To really understand the depression we have to stop “pulling red herrings from the hat”

In 30 troubling years Krugman has this to say:

Second, a dramatic rise in household debt, which many of us now believe lies at the heart of our continuing depression. Here’s household debt as a percentage of GDP:

Scott Sumner counteracts:

What do you see?  I suppose it’s in the eye of the beholder, but I see three big debt surges:  1952-64, 1984-91, and 2000-08.  The first debt surge was followed by a golden age in American history; the boom of 1965-73.  The second debt surge was followed by another golden age, the boom of 1991-2007.  And the third was followed by a severe recession.  What was different with the third case?  The Fed adopted a tight money policy that caused NGDP growth to crash, which in turn sharply raised the W/NGDP ratio.  Krugman has another recent post that shows further evidence of the importance of sticky wages.  Forget about debt and focus on NGDP.  It’s NGDP instability that creates problems, not debt surges.

I agree with Scott.

Why does the share of debt rise? I believe it reflects peoples “optimism” about future prospects. In the chart below I break down Krugman´s chart and separate mortgage and non-mortgage household debt as a share of NGDP. I also add the behavior of the stock market (here represented by the Dow-Jones Index).

Non-mortgage debt remains relatively stable after 1965, fluctuating in the range of 17% to 22% of NGDP. No problem there. During the 1950s and first half of the 1960s we observe a rise in household debt. People felt good about the future. The stock market gave out the same information.

Note, however, that as soon as inflation begins to trend up in the second half of the 60s, the future doesn´t look so bright anymore. Households’ don´t increase indebtedness and the stock market stops rising (falls in real terms).

Following the “Volcker Transition”, with inflation being brought down permanently and the economy entering the “Great Moderation”, future prospects ‘brighten’ up again. Both mortgage debt and the stock market trend up. This goes on until the early 90s. At that point, likely reflecting the S&L debacle, mortgage debt stops rising despite future prospects remaining bright as indicated by the stock market´s upward trend.

In the 00s the story is reversed. The stock market ‘brakes’ while mortgage debt picks up strongly. To me that´s an indication of some inconsistency.

To keep the populace happy, Roman Emperors gave them ‘bread and circus’ (free bread and gladiator fights to the death). In order to divert attention from his ‘undesirable’ war policies and consequent increase in public deficits and debt, President Bush came up with the idea of:

1)      Tax reductions (‘free bread’)

2)      ‘Homeownership for all’

The institutions that permitted the ‘homeownership’ program were in place (CRA, tax breaks) and Fannie & Freddie were there to provide “guarantees”. A bit of required macroeconomic adjustment also came in ‘handy’. Following the Asia crisis in the late 90s, the US became the ‘buyer of last resort’ to the world. The US current account deficit increased. For that to take place, while ‘Asia’ had to relocate resources from the nontradable (say housing) sector to the tradable sector, the US had to travel the opposite route. In other words, houses had to move from Asia to the US! And it was done in spades!

Wrong incentives, bad policy, and corruption. That´s all true and there was no escaping ‘judgment day’. What didn´t need to happen was monetary policy trying to ‘suffocate’ the economy while it was in the process of adjustment. Just think what would have happened if the post WWII adjustment (that required a steep reduction in government spending, the generation of civilian employment for millions, etc.) had to take place with the Fed at the same time pursuing a contractionary monetary policy, i.e. restraining spending (NGDP) growth. The US would be another country altogether today.

13 thoughts on “To really understand the depression we have to stop “pulling red herrings from the hat”

  1. Pingback: Paul Krugman on Bernanke not wanting to help Obama and the IMF on risk of deflation in the Euro Zone « dajeeps

  2. Pingback: Skepticlawyer » Debt and boom

  3. Sadly I have to disagree. Some portion of the rise in debt is likely attributable to optimism but another portion is almost certainly due to stagnating wages, which required households to borrow in order to maintain consumption levels. Rising debt is not necessarily a bad thing but, when the aggregate level becomes large enough, the corresponding interest costs become a headwind to consumer demand. A more elaborate reply to Sumner’s post is here

    • Woj, I find it hard to square stagnating wages to the debt increase, especially given the increase in debt after 2000, for all the “wrong” reasons. Why, given stagnated wages, didn´t debt grow in the 1990s?

      • Household debt to GDP did grow in the 1990’s although certainly not as much in the 2000’s. If I’m not mistaken, GDP growth was faster in the 1990’s than 2000’s, hence income grew more slowly. The surge in the 2000’s was also likely, in part, driven by the housing bubble and lax lending policies.

      • Your entire argument is based on an erroneous concept. Household debt during the 90’s grew by over 5% every year, and most of that time consumer credit grew faster than mortgage debt.

        You can’t look at a graph of A/B and attribute the wiggles in changes in A alone. Worst case, your assessments will be exactly backward, and that is mostly what happened here with Sumner’s statement about debt surges.

        Ironically, he – and you along with him – ignore the effect that GDP has on the ratio.


  4. “In the 00s the story is reversed. The stock market ‘brakes’ while mortgage debt picks up strongly. To me that´s an indication of some inconsistency.”

    Or we can see it as mortgage debt catching up to the elevated level of stock prices, which it had been following quite closely until 1990.

  5. It only took me three days to realize you gave further definition to my ‘non-tradables is the problem’ argument. This post just made its way into my notes. Governments of all political stripes will back certain unions when they add so much to their nation’s prosperity for tradables and non-tradables equalization, even when technology gets set back in the process (non-efficient homes that are extremely wasteful and time consuming to build). Whereas healthcare uses high technology for the exact opposite purpose.

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