The Great Recession: NGDP fueled or Balance Sheet fueled?

In the comment section of Scott´s “A NGDP counterfactual” Peter N shows this – as he says ugly – chart:

and writes the following story (my highlights):

You can see that until the mid-1980s the ratio of net worth to GDP was fairly stable around 3.5 and liabilities as a percent of net worth after a run up after WWII from, 7% to 14% around 1965 stabilized there. I interpret this as healthy borrowing, since it had no effect on the ratio of net worth to GDP – that is it caused net worth and GDP to increase at an equal rate.
What happens next is the great dotcom stock market boom. This produces some asset inflation, but it’s mostly just the irrational exuberance of people investing their own money. You see that the increase in (net worth/GDP) is pretty much entirely due to an increase in financial assets.
After the dotcom bust, however, the Fed loosens, arguably for too long, and another asset inflation up leg follows without the preceding inflation having been completely wrung out.
Unlike the previous boom, this one is fueled by debt leverage taking liabilities as a percent of net worth from 16% to 26%. Regardless of whether you believe this was rational, it clearly wasn’t sustainable, and a naive reading of the chart would indicate that we’ve only retreated 3/4 of the way to historically normal levels (which, I suspect is a lot more than the Europeans have managed).
There are 2 possibilities. Either:
1) the 4.8 ratio of net worth to GDP was sustainable, and it should have been supported by fiscal or monetary policy depending on your persuasion in that area.
2) The ratio wasn’t sustainable, and it should have been allowed to fall with the fall being cushioned by some combination of fiscal or monetary policy again depending on your persuasion.

It seems to me, however, that the choice of policy depends to a large extent on whether you believe 1 or 2 above.

The chart below shows Liabilities as a percentage of Net worth (leverage). Peter argues that from 1965 to the early 1980s, the stability of this ratio is an indication of “healthy borrowing”. I would interpret it very differently. Since the relative stability of ‘leverage’ takes place during the period of the “Great Inflation” it more likely means people were averse to borrowing. There was simply too much uncertainty in the outlook. Remember price controls, oil shocks and go-stop monetary policy.

‘Leverage’ takes off again during the “Great Moderation”, a period in which the outlook became much less risky or even uncertain.

The behavior of the stock market is a reflection of this less risky environment, not an “irrational exuberance” of investors ‘gone mad’. Even the dotcom boom, which went on for a short period in the late 1990s, was likely not an irrational response by investors.

I´ll skip straight to Peter´s punch line:

After the dotcom bust, however, the Fed loosens, arguably for too long, and another asset inflation up leg follows without the preceding inflation having been completely wrung out.
Unlike the previous boom, this one is fueled by debt leverage taking liabilities as a percent of net worth from 16% to 26%.

The chart below puts together the NGDP gap and ‘leverage’. In the late 1990´s the Fed errs in the direction of excessive nominal growth (excessive relative to the trend path) and in the early 2000s it was excessively contractionary. Initially there is ‘deleveraging’ and then ‘leveraging’. But as seen we don’t´ have a “boom fueled by ‘exploding’ leverage. The house boom was mostly the result of distorted homeownership incentives while the growing ‘leverage’ was the result of inadequate NGDP growth.

In mid-2003, when the Fed adopted ‘forward guidance’ NGDP began to travel back to trend and ‘deleveraging’ set in. Unfortunately, Bernanke´s inflation phobia was instrumental in letting NGDP fall back away from trend, setting the scene for the late-2008 debacle! The chart also indicates what would likely have happened if NGDP had not first ‘boomed’ in the late 1990s and then tanked in the early 2000s. If NGDP had evolved along the dotted line, quite likely ‘leverage’ would have remained stable.

This is what happened in 2008 and after:

Note that QE1 (March 2009) was instrumental in braking the fall in nominal spending. Although nominal growth resumed, it did so at a rate that has been too low to close the gap. It has nevertheless allowed ‘deleveraging’ to take place, in part because Net Worth has increased following stock market gains.

Just as David Beckworth has argued in the case of Europe, in the US it was also (at least mostly) an NGDP fueled crisis.

So Peter, it´s not a question about your alternatives (1) or (2), but about not letting monetary policy (NGDP) get out of ‘whack’. And if it does devote all efforts to take it back to its ‘rightful place’!