Turner Turns (5) De-leveraging

Adair Turner explains that during the upswing, debt contracts fool us.

The mode of the frequency distribution of returns is getting all your money back. People start to believe that the mode is the entire distribution of possible returns. Prior to the GFC, banks lent money where there was not a reasonable expectation of return. Risks of default were neglected. Subprime lending is the worst example.

In the downswing, debt contracts exacerbate the problem. Irving Fisher’s article covered three problems.

1. Bankruptcy and Default
   Debt contracts do not respond to downturns in the economy, because they are non-state contingent. Adjustments occur in a jumpy fashion through bankruptcy and default. Real estate fire sales occur. Bankruptcy and default were missing from the DSGE models used by central banks.

2. Roll-over needs and Impaired Lending Capacity
   An equity contract goes on forever. It may decrease in value, but it does not have to be repaid. Debt contracts have a specific term and have to be rolled over. If banks stop lending, there is a problem.

3. Debt Overhang
   People feel shocked at their level of leverage and try to repay debt. Companies stop investing. Households stop consuming. These effects exacerbate the economic downturn.

The debt overhang is the reason why we have had such a slow and weak recovery from the GFC.

We do not know how to get rid of leverage in an economy. We just know how to shift it around, mostly from the private sector to the public sector. Excessive private debt is shifted from the private sector to the public sector or from one country to another. The rise of Chinese debt is the natural consequence of de-leveraging in the west, which was driving a deflation in china. We do not know how to get rid of leverage.

The accepted wisdom does not produce the optimal quantity of credit. The reason is that there is not one natural rate on interest. Natural interest rates are heterogeneous through time, and across sectors and categories of lending. In a real estate boom, shifting the interest rate from 5% to 5½% will do nothing. Increasing the interest rate to 10% will wreck the real economy long before the boom is slowed. There is heterogeneous interest rate elasticity of response.

This last paragraph explains why orthodox monetary policy does not work in New Zealand. When low interest rate cause a housing boom, the Reserve Bank of NZ pushes up interest rates. The carry trade responds by bringing funds to New Zealand to get the higher rates. This strengthens the NZ dollar, which creates problem for the export sector. This policy hurts the export sector long before it cools the housing market.