Debt, Deleveraging, and the Liquidity Trap
November 18, 2010, 2:25 pm
That’s the title of a new paper I’ve written with Gauti Eggertsson of the New York Fed. Paper here (pdf, very wonkish). Relatively informal summary at VoxEU.
More a bit later.
Update: And, back above ground.
The usual disclaimers apply to the paper: it represents Gauti’s and my views, not those of the NY Fed. For those who haven’t been following, Gauti has really been taking the lead in trying to model policy when interest rates are up against the zero lower bound; what we’re doing here is trying to apply his expertise to the problem of how to think about what happens in a “Minsky moment,” when everyone decides that debt is too high.
What follows are my views only.
The first question many readers might ask is, why do this? It’s actually a very simple model by the standards of modern macroeconomics, but it does have some formidable-looking equations, even as it rests on some patently untrue assumptions about reality.
The answer I’d give is that models are an enormously important tool for clarifying your thought. You don’t have to literally believe your model — in fact, you’re a fool if you do — to believe that putting together a simplified but complete account of how things work, with all the eyes crossed and teas dotted or something, helps you gain a much more sophisticated understanding of the real situation. People who don’t use models end up relying on slogans that are much more simplistic than the models — debt bad, inflation bad, savings good, all of which are just wrong some of the time.
Regular readers may note that my own writing on the current crisis has gotten — I think it has gotten — considerably clearer in the past few weeks. That’s because I have been working on this model!
The other thought I have is that if our view of the current crisis as largely a deleveraging shock is correct, and if our basic outline of how things work in the aftermath is also correct — both of which I believe — then the gods really hate us. For the slump that follows a deleveraging shock is simultaneously gratuitous and almost impossible to avoid.
What do I mean by that? The model, and more broadly overall logic, suggests that there is good no reason why the economy has to suffer a large loss of output and employment after a Minsky moment. The capacity is there, and nothing about the fact that some people have too much debt makes it impossible to use that capacity to produce goods and services for other people.
But the policies that can prevent that gratuitous slump — a commitment to higher inflation over the medium term, and/or deficit spending — run right up against ingrained prejudices. The foundations for the shock were laid by a long period of relative stability, especially low inflation; it’s very hard for policy makers to accept that what was good in 2000 or even 2007 is no longer at all good now that Minsky has struck. And everyone has just seen the punishment for too much debt; asking others to run up debt to help fix the problem, even though it’s right, is unavoidably a tough sell.
We might nonetheless have been able to get through this with less damage if we’d had strong leadership and clear thinking from the economics profession. But as it was …
Anyway, if you want to know what’s lurking behind what I say about our economic mess, now you know.
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