February 18, 2009

How to Avoid a Lost Decade (updates ongoing 6/15)

(This post will be updated and/or revisited several times, due to its importance. I prefer to focus on the most important issues and stay with them until all the most valuable aspects are uncovered.)
updated 2/19 -- refined loan idea
update 2/23 -- Japan article
update 3/3 -- some thoughts on comparing the U.S. and Japan (see "Update")
update 5/11 -- clarifying the broad effects of my proposed solution on national debt
update 6/15 -- loan repayment contingencies

Martin Wolf brings up a crucial point about recovery from the end of a credit bubble (our big-picture economic situation).

Even if stimulus helps the situation, and banks are fixed so that they are able to make sound loans (instead of being overly restricted), that still doesn't get you out of the fallout of the credit bubble.

Readers of this blog have heard the suggestion we won't get back to a 1999 or 2005-like growth. Martin Wolf offers a explanation of the whole picture. In part, we can't get a rapid recovery because people are over-indebted, and trying to pay off their debts.

What has Japan’s “lost decade” to teach us? Even a year ago, this seemed an absurd question. The general consensus of informed opinion was that the US, the UK and other heavily indebted western economies could not suffer as Japan had done. Now the question is changing to whether these countries will manage as well as Japan did. Welcome to the world of balance-sheet deflation.

As I have noted before, the best analysis of what happened to Japan is by Richard Koo of the Nomura Research Institute.* His big point, though simple, is ignored by conventional economics: balance sheets matter. Threatened with bankruptcy, the overborrowed will struggle to pay down their debts. A collapse in asset prices purchased through debt will have a far more devastating impact than the same collapse accompanied by little debt.

Most of the decline in Japanese private spending and borrowing in the 1990s was, argues Mr Koo, due not to the state of the banks, but to that of their borrowers. This was a situation in which, in the words of John Maynard Keynes, low interest rates – and Japan’s were, for years, as low as could be – were “pushing on a string”. Debtors kept paying down their loans.
Full article here. Martin goes on to clear up questions about Japanese stimulus and other aspects that have confused many commentators, and explains the huge risk in trying to reduce deficits simultaneous to consumers paying off their own debts. He says we face a very real danger of a lost decade in the U.S. and also for the world. I recommend reading this article.

Readers may recall I pointed out the upside in the inevitable fact that many consumers will use tax reductions to pay down their debt more rapidly (we've all heard the downside already) -- how this would lead progressively to increasing consumer spending over time. Each month would have some contribution of a modest increase in discretionary spending due to more people reaching the end of their credit card debt (to add into the sum of all other factors). These increases will accumulate into more economic strength over time versus the outcome without this effect.

So therefore, the modest Obama income tax reductions that help consumers pay off their debts more rapidly are supportive of economic recovery in complementary way compared to conventional Keynesian stimulus such as infrastructure spending. (Note: We need something more rapid to reduce total public+private debt -- see the key new idea proposed further below.)

In other words, while even larger government spending would be helpful, this alone will not cause an economic recovery until consumers have paid off enough personal debt or saved enough to feel good about spending more.

Further, once frugality becomes ingrained, an economy can become widely trapped in this new habit both by psychology and wage reductions, and finally by a need to secure retirement (see NYTimes article here).

Having considered differences between the United States and Japan for a while two conclusions stand out for me at this point. 1) No matter how you slice it, having a higher number of young people that aspire to buy houses, appliances, autos and such makes an enormous difference in net domestic demand, and thus employment, in the absence of large external demand for a nation's output. In other words, Japanese manufacturing suffers greatly now that the U.S. consumer is pulling back and its own domestic consumers do not have a large aggregate desire to buy in great quantity the products that Japan produces. The U.S. in contrast has a much higher proportion of young people, and thus will have a natural level of demand for new products, once some economic recovery arrives. Put another way, and this applies in lesser extent also in the U.S., older generations will not be able to maintain rising standards of living unless there are enough young people to help produce the products and especially to drive the economy (demand) upon which "wealth" depends. Of course...a true "standard of living" does not depend exclusively on an increasing quantity of stuff per capita consumed, but is a conglomeration of many factors and aspects, so we need to temper concluding too much about Japanese lifestyles from the outside.

The 2nd observation I have for now is that culture is a major and decisive factor in a nation's economy. Thus there are limits to how many parallels one can draw between the U.S. and Japan. Instead, we can only draw some broad points.

One crucial piece of a good "standard of living" in any case is that young families are in fact actually able to securely feed themselves, house themselves, and clothe themselves, and have some amount of free time in which to enjoy life. If an economy is so unstable as to prevent a significant fraction of young families from having any security at all, then this is indeed a profound and real failure.

Thus, back to the basic economic situation...

While the our new tax reductions are beneficial even when used in paying off consumer debt, and will gradually help us towards a recovery,...might there be another way to get there even faster?

What might help consumers pay off their non-mortgage debt faster?

Once we frame the question clearly like this, more effective economic recovery ideas can be imagined.

One possibility is to imagine a federal lending program (which has better long-term monetary and interest-rate consequences than deficit spending) for households to be used in a controlled way against existing personal non-mortgage debt. Consider for instance the 2008 $7500 first-time homebuyer loan, which carries 0% interest and is paid back at $500/year for 15 years, as an initial model. (note below on the profound difference of restructuring debt vs. pure deficit spending) This idea can be modified to fit our purpose here.

For example, this could take the form of an available up-to-$5000 (or even $7000) 0% interest loan to each taxpayer, repayable over 10 years through withholding or at tax time. Even the repayment terms could be responsive to the economy or job status of the borrower. For instance, the starting date for the 10-year repayment schedule could be delayed for each year during which the economy is still in recession or the individual is jobless, or the payments already underway interrupted during periods of joblessness.

A way to make this into a debt-restructuring stimulus would be to require all of the new loan must be paid against existing non-mortgage debt. For instance if an individual has $4700 in non-mortgage debt as of the effective date, they could then request a transfer of $4700 in debt. The U.S. treasury would then directly pay the creditors. The effect is similar to having a balance transfer to a 0% interest account on which one cannot make new charges (note this won't increase total public/private debt much even later -- credit card companies are much more conservative now about extending credit, widely decreasing credit limits instead of holding them steady.)

The point of this debt restructuring is the much better interest rates U.S. treasuries (which after all are tax obligations of all of us) must pay versus credit card interest rates. Households get a much lower interest rate effectively, and this will accelerate household debt reduction, and subsequent household spending recovery.

This would drastically change the debt-service loads that are weighing so heavily against the U.S. economy now. When an increased portion of the total spending power in the U.S. is left in household hands (instead of so much narrowly concentrated in wealthier investor and bondholder hands), the economic fabric of local economies (which in turn constitute the national economy) re-builds faster via the increased circulation of money in local economies.

The implication for U.S. treasury bond interest rates (a function of international confidence in the future U.S. economy) is quite different for a debt-restructuring plan (this idea) versus the outcome of pure deficit spending. Pure deficit spending, which increases the national combined public/private debt load, can be bad or good depending on it's effect in increasing future economic activity -- how well (or poorly) specific federal spending increases the future U.S. ability to pay back the increased national debt. In contrast, a debt-restructuring does not increase the combined public/private national debt load (after all the same households are responsible for both), but does increase economic activity by reducing interest rate burdens. This happens because a restructuring increases bond-investor confidence in a nation, corporation, or household as a good borrower. The net effect is less interest-rate burden (current and future) on U.S. households overall, in sum, on the combination of household debt and future tax obligations (on the same households).

Feeling more secure about debt payments and even about the whole national economy due to the plan, individuals would become less stingy with their discretionary funds, and thus a modest and increasing amount of additional discretionary spending will then flow into our dry-as-a-bone economy. As this stabilizes and supports the economy, job losses would be sharply lowered, and gradually a normal level of confidence would return, allowing a recovery.


  1. Can't read Martin Wolff's article - FT requires you to register, and their registration link is broken, you can't do it. Maybe some day they'll fix it :(

  2. That link is working for me (free registration is available). But here are excerpted versions.



  3. Here is the way how we could cure the balance sheet of each insolvent economic entity.

    Bubble is caused by peoples’ expectation that the price of certain asset(real estate) will rise in future, with bank's pouring high-powered money to the asset side of economic entities’ balance-sheet. And one day it busted. So, to solve this problem, such asset bubble on economic entities’ balance-sheet must be gotten rid of, by the new system as below.

    1. Every economic entities’(including banks) assets that caused the bubble(real estate or CDO et al) on balance sheet should be evaluated on mark to market basis by the authorization of a third party(maybe on calculated basis by law firm, on assuming the bankruptcy filed), which brings about some insolvent(i.e. debt section surpasses asset section on balance sheet) economic entities..
    2. FRB decide to write off a certain amount of the loans to the banks, which amount distributed to each bank according to the amount of each banks’ insolvency, calculated on 1.
    3. Every bank that gets profit from written off should next legally enforced to, by using the profit from written off as original fund, write off its loans to its each debtor, in proportion to the amount of insolvency of each debtor. If the bank is unable to use all the written off profit it earned, the remainder is taxed all and absorbed by tax authority.
    4. Other economic entity that gets profit from the written off by the bank should next legally enforced to, by using the profit from the written off as original fund, write off its loan(or trade claim) to its each debtor, in proportion to the amount of insolvency of each debtor. If the economic entity is unable to use all profit it earned, the remainder is taxed all and absorbed by tax authority. These processes are to be repeated operationally(multiplier effect).
    5. In consequence, the bubble portion of the targeted asset is extracted from the economy, and is transformed to tax.
    6. The tax claims is finally assigned to FRB(or a public institution established). It’s up to FRB how they dispose of their above claims, considering the situation of economy, of each bank and of each economic entity. As a option FRB should examine the possibility of the bank’s and the economic entity’s turnaround, together with the other creditors, remaining desirable debt to the bank and the economic entity(empirically it's ten to fifteen times annual earnings before interest, taxes, depreciation and amortization, known as EBITDA), and writing off the rest debt, with taking into account the value of disposable collateral(that do not accrue earnings), of guarantor and of consolidated basis.
    7. Every write off must be supervised and traceable by centralized function of the system. So every write off must be executed through this function. Every write off may be done through this function, which exist on internet for access.
    8. For cross-border. For each non-residential economic entity, the amount of write off should also be calculated in the same way as 4. , on the only cause from specific asset depreciation in the resident country. Economic entity that will be written off should next write off in the same booked currency. In case profit of the written off exists on the non-residential economic entities, it's taxed and absorbed by the foreign(=non-residential) government and handed over to the sovereign(=residential) government of the currency, based on treaty.
    9. FRB should carefully watch the rate of the number of insolvent economic entities to the number of all economic entities in the US, when deciding the amount of the loans(trade claim) written off on 2.
    10. FRB may become insolvent for the write-offs to the banks, but it should be permitted, under extraordinary situation. The role of FRB is to become last resorts of risk taker. And FRB will not bankrupt, because there is no one to claim for repayment. But the value of dollar might be depreciated.
    11. In case price inflate expectation exists(not now), the system enables FRB to on one hand raise benchmark rate to cope with inflation expectation, on the other hand restructuring the balance sheets of economic entities.

    For further details, please see the post on the blog as below:

    The Post on December 16, 2007, August 14, 2007 on the blog

  4. yamada, these look like some interesting ideas, but it was difficult to read through the sentences in terms of clarity. For instance, #5 is an interesting conclusion or assertion, but the sentences make it difficult to know exactly what you are saying. You could consider laying out a detailed example to illustrate your points.

    One question I wonder about is whether the FRB has the legal authority to write off loans to solvent corporations. In effect such a bailout is usually a political decision. In other words tax dollars (or profit of FRB which is equivalent) are only spent under the authority of duly elected representatives in the U.S.

  5. Living in Japan during the end of the 90s, people there said things weren't so bad. Although the economic data was bad, people weren't in danger of going bankrupt or losing their homes.

    Most don't spend a large percentage of their income on housing as its either provided by the employer or they live with parents.

    They have national health care so no one worries about financial ruin due to healthcare costs.

    So our way of life makes this crisis more damaging.

  6. Susan, those are a couple of great points. Healthcare cost shocks are the predominate cause of bankruptcies, as Elizabeth Warren recently pointed out.

  7. Thanks for the information, this article was highly important for me to learn how to avoid a lost decade (updates ongoing 6. Regards