dilapidation would steal upon you progressively.

What is true for individuals is true for whole nations – and not just nations in the eurozone. Britain’s decision to keep the pound bought us time: the sterling devaluation is the only reason that we have not suffered as Spain and Ireland have. But, unless we make use of that time, we shall simply have deferred the reckoning.

Incremental poverty is not some fanciful prospect. It has already begun. Most of my constituents are less well off than they were last year, and were worse off then than that the year before. The same is true across much of Europe and the United States. Economic contractions have until now tended to be brief. This time, though, the debt burden, the main depressor of growth, is as heavy as ever. What if we face another five or ten years of falling living standards? What if, instead of alleviating the problem, European policymakers exacerbate it with their stimulus programmes, their tax rises, their attacks on financial services and, not least, their determination to keep the euro together

Myself, I do not see a way out of gradual decline in material living standards for a while. Due to loose credit conditions and bad risk-assessment, households in America were able to raise their standard of living beyond a sustainable level.* They were able to buy a big new home, purchase that swanky new car, and send their children to expensive private colleges to study gender and sexuality studies by complementing their income, which has for much of America been stagnant over the past thirty years.

 

 

That was then, this is now. Now they are on the edge of foreclosure, still have the car but will be hoping it lasts for the next decade, and are hoping their children come to their senses and transfer to a cheaper college. Now instead of taking a vacation to Hawaii, they settle for a nearby beach on the coast and use the savings to help pay the interest on their debt and perhaps even paying some it off. Even though most have not lost their source of income, many have lost the ability to use credit to complement their wages, so some dilapidation, so to speak, will come in the natural course of things.

The malaise has lasted long and will last longer. Deleveraging is painful and fraught with economic problems. Wicksellian rot was and still is a very real danger. Despite that, the deleveraging among American households must continue. Only then will they be able to get in control of their balance-sheets to set the stage for economic growth created by spending that can be maintained over time. 

The best news is that the median citizen in the West still enjoys a standard of living still unprecedented in human history. The good news is that the deleveraging is actually happening. The bad news is that it is often done by simply by writing off delinquent debt. The worst news is that for those in MEP Hannan's England and his beloved Spain, though, it has yet to begin. (Options for the optimists and pessimists alike to focus on.) For the numbers on this deleveraging of household debt, which I sadly cannot reproduce graphically here, check out this report by McKinsey & Company: “Working Out of Debt.”

 

 

* By sustainable I mean beyond what could be expected as a permanent stream in the future ceteris partibus. Sustainable plans for consumption closely approximate equilibrium in that while in equilibrium the ex post situation is identical to the ex ante plans of people, sustainable plans need not be identical. Instead, the key condition for plans being “sustainable” is that mistakes in planning are evened out by the Law of Large Numbers among people making their own plans for their own actions within the economy.