It's Time for Debt Forgiveness, American-Style
Economists Michael Kumhof and Romain Rancière wrote a breakthrough paper for the IMF that made the connection between inequality and financial crisis. “The crisis,” they wrote, “is the ultimate result, after a period of decades, of a shock to…two groups of households, investors who account for 5% of the population, and whose bargaining power increases, and workers who account for 95% of the population.” The 5 percent, broadly speaking, lend to the 95 percent, and in so doing gain still greater wealth and power. The shock comes when the creditor class suddenly realizes that the borrowers are drowning in debt and cannot possibly absorb any more. At that point, financial assets connected to consumer debt are dumped and prices crash, much as they did in 2007. The authors add, “To our knowledge, our framework is the first to provide an internally consistent mechanism linking the empirically observed rise in income inequality…and the risk of a financial crisis.”
It took three decades of lopsided borrowing to produce the breakdown, Kumhof and Rancière explain, but the ominous trend was evident for years. In the early 1980s the 95 percent had debts equal to about 65 percent of their income. By 2006 that figure had risen to 140 percent. They were devoting so much of their paychecks to making payments on old debt—credit cards, equity lines and mortgages—there was nothing left to make the payments on new debt. Defaults and bankruptcies were already swelling. The collapse came when creditors grasped the danger and started selling off their mortgage bonds and loans to consumers.
It seems odd that the financial interests, with their brilliant analysts and high-speed computers, didn’t see the nature of the crisis until it was breaking over their heads. They may have been blinded by the fabulous wealth they were harvesting. Kumhof and Rancière point out that the same ominous combination—a run-up of debt accompanied by gaping inequality—preceded the crash of 1929. Greed may inspire optimism.
But why did ordinary debtors fall into this trap? The standard line is that they, too, were blinded by greed, eager for consumer pleasures they couldn’t afford. This is true for some, but the explanation libels most working people. Wage stagnation started in the 1970s and spread widely in the Reagan era. Typically, as incomes faltered, families faced two bad choices—either go deeper into debt or surrender their middle-class standard of living. Naturally, most people tried to hang on to what they had.
The responses to this crisis are well-known. People worked more—women and teenagers entered the workforce, family members took two or three jobs. And they borrowed more, paying the bills with credit cards. In these terms, average families were making heroic efforts to maintain their standard of living. They were doomed to fail unless dramatic economic reforms improved their lot. University of California economist Clair Brown predicted nearly two decades ago in her landmark study of American consumption that sooner or later working people would have to retreat to lower levels of consuming. Working harder and borrowing more had sustained them for twenty years, but neither of these remedies was repeatable. At some point the merry-go-round would have to stop.
The retreat is now in full flight. Homeownership has declined by 1.1 percent over the past decade. Wages are stagnant or falling. Foreclosures are tearing through communities, and falling home prices are destroying family equity. Americans, as Whalen says, are experiencing the reverse New Deal.
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The president is losing the policy bet he made at the outset of his administration. Government regulators, he decided, would give leading banks a pass on stern cleanup and rigorous reforms. With blanket forbearance and enormous lending supplied by the Federal Reserve, the assumption was that the largest financial institutions could earn their way back to solvency, gradually shedding all those “toxic assets” left over from the collapse of the housing bubble. Recovery of the broad economy was supposed to follow.
Obama’s bet looked very much like the one Japan made in the 1990s, after its spectacular housing bubble burst. Obama’s failed just as Japan’s did, and for some of the same reasons. Neither nation wished to take on the biggest banks or do something about the mountain of bad debts suppressing new economic activity. If Japan is the yardstick, the United States is in for a long, slow drag of ten to fifteen years. Japan spent a fortune on stimulus in the form of infrastructure spending, which probably helped, since unemployment never got above 6 percent. But its federal debt has risen to more than 200 percent of GDP, and the country is still demoralized by a soggy economy.
“Let me tell you the basic parallels,” says economist David Weinstein of Columbia University. “The United States and Japan both have big debt overhangs as the economies slowed. Both tried fiscal policies, which were probably held back by fiscal conservatives. At least in the Japanese case, that stimulus really was working. The mess in the banking sector fed into manufacturing and many other sectors. Instead of lending, the bankers were trying to reserve that money to cover their losses, trying to hide their losses. All of that was going on.” Like other experts, Weinstein believes there will be a second banking crisis in the United States.
Obama hasn’t changed his failed strategy or relieved the advisers who sold it to him. But the original plan has come back to haunt him. If he tries to act now, he will face a new dilemma: can government act aggressively to force reform and restructuring on the biggest banks without triggering insolvency for some of them? The alternative is to keep bumping along with stagnation or to foster inflation as a way to reduce the value of old debts and ease the pressures on debtors. Either promises bitter controversy. Rob Johnson, the former banker now at INET, thinks government will eventually have to intervene decisively to clear away the rubble and restart the economy.
The country needs a bank holiday somewhat like the one FDR ordered in 1933. “We basically have four banks and two investment banks that now call themselves banks [JPMorgan Chase, Bank of America, Wells Fargo, CitiGroup, Goldman Sachs and Morgan Stanley],” Johnson explains. “These institutions are so intertwined they are a system. You can’t deal with one bank alone; you have to deal with the system. You call a monthlong bank holiday for the twenty largest banks, and that holds everything in place while the regulators mark down the assets and see how everybody’s losses will affect everyone else.
“Then you wipe out stockholders, wipe out management, possibly some of the unsecured debt. Mortgages would be refinanced based on real value. Once everybody has taken their hit and you’ve wiped out existing stockholders, then the government comes in and properly, transparently recapitalizes all of them. As these new institutions gain a footing, eventually they can be sold back to the private market.” This is rough stuff, but the nation could get a fresh start and a new banking system out of the hard knocks. Think Jubilee, American style.