The New Republic

At least this time Galston makes some effort to get at the facts, but the argument is a bit weak on cause and effect. What is the "channel" of causation here? The fact that consumer spending was maintained for years based on borrowing, whether it was credit card of mortgage, has been clear for a while. But the implications elude Galston. It is this: If income distribution has become more and more skewed to the wealthiest, then the economy becomes progressively starved of the demand it needs to sustain itself. For a time, producers sustain demand by finding ways for consumers to borrow. This is, however, unsustainable if it leads to an increasing ratio of debt to income, just as the increasing price of homes to income was unsustainable, the two in this case being directly related. To some extent, decreasing the burden of consumer debt would increase spending just by relieving consumers of debt service. The best way to do this without killing lender balance sheets would be to force a reset of interest rates, especially given the low rate environment. The banks have been making a killing by pocketing the spread between their old loans and the government induced near zero interest rates they pay. That has recapitalized the banks. Essentially, the government made consumers pay a huge tax that went into the coffers of the banks. But enough is enough. Time to force loan rates down so that consumers begin to get the benefit of the low rates, not just the burden in lost investment income. But this still misses a lot of the critical point which is that household income is too low. That's why the investment sector had to lend back to the consumer sector to sustain demand. We do not want simply to start the cycle all over again by reducing household debt only so that households can then increase their debt again in order to spend. Rather, we need to reverse the effects of the skewing of income distribution to the extent that we can. How? With much more steeply progressive tax rates, that's how. If the top tier is taking an enormous share of household income, then the easiest way to mitigate that shift is to shift the tax burden in that direction. Then the investor class will no longer have much more money that it can spend that it can no longer lend back to consumers to sustain demand. Instead, consumers will have more disposable income, permanently, with an after-tax distribution closer to what it was 30 years ago before we full into the grip of supply-side nuttery. At one and the same time, we could resolve the deficit because, instead of taking upper income consumption share by issuing debt, we could just tax away the excess income. Is this politically feasible? Doesn't seem so. Not as long as there are Republicans around wielding power. The next best solution is a massive government program of infrastructure spending. We need the infrastructure and the rich can imagine themselves getting richer that way. Surely less resistance than upper-end tax increases combined with lower end tax cuts. If we can get some zip into the economy this way and start printing more money, we might just get some moderate inflation going, say in the 4-5% range, which would further stimulate spending and also start deflating the debt away, depressing the value of the dollar, reducing net imports, and further increasing domestic demand. The declining dollar will increase prices for imported energy. Slap on a pretty stiff carbon tax so that a good share the price increases remain at home (something we should have done years ago) and we might get out of this mess and have a much more sustainable economy to boot. So, in this case, it is yes and no to Galston. The aggregate household balance sheet is a problem, but not the particular problem that Galston thinks it is. We have at root an income distribution problem, not a balance sheet problem.

- roidubouloi

July 13, 2011 at 12:23am

This idea is hardly new. Richard Koo has been all over it in his book "The Holy Grail of Macroeconomics" and the argument has been endorsed by Krugman and others.

- dmbrown

July 13, 2011 at 12:28am

Also, this analysis neglects the fact that some on the left have been emphasizing this: "The core of our economic problem is, instead, the debt — mainly mortgage debt — that households ran up during the bubble years of the last decade. Now that the bubble has burst, that debt is acting as a persistent drag on the economy, preventing any real recovery in employment. " Paul Krugman, May this year

- darklayers

July 13, 2011 at 12:37am

Krugman also pointed out, well before the housing bust, that we could not sustain the boom by swapping our houses back and forth. While some of the debt was extracting equity in the form of home equity loans, swapping houses back and forth effectively does the same thing. I buy a house for $100 with an $80 mortgage. I sell it to you for $200 with a $160 mortgage. The net increase in debt is $80. A few more rounds and the debt to income ratio gets sky high. Doesn't even much matter whether the home values then collapse (although they must once they stop increasing) because the debt to income ratio cannot grow indefinitely even if the nominal home values are maintained. The form of the debt is not that relevant. What matters is that the investment sector was extracting more income from the nominal economy than was sustainable and so had to lend it back to the consumer sector. But that couldn't last. If we now write down mortgages, who takes the loss? It cannot just be made to vanish. Better to adjust the debt service and the income if possible. If the former goes down and the latter goes up, we get to the same place, especially if we can get a little inflation going.

- roidubouloi

July 13, 2011 at 12:54am

Well we clearly have a balance sheet problem - but, that is hardly the whole story. Roid is right, there's an income disparity issue; but also, there are underlying problems that were not caused by individual balance sheets. It's the other way around. One is petroleum and associated war expenses; another is the weather which is wreaking havoc and will continue to affect the price of food, perhaps for years to come. Finally, there just are not enough good jobs in the US and I don't think that can be attributed to the household balance sheet. Again, it's chicken/egg. But, the housing issue is huge; the cost of housing is ridiculous vis a vis payment for work, whether one is renting or "owns," ditto medical care, unless you're in the upper few percent. Also, people's savings are worth much less, ditto our so-called investments. So, the point is well-taken, but sadly we're not in control regardless.

- Sophia

July 13, 2011 at 1:36am

"Keynesian liberals, meanwhile, counter that the problem is the collapse of demand. . . ." Well, uh, yes, the Keysian liberals are right, it is the collapse of demand resulting in part from excessive household debt and the historic drop in housing values (including the opposite of the wealth effect). Galston has a great idea. Unfortunately, "devising a plan for reducing household debt" isn't easy and takes more than financial wizzards. One simple proposal is to write down every home mortage by a certain percentage. But who bears the loss? The lenders? The government (i.e., you and me)? And what about those homes whose value exceeds the debt, wouldn't that be an unnecessary windfall for them? And, of course, there's the moral hazard issue, which warns that forgiving all that debt will encourage homeowners to repeat the same behavior (incurring excessive debt) in the belief that similar debt relief would be adopted again. For those not paying attention, the stimulus included funds for debt relief, about $50 billion, of which only about $1.5 billion has actually been spent. I'm not disagreeing with Galston (though his premise, that both liberals and conservatives are wrong about the source of the very slow recovery, is false), but one gets the impression from this essay that he just awoke from a long slumber.

- rayward

July 13, 2011 at 7:18am

Like the other commenters, I'm stunned that Galston thinks this is a "third-way" explanation (i.e. neither conservative nor Keynesian) rather than a dimension of the Keynesian explanation. This is, and has been from the start, a big part of the Keynesian story of what has suppressed consumer demand so severely and persistently. All Galston's done is revealed that he embraces the Keynesian explanation but hates that yucky K-word.

- acbrod

July 13, 2011 at 8:07am

Nice comments! Maybe you guys should be writing the mag!

- AlanVann

July 13, 2011 at 8:43am

Right, rayward and acbrod. It is the collapse of demand, of course. Galston is just giving one of the possible reasons for that, but is unable to consider the broader implications of the very reason he cites. How and why did the economy need all this debt to sustain itself?

- roidubouloi

July 13, 2011 at 9:26am

Krugman takes a break from bashing David Brook's head against the floor to directly address Galston: http://krugman.blogs.nytimes.com/2011/07/13/this-morning-in-peevishness/

- mtinora@me.com

July 13, 2011 at 10:06am

Yesterday PK observed "the extraordinary lengths to which the Chicago School is going to avoid a straightforward interpretation of the mess we’re in". And as if on cue, Sufi pens his op-ed in Bloomberg and Galston adds to its circulation. PK has a post this morning on his blog about Galston's essay ("why didn't I think of that?", he asks sarcastically). The better comment would have been in line with what he wrote yesterday about the Chicago School, agreed with both Sufi and Galston that they have a great idea, planned a camping trip together to sing some capfire songs, and then jointly solved the economic crisis with the oh so non-Keyneisan idea of debt relief to spur demand all the while giving all the credit to the fresh water economists for coming up with such a great idea.

- rayward

July 13, 2011 at 10:23am

What's interesting is that in your simplistic summary of what the 'left' has prescribed you fail to mention that much of the emphasis has been on exactly this problem - that the failure to implement a comprehensive reduction of the mountain of housing debt has been a major contributor to the lack of recovery, and that measures to reduce it have been neglected throughout the 2008 - 2011 period. In addition, Krugman's strong suggestion that the inflation rate should be allowed to rise is part of the solution also. During all of the periods Sufi mentions when the household debt level was lower it was also under control (from the consumer standpoint) through the effect of inflation. Since we have largely eliminated inflation now - and since the focus is more on controlling it than on employment issues - we are unlikely to see that as a way to ameliorate the problem.

- jessekrosen

July 13, 2011 at 10:47am

I wouldn't dismiss Sufi's argument. The issue is how compatible is it with the Keynesian and the conservative explanations for what's holding the economy back. I have no idea if the conservative explanation incorporates debt at all. However, the Keynesian approach clearly does, as described by Eggertsson and Krugman. The thing to note is that the debt level does not in and of itself drag the economy down. It is the fact that lenders look at those balance sheets and refuse to extend more credit, hence the expression "liquidity trap." Fixing the balance sheets by writing off the debt may not solve this problem, because lenders will then look at those beneficiaries and instead of seeing a balance sheet with excessive debt will see debt that had been written off rather than repaid, hence not but better credit risk, hence the liquidity trap would remain. The other approach is fiscal stimulus. This would affect aggregate consumption in a few ways. One is that reducing real interest rates (whether by decreasing nominal rates or increasing inflation) would encourage net lenders, who are not restricted by the liquidity trap, to spend more rather than horde cash. The other is that it would increase incomes, which could then be used in part to retire the debts.

- sighthnd

July 13, 2011 at 11:04am

His argument appears to attempt to explain that Keynesian economics has it wrong, but his answer IS Keynesian economics: demand has collapsed, so stimulate demand. He just gives a very specific answer as to why demand has collapsed and how to resolve it.

- GSpinks

July 13, 2011 at 12:19pm

I've watched this situation develop over 30 years as a marketing professional and business owner. It's nice to see someone noticing it now. But household debt is the (Fed and financial services industry-encouraged) coping mechanism used by US households to deal with a much larger problem; long-term, persistent economic changes that have lowered wages (along with the cost of non-essential consumer goods) at the same time that the cost of essentials like housing, education, health care and transportation have been drastically inflating. Americans are more indebted because they are poorer in real terms. While the basic cost of living is greater than ever. With government encouragment, the financial services industry has taken advantage of that fact by creating a multitude of (for them very profitable) financial instruments aimed at even the ranks of the very poor (a section of the economy that has seen real growth). The industry's encouragement of unaffordable borrowing for housing, for instance, that led to the mortgage crisis, arose from the fact that the market of buyers who could genuinely afford housing at the pricing levels reached in the 90s and beyond was shrinking, rather than growing. New financial instruments created an artificial market and artificial growth in housing values, and artificial growth in the economy at large. The fact is, wage pressure and job losses, through automation and off shoring, has been shrinking the middle class mass consumer market since the 1970s, escalating especially after the recession of the early 80s (when that market started its sharp divide into a small but increasingly prosperous "Nordstrom" market of upscale consumers and an ever larger and less prosperous "Walmart" market of almost everyone else). (Since then, large numbers of fallen from the Walmart market to Value Village (used clothing and consumer goods) market. The Nordstrom market hasn't grown.) (This was the era that marked the beginning of the end of the century-long tradition large regional department stores that catered to an entire community -- from the bargains in the basement to the fine silver, china and furs in the very top floors.) Easy credit has been a mask for the economic realities that are making Americans poorer. It's a symptom of, and a contributing factor to, those realities -- but paying down household debt offer any significant solution to the economies problems. The bigger reality is that private investment in our domestic economy and private job creation has been, and will continue to be weak because those long-term trends -- automation, the shift away from manufacturing to lower paid service employment, various sources of downward pressure on wages, the greater potential provided by growing consumer markets elsewhere -- have diminished the spending power, attractiveness and importance of the once mighty US mass consumer market. All of those trends and have and will continue to work against adequate increases in private sector investment in the US economy. The kind of investment needed to create jobs and provide the income to put households back on track and debt free.

- esmense

July 13, 2011 at 12:31pm

Of course household debt is causing the problem. But what's causing household debt? It's the income disparity between the rich and the middle class that has been increasing for decades. Middle class people want what they believe they should have and are used to in an affluent, expanding economy. But they borrow because their wages are going down and they can no longer afford what they had come to expect as normal. With housing values rocketing, they bought more expensive houses and borrowed on their equity, which seemed safe enough at the time. They also borrowed on their easy credit of course. With the middle class now having decreased buying power it can no longer spend enough to fuel a recovery. The solution is to find ways to decrease this disparity between the rich and the middle class, and there are many. The current austerity and preoccupation with debt reduction will only make things worse. Much worse. The reason for the boom after WWII was the safety net and the availability of well paying jobs. The affluent understood that a smaller slice of an expanding pie was better than a bigger slice of a contracting pie, so everyone was better off. Take a look at Robert Reich's book "Aftershock" or see his web site, RobertReich.org.

- Erik_S

July 13, 2011 at 1:42pm

"To understand the burden this imposes on households, let’s look at a key measure: the ratio of household debt to disposable income. Between 1965 and 1984, the ratio remained steady at 64 percent. Between 1985 and 2000, it rose virtually without interruption to 97 percent. And then, it shot into the stratosphere, peaking at 133 percent in 2007. Four years later, according to the Federal Reserve Bank of San Francisco it has come down only modestly: Household debt still stands at 118 percent of disposable income." The data here speaks for itself and given these figures the idea that more tax cuts, or "smaller government" will stimulate the economy will only drive is into more devastating recessions. I hope the data gets wide publicity in the media along with articles that put the blame where it belongs: the Republican economic theories not just under Bush, but those they have been pushing since Ronald Reagan became president.

- arnon

July 13, 2011 at 2:24pm

Let's assume for a second that Sufi (and Galston) are entirely correct, that household debt is dragging the economy down. Galston proposes some complex but as-yet-undefined method by which the government lowers mortgage payments. But if you want to cut household indebtedness markedly, there's a more straightforward solution: have the federal government absolve part or all outstanding federal student loans. Most people paying student loans are younger workers (or would-be workers) who have modest means; this would be a massive boon to many of them (and their parents, who are often paying loans they took out on behalf of their children). Unlike mortgages, the feds hold a sizable fraction of student loan notes; it's just a matter of declaring that they won't be collected, and then writing off the hit the government's balance sheet takes.

- benjamin81

July 13, 2011 at 3:19pm

Up next from Galston: "One theory says the earth is flat, another says it's round. What if they're both wrong? A new theory suggests that it's actually a flat surface that happens to be wrapped around a gigantic ball."

- Jeff_Smith

July 13, 2011 at 4:06pm

Let's go Galston and assume that he has in mind a higher inflation rate, which the Fed is certainly capable of doing and has the effect of lowering the value of the debt (relative to the value of the homes that secure it), generating the wealth effect (and likely higher wages) that would free homeowners to go on a spending spree. There. Problem solved. And solved with a monetary solution, no less. Thanks, fresh water economists!

- rayward

July 13, 2011 at 4:06pm

Erik_s writes: " Middle class people want what they believe they should have and are used to in an affluent, expanding economy." But today's middle class (and in fact, society as a whole) already have more than the middle class of 50 years ago in terms of stuff. So your argument that they are taking on debt to meet what their parents had cannot be right. Our parents didn't have cable in every room, family cellphone plans, unlimited internet, two cars and big houses. But our middle class today does. The bigger question is why are people today so much more willing to take on massive debt to get these things? Our parents were not comfortable with such debt, and instead did without.

- seattleeng

July 13, 2011 at 4:29pm

The investment/production class has to find a way to lend its excess income back to consumers, otherwise output sputters and producers have idle capacity and take losses. Where there is a will, there is a way, be it no-income-verification mortgages or something else. You should be deliriously happy, seattle. Here is the free market at work. The perfect solution to everything. Except that the aggregate outcome is not very good. It would be much better if income were much more equitably allocated so that we could operate at capacity without people needing debt financing. Then the investor/producer class would not have excess income to lend back to workers who are short of income and we would have a sustainable growth path. This is the thing you can never understand, seattle, that the distribution of consumption and investment is the "real" income allocation of the country. The real income of the government is its spending. The real income of labor is its consumption. The real income of capitalists is the quantity of real investment. But the nominal income shares may be different which is why some sectors have surpluses, investors for a long time now, and others, government and consumers, have deficits. If we simply aligned the nominal shares with the real shares, voila, most problems are solved. When the accounting/financial allocation is out of sync with the real distribution, due to such things as insufficiently progressive or even regressive tax structures, THEN we have problems. If the real and nominal distribution is the same, everything can proceed smoothly. If we think consumers have too much disposable income for junk, then it is simple enough to tax it away and spend it on necessary social infrastructure. Then we are still at capacity and investors do not have extra income to lend to consumers. It isn't really that hard, seattle, but you have to stop thinking of the economy as a big household. It isn't and analogies to a big household -- like consumers lowering their spending -- lead only to confusion, especially supply-side confusion.

- roidubouloi

July 13, 2011 at 4:47pm

Galston, please add Krugman's blog to your bookmarks and stop trying to act like you're so much smarter than he is. Thanks! http://krugman.blogs.nytimes.com/2011/07/13/this-morning-in-peevishness/ http://krugman.blogs.nytimes.com/2010/06/01/pre-refuting-william-galston/

- tysonsahib

July 13, 2011 at 5:42pm

Seattle does have a good point, though, in that contemporary society is, in some ways, richer in material assets (2 cars rather than 1) than it used to be. Why do we feel the need to stretch that even further with debt, I wonder? Part of it is a change in social norms (i.e. debt is more acceptable), but there has to be more to it.

- Curran1

July 13, 2011 at 6:37pm

"But today's middle class (and in fact, society as a whole) already have more than the middle class of 50 years ago in terms of stuff." Two points, first the obvious one: it's impossible to compare today's "middle class" to that of 50 years ago or older. It's precisely in the 1970's that the middle class started to lose ground and had to go into debt (credit) in order to stay "middle class." Second, since when has it become a sign of wealth to own two cars. We live in a society with uncertain public transportation and in a family where both spouses work two cars becomes a necessity. It's hardly a sign of being well off. But you can't just counts objects that people have in order to determine their status in society. This is a favorite conservative game. You can read an article from this point of view on many conservative magazines like the Weekly Standard, or the National Review. This is where Galston's point is useful when trying to figure out what is going on both economically as well as socially. The fact that so many "middle class" families have more debt than they do assets should tell us the difficult time middle class families are having staying middle class. And it's only going to get worse. In every city and town the public employees and their unions are under siege. They are asked almost daily to give up this or that benefit. We are talking about millions of teachers, firefighter, policemen, etc who consider themselves middle class because the pension plans, the health and other benefits, have allowed them to live in relative security. Having two cars and two TV's won't help you if you ill and with basic or no medical insurance, or if the value of your property goes down, or if you lose your job. At best two cars will let you drive from one part time job to another, until your cars breaks down, that is.

- arnon

July 13, 2011 at 7:50pm

One might also then ask why our wealthiest, who not only are much wealthier than those of the same decile or quintile of 50 years ago but have a much larger share of our total output than 50 years ago are so absolutely resistant to taxes that would eave them still with a much larger share of a much larger per capita output than we had when Ronald Reagan is elected. Why on earth do they need more and more and more when their insatiable greed is destabilizing the economy of our country and of the world? Any answer, seattle? This is why seattle's argument is a crock. It can be applied to everyone and explains nothing.

- roidubouloi

July 13, 2011 at 8:07pm