Saturday, June 28, 2014

It’s debt, stupid!

by Michael Roberts

“Recessions are not inevitable – they are not mysterious acts of nature that we must accept. Instead recessions are a product of a financial system that fosters too much household debt”. So say Atif Mian and Amir Sufi, two leading mainstream economists at Princeton and Chicago universities in their book, House of Debt, recently described by the ‘official’ proponent of Keynesian policies, Larry Summers, as the best book this century!

See my post (
The two economists then make a very bold claim: “excessive reliance on debt is in fact our culprit… but it can potentially be fixed. We don’t need to view severe recessions and mass unemployment as an inevitable part of the business cycle. We can determine our own fate.”   We Marxists would also like to claim that we can fix recurrent slumps and mass unemployment by the replacement of the capitalist mode of production. But Mina and Sufi reckon it can be done by just dealing with debt.

The good thing about this book, apart from its excellent simple prose style, is that the authors deny the usual mainstream position that “severe economic contractions are in many ways a mystery. They are almost never instigated by any obvious destruction of the economy’s capacity to produce….The economy spluttered, spending collapsed and millions of jobs were lost. The human costs of severe economic contractions are undoubtedly immense. But there is no obvious reason why they happen.”
Instead, they reckon they have discovered the secret of the cause of the Great Recession and the Great Depression on the 1930s: “One important fact jumps out: the dramatic rise in household debt. Both the Great Recession and Great Depression were preceded by a large run-up in household debt… And these depressions both started with a large drop in household spending.”

Mian and Sufi make the valid observation that the Great Recession was not caused by excessive government spending or debt. It was the sharp rise in private sector debt that was the feature prior to the crash – a point made by Steve Keen in his work (see my post, But for Mian and Sufi, it is not the build-up in corporate debt that was the problem, but household debt i.e. mortgage debt to buy homes, ‘residential investment’.

The authors dismiss the neoclassical and macro consensus that recessions are just unpredictable ‘shocks’ to an otherwise steady equilibrium growth path as fantasised by all those neoclassical DSGE models (see my post, And recessions are not just the result of some ‘financial panic’ or banking crash, as argued by former Fed chief and depression expert, Ben Bernanke (see my post,

Instead, the authors lay the blame fair and square with ‘too much debt’, in particular, the debt built up by relatively poor households in trying to buy homes during the great housing bubble of the early 2000s. What caused the Great Recession was a collapse in house prices leading to defaults by the poorer homeowners. As these people spend more and save little, this led to a collapse in consumer spending.

Mian and Sufi argue that the recession of 2001 after the hi-tech stock market bubble burst was very mild because it mainly affected rich stock market investors who still have plenty of wealth to spend. The Great Recession was way bigger because it hit those who had little wealth but their houses and the housing bust wiped out what little ‘equity’ they had. In mortgage contracts, debt losses are concentrated on the debtors; they take the primary hit any house price collapse, not creditors.
Mian and Sufi show with a range of empirical studies that the bigger the debt rises in an economy, the harder the fall in consumer spending in the slump. So for them, the best predictor of a coming slump is a fast rise in household debt and the best forecast of imminent recession is a fall in household spending, which usually precedes the rise in unemployment.

This is all well and good. The authors are not the first to show that ‘excessive debt’ is a factor in the magnitude and duration of any slump. They mention themselves the work of the Bank of England and Charles Kindleberger. More recently, Claudio Borio has shown that debt moves in cycles so that points can be identified when the risk of slump is high ( I have covered much of these studies and offered a Marxist analysis of the role of debt in crises in my paper, Debt matters.

But the issue here is what Mian and Sufi do not address. Credit is necessary to lubricate the wheels of capitalist commerce. But why does debt build up so much that it becomes ‘excessive’ and what does it mean to be ‘excessive’? The authors only hint at the reason. They talk about the Asian financial and debt crisis of 1998 when huge credit was ploughed into ‘unproductive’ assets like property which then went bust. This was caused by a ‘savings glut’. In other words, there savers (capitalist companies and rich people) did not invest in new infrastructure, plant or technology, but instead in property or financial assets.

The term ‘savings glut’ is popular with the likes of Ben Bernanke and Larry Summers because it hides what is really going on. Prior to the Asian crisis, savings as a share of national output had not risen hugely; what happened was that investment in productive assets as a share of GDP fell. Capitalists stopped investing in value-creating sectors and instead looked for better profits in financial and property speculation. And they lent huge amounts of savings to do so. Borrowers got cheap credit and debt rose ‘excessively’. The assets purchased were ‘fictitious’. They represented titles of ownership to houses, golf courses and companies that eventually did not deliver real returns and could not be sold on for more cash.

So the ‘savings glut’ was really just a failure to invest in the real economy. Why was there a failure to invest? The profitability of the productive sectors was too low. In the US, profitability of the non-financial sector began to fall back after the last 1990s (see my many posts on this), generating the hi-tech bust and forcing investors to switch to property investment, generating the housing bubble. Investors bought new-fangled financial instruments that packaged-up mortgages, ostensibly to reduce risk, but in reality to pass off risky investments as safe. And the rest is history. Behind the rise in debt and the subsequent collapse is a crisis in the profitability of capitalist production. None of this explained, naturally, in House of Debt.

Mian and Sufi reckon that the Great Recession was immediately caused by a collapse in consumption. This is the traditional Keynesian explanation, usually without any explanation of why consumption collapsed. At least, the authors bring debt into the equation. But behind debt lies profit, which the authors ignore. Sure, consumption falls in recessions, but investment falls even more. The Great Recession and the subsequent weak recovery is not the result of consumption contracting, but investment virtually stopping (see my post, And behind investment (whether in productive or unproductive sectors) lies profitability.

As Mian and Sufi just consider debt is the problem, their recipe for solving avoiding all future recessions and getting out of any quickly becomes wonderfully simple. When households have too much debt and cannot recover, the government should write it off. And all mortgage contracts in the future should share the burden of risk between creditors and debtors. Any loss in the sale of a house should be shared with the bank, but so should any profit from sale.  “The culprit is debt and the solution is straightforward: the financial system should adopt more equity-like contracts.” 

Unfortunately, the likelihood of banks and governments agreeing to share losses with mortgage borrowers or allowing debts to be written off and taking the hit is as low as Thomas Piketty getting governments to agree to imposing a wealth tax or raising tax rates for the rich to reduce inequality, the other fashionable cause of crises (see my posts on Piketty).

Nevertheless, Mian and Sufi tell us that recessions are easy to solve. Why did we not think of it before?  We’ve not been smart enough up to now.  It’s debt – stupid!

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