Few popular terms irritate me as much as “deleveraging”.
Yes, the concept is important. In fact, it’s probably central to understanding why we’re in such a rut. But almost everyone talking about it fails to understand why it matters, and why it’s intimately related to monetary policy.
Sure, most people know the basic idea: during the crisis, consumers and businesses experienced an enormous hit to net worth, and now they want to improve their balance sheets. To do so, they spend less—but since lower spending means lower income somewhere else in the economy, in the aggregate balance sheets barely improve at all. The economy is depressed as it gradually returns to the correct level of leverage, and we experience the “long, painful” process of deleveraging. (In the words of, well, every blogger and amateur econ pundit in the world.)
Great story. Too bad it ignores everything else we know about macroeconomics.
After all, why should the desire to spend less and save more hurt the economy? If I want to save, I hand my money over to someone who wants to borrow or invest it. Net saving is channeled into productive investment. If consumers want to save more, we’ll see lower consumption but an investment boom—hardly a disaster for the economy.
Sure, you say, but maybe no one wants to invest this money. Won’t an increase in savings then mean that the economy crashes? After all, the money isn’t being spent on consumption, and it has nowhere else to go.
Although this sounds plausible, it doesn’t really make sense. At the micro level, economists don’t worry about weak demand causing a supply glut: instead, they correctly say that prices will adjust to clear the market. The same is true for macro as well. There’s a price—the real interest rate—that determines willingness to save and invest. Like all prices, this price has a market-clearing level: at a sufficiently low real interest rate, the supply and demand for savings will equate, and consumers’ desire to save will translate into an investment boom, not an economic downturn.
The hitch is that the “market” doesn’t quite control interest rates: the Fed does. It controls both nominal interest rates (by setting them) and real interest rates (by shaping inflation expectations). Worse, nominal interest rates can’t go below zero. And if a real interest rate of -X% (0% nominal minus X% inflation) isn’t enough to clear the market and channel money from savers to investment, we’ll see a downturn after all.
So yes, deleveraging can be very bad for the economy. But this is only because monetary policy doesn’t adjust enough to match the market.
In failing to understand this core logic, most commentary about “deleveraging” is rather bizarre. At some level, it’s the same cluelessness that we once saw from central planners: they’d trip over themselves in the complexity of fixing a shortage in one market or a glut in another, never quite realizing that the price mechanism would do their work for them. Right now, historically low inflation expectations and below-potential output are prima facie evidence that real interest rates are too high. That’s what every macro model tells us is associated with contractionary policy by the Fed. Yet we see pundits lost in all kinds of complicated, small-bore proposals to stimulate the economy—when the fundamental, overriding dilemma is getting the price (in this case, the interest rate) right.
This isn’t to say that non-monetary proposals should be abandoned entirely. Monetary policy doesn’t stop working at the zero lower bound, but it is a lot harder. Even an ideal Fed would probably find itself constrained. This means that we should be open to other policies that affect demand—possibly via government spending, transfers, or tax incentives. But once we recognize that the fundamental problem is monetary, the issues become much clearer. The Fed’s failure to use all the tools at its disposal—in particular, its failure to make a conditional commitment like the one proposed by Chicago Fed President Charles Evans—is by far the most serious failure of economic policy today.
Note: High on the list of people who do understand deleveraging are Gauti Eggertsson and Paul Krugman. It’s even obvious from the title of their paper: “deleveraging” comes right before “the liquidity trap”, i.e. the zero lower bound making it difficult for the Fed to properly accommodate the effects of deleveraging.