Is This a Recession or a Contraction and Does It Matter?
September 3, 2011 § 1 Comment
Every trial lawyer knows that to get the right answer, you must ask the right question. And the words you use matter. Kenneth Rogoff, a professor of economics and public policy at Harvard University and former chief economist for the IMF, contends that the present economic downturn is not a recession but a “contraction”. See “The Second Great Contraction” and “Inflation is Now the Lesser Evil“. He argues that the Obama administration has been trying to answer: “What do we do about the recession?”, when it should have been trying to respond to : “What shall we do about the contraction?”
Professor Rogoff’s claim is that we are dealing with a financial crisis, not a “housing bubble” or a “dot.com bubble” or “tulip mania” – the kind of “irrational exuberance” given a catchy label by Alan Greenspan. He writes that we are in a financial mess, not a commodity mess or the kind of mess devotees of free-market capitalism refer to as “creative destruction”, when the rich become so greedy that their schemes implode, causing widespread destruction of working-class economic security. [The professor would not characterize these messes as I have but, whether he would or not, they are the kind of messes he claims we are not in.] He describes our present mess as follows:
“Modern finance has succeeded in creating a default dynamic of such stupefying complexity that it defies standard approaches to debt workouts. Securitization, structured finance, and other innovations have so interwoven the financial system’s various players that it is essentially impossible to restructure one financial institution at a time. System-wide solutions are needed.” See “Inflation . . . .” supra.
Rogoff identifies two main problems: residential housing debt and credit card debt. He argues that those problems have become threats to the entire financial system because of the “stupefying complexity” to which he refers.
I am suspicious of professor Rogoff for two reasons: First, he identifies Paul Krugman as an example of economists who have, according to Rogoff, misdiagnosed the problem. Second, he mentions with apparent approval Milton Friedman, who invariably disagrees with just about everything that seems smart, reasonable or honest to me.
I don’t dismiss Rogoff, however, because what he writes raises some issues I had not before considered.
For example: My recollection, from college economic instruction from Professor Hale, is that Keynesian economic strategy works because when money is transferred from rich people to working class people the recipients will spend it and the “multiplier” effect will significantly add to its impact when it passes from the original recipients’ hands to vendors of goods and services, who will thereby perceive increased demand and react by hiring more employees to handle it, etc. etc. etc.. Left in the vaults of the rich, on the other hand, the money would merely fatten their bank accounts or reward their stockholders, because their “propensity to consume” has already been sated with ample bloat. So, when recession threatens, tax the rich and shovel money into the pockets of the poor and the working class.
Paul Krugman relentlessly complains that this simple and logical strategy would work if adequately applied. His explanation for its failure, so far, is that too little money was disbursed. And, or course, the GOP has seen to it that nothing has been done to lower the level of money filling the troughs where the Wall Street hogs triumphantly gorge themselves. When that trough threatened to capsize, the government handed out blank checks on the treasury like they were Monopoly money.
Rogoff suggests another explanation for the failure. Keynes assumed that if money were handed to working class wage earners, they would spend it. Suppose, however, that those wage earners are facing foreclosure of their homes and, having maxed out their credit cards, are being hounded by bill collectors. Are they going to spend any extra money they get their hands on, or will they use it to hang on to their homes and credit cards? If they do, the multiplier won’t work. Payments to mortgage lenders and credit card companies do not create more demand for goods and services. And suppose they have “underwater mortgages” and so much credit card debt that they can’t do anything to save themselves. How likely is it that, having experienced the bitter and frightening result of over-spending and over-borrowing, they will feel in the mood for a new car or a new refrigerator?
The working classes’ high “propensity to consume” may have been dampened by what economists call an “overhang of debt” like the shadow of a sword of Damocles that haunts their dreams of the good life.
Professor Rogoff contends that, until that “debt overhang” is reduced, stimulus money will not cure the present recession. He thinks that the over-leveraged debt has to be “contracted” before recovery can be achieved. His estimates that the process will require at least four years.
He proposes two solutions: An inflation rate of 4 to 6 percent for a few years and government mandated restructuring of residential mortgage debt. He assumes that the only solution is to transfer a very large amount of money from the creditors to the debtors so that the amount of remaining debt can be handled without massive financial disruption. High inflation would enable repayment of debt with devalued dollars. Restructuring the mortgage debt would allow home owners to retain their homes and make much reduced payments to the mortgagees.
I have two problems with Rogoff’s suggestions: First, given the present state of our political culture, there is no chance that they will be considered, much less employed. Second, increased inflation would indeed enable the repayment of borrowed dollars with much devalued dollars and thereby theoretically facilitate the repayment. The repaid dollars would not, however, be the only dollars devalued. The dollars available to pay rent, buy groceries, gasoline and health care would also be devalued. Those least able to pay the higher prices would be the ones most hurt by inflation. Rogoff acknowledges that the inflation solution would be “arbitrary and unfair”, but offers it as an alternative to long-term economic recession.
His idea for restructuring residential mortgage debt is more interesting. He describes this idea as follows:
” . . . governments could facilitate the write-down of mortgages in exchange for a share of any future home-price appreciation.” Contraction, supra. I assume that the federal government could legally coerce the mortgagees to revise the terms of the loans secured by their mortgages. It could, for example, change the rules to remove government guarantees from all residential loans not revised. It could make interest payments on non-revised residential loans non-deductible from federal income tax liability. The federal government is so enmeshed in the residential loan business that there are probably other ways that such coercion could be designed.
How the government could enable the mortgagees to benefit from any future appreciation in market value of the homes covered by the revised loans would be more challenging. Several issues appear likely. How would the extent of the appreciation be determined? By relying on ad valorem tax valuations? The process for fixing those values is left to state and local governments and systems vary wildly. The alternative of a nationwide system of property valuation would be a massive undertaking and would face immense opposition from state and local politicians. Professor Rogoff does not, at least so far as my limited research into his ideas has revealed, offered any details about how this part of this proposal would be implemented.
There would be several other vexing issues. Whose loans would qualify for the mandated revision? Would real estate speculators qualify? Would the revised loans and mortgages be transferable? If so, would there be restrictions on the terms of the transfers? How much howling would emanate from home owners who don’t qualify? How could the program keep from rewarding only the profligate?
I can see lots of problems with the solutions offered by Rogoff. I cannot, however, deny that he raises a real basis for questioning the efficacy of handing federal money to financially insecure poor and working class [unfortunately there is increasingly small distinction between “working class” and “poor] Americans and expecting Keynes’ multiplier to kick in. He leaves me with a credible problem but no credible solution.
It is easy for me to understand why this kind of problem did not concern Keynes in 1937, when he published his General Theory of Employment, Interest and Money. Unsecured loans to poor and middle class workers in response to widely distributed plastic cards was unheard of in 1937. The transistor had not been invented. Communications technology allowing instant transmission of information around the globe was only discussed in science fiction magazines. Most Americans lived in rural communities surrounded by farms and ranches. Homes were appurtenances of rural land ownership. The post WWII housing developments, made possible by VA loans, were not part of Keynes’ speculations.
Rogoff and Paul Krugman have engaged in a long-running debate about these issues. Fareed Zacaria’s Sunday morning program featured them a few weeks ago. You can see and hear them in a two-part YouTube presentation: Debate Part 1 and Debate Part 2 .
I doubt that Keynes considered the possibility of “debt overhang” as an issue for poor and working class Americans because that kind of debt was not available. People lived “within their means” because that was all the “means” they could get.
A framework for understanding our present economic system was offered by Thorstein Veblen, a multidisciplinary thinker who confounded his contemporary scholars by mixing sociology and psychology with his economic analysis. Veblen’s Theory of the Leisure Class playfully and sometimes savagely described the inclination of people to yearn for goods and services, not because of their utility but because of their lack of utility. He would not have been surprised at the spectacle of hordes of eager customers, clutching their credit cards and buying endless supplies of mostly useless gadgets, creating a “throw-away” culture that overwhelms our landfills. His book was aimed at the rich, but only because the rest of us lacked the credit to ape the foolishness he described. I recall yellow signs posted throughout a Sears Roebuck store in Houston that read, “Want it? Charge it!”
What we found out was the truth of John Steinbeck’s observation, “Socialism never took root in America because the poor see themselves not as an exploited proletariat but as temporarily embarrassed millionaires.” When we got the opportunity to shop and buy like millionaires, we did our best to measure up. And when it suited Wall Street bankers to lend more money in the form of residential mortgages, we jumped for the bait like nebbishes. McMansions sprouted all over America.
Veblen would have also understood that transistors and worldwide communication networks would transform our financial system. He taught us that technology is the dynamic force that is always accompanied by institutional change. Bob Montgomery,, my UT professor, used to say, “The universal constant is that man will always play with his gadgets.” [He had no faith in “mutual assured destruction” as a means of keeping us safe from nuclear holocaust. I had just about concluded that he was too pessimistic . . . until I began hearing about jihad and suicide bombers.]
I have some more ideas about these issues but this is already too long. I will be interested to see what President Obama has to say about our problems next week. I hope someone has suggested he read some of Harry Truman’s speeches about the “Do nothing 80th Congress”.