The IMF Goes All-Out on Balance-Sheet Recessions, Providing Sanity on Economic Policy

Jul 3, 2012Mike Konczal

The literature summary I just put out on balance-sheet recessions examines the recent April 2012 World Economic Report by the IMF. It is remarkable how important this report is. The relevant part is Chapter 3, Dealing with Household Debt. This IMF report is well to the Keynesian side of almost all major US debate, and its recommedations and observations are incredibly sensible. You should read it all, but I want to point out five few high-level arguments they make:

1. A run-up in household debt and leverage explains the economic collapse across countries.

Here's a graph they include, comparing increases in household debt-to-income ratios from 2002-2006 against consumption collapses in 2010.

Implicit here is that the problems aren't labor "inflexiblity" or whatever the latest faddish argument is. It's household leverage.

You see the same exact relationship across the states in the United States, where the biggest increases in household leverage ratios (i.e. the places with the biggest housing collapses) have the worst unemployment and consumption collapses. In the United States monetary policy and transfers help mitigate this. We send checks to Arizona and Florida, where housing is a disaster. As Paul Krugman and others have pointed out, there are no equivalent transfers across these countries, especially in the Euro.

2. Financial crises are not a driver of prolongued recessions. If anything they are a symptom.

There's a common wisdom among many elites that prolongued recessions are just what happens in the aftermath of a financial crisis. Most people who argue this derive it from Kenneth Rogoff and Carmen Reinhart's This Time It's Different. These arguments have always been a bit difficult to justify. Usually people who invoke them call for inaction, as if there isn't anything to be done but let the recession run its course.

The IMF report looks at OECD data on housing busts over the past 30 years and compares housing busts with large household leverage ratios with those with low ratios. Busts with large household leverage ratios have much bigger drops in consumptions years out, just like what we see in our recession. What is important is that this holds with or without financial crises:

They don't discuss it, but this implies that the causation runs the other way; countries that have giant drops in housing values and/or increases in debt-to-income ratios probably create financial crises. But this means that having a financial crisis, like we did, doesn't change the game; it just amplifies the case for normal demand-side stimulus.

III. HAMP is a failed program.

I remember when saying that HAMP was a failed program that was making the situation worse was a controversial opinion. At the recent Netroots Nation I was chatting with David Dayen and we talked about his portrait of HAMP series from fall 2010, which included the title that HAMP "makes your financial situation worse." That was an argument that had to be built, one data dump and one blog post at a time, over Treasury trying hard to convince people otherwise.

We bloggers ringing the bell about HAMP also argued two additional points: that Treasury wasn't actually spending the money Congress told it to spend on homeowners. This was at a point where trying to find additional funding for stimulating the economy was the highest priority. And it was also well after the second round of TARP funding went out based on promises by Larry Summers of spending that allocated money on homeowners. And, secondly, that these problems weren't going away, because they were fundamental to how HAMP was designed.

Here's the IMF: "HAMP had significant ambitions but has thus far achieved far fewer modifications than envisaged....By the same token, the amount disbursed under MHA as of December 2011 was only $2.3 billion, well below the allocation of $30 billion (0.2 percent of GDP). Issues with HAMP’s design help explain this disappointing performance." All three points, taken for granted in the report.

IV. Foreclosures are a problem.

It's never been clear whether Treasury views mass foreclosures as a macroeconomic problem. Well, the IMF does:
A further negative effect on economic activity of high household debt in the presence of a shock, postulated by numerous models, comes from the forced sale of durable goods (Shleifer and Vishny, 1992; Mayer, 1995; Krishnamurthy, 2010; Lorenzoni, 2008)...The associated negative price effects in turn reduce economic activity through a number of self-reinforcing contractionary spirals.
The IMF staff notes that “distress sales are the main driving force behind the recent declines in house prices—in fact, excluding distress sales, house prices had stopped falling” and that “there is a risk of house price undershooting” (IMF, 2011b, p. 20)...Overall, debt overhang and the deadweight losses of foreclosures can further depress the recovery of housing prices and economic activity. These problems make a case for government involvement to lower the cost of restructuring debt, facilitate the writing down of household debt, and help prevent foreclosures (Philippon, 2009).
Couldn't put it better myself. Ironically I had first heard the theoretical financial-macroeconomic arguments about preventing the fireselling of assets into a depressed market from Shleifer/Vishny's 1992 paper that the IMF cites. Shleifer is a protégé of Larry Summers, so I assumed Summers might have gone a bit harder about preventing the mass fireselling of the largest consumer asset, an asset which just has a gigantic collapse in value, into the largest economic downturn since the Great Depression. Alas.
V. Demand demand-side stimulus. Across the board. Now.
One has good reason to dread hearing the policies the IMF recommends for a country in a crisis. Maximal labor "flexiblity"? Cat food for old people? Picking government functions out of a hat to privatize? What does the IMF recommend here? Ok, brace yourself:

Temporary macroeconomic policy stimulus...simulations of policy models developed at six policy institutions suggest that, in the current environment, a temporary (two-year) transfer of 1 percent of GDP to financially constrained households would raise GDP by 1.3 percent and 1.1 percent in the United States and the European Union, respectively...Monetary stimulus can also provide relief to indebted households by easing the debt service burden...A social safety net can automatically provide targeted transfers to households with distressed balance sheets and a high marginal propensity to consume, without the need for additional policy deliberation...

Support for household debt restructuring: Finally, the government may choose to tackle the problem of household debt directly by setting up frameworks for voluntary out-of-court household debt restructuring—including write-downs—or by initiating government-sponsored debt restructuring programs. Such programs can help restore the ability of borrowers to service their debt, thus preventing the contractionary effects of unnecessary foreclosures and excessive asset price declines.

There's then a major discussion about what went right in the United State's Great Depression and Iceland's recent collapse on comphrensive housing policy.

Huh. That's actually an amazing set of polices. When can we start? And can we get the IMF advising US economic policy if this is what they are suggesting?

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