Debt, deleveraging, and the liquidity trap: A new model | vox - Research-based policy analysis and commentary from leading economists

Debt, deleveraging, and the liquidity trap: A new model | vox - Research-based policy analysis and commentary from leading economists:

...much analysis (including my own) is done in terms of representative-agent models, which by definition can’t deal with the consequences of the fact that some people are debtors while others are creditors. ...instead of thinking in terms of a representative agent, we imagine that there are two kinds of people, “patient” and “impatient”; the impatient borrow from the patient. There is, however, a limit on any individual’s debt, implicitly set by views about how much leverage is safe.

We can then model a crisis like the one we now face as the result of a “deleveraging shock.” For whatever reason, there is a sudden downward revision of acceptable debt levels – a “Minsky moment.” This forces debtors to sharply reduce their spending. If the economy is to avoid a slump, other agents must be induced to spend more, say by a fall in interest rates. But if the deleveraging shock is severe enough, even a zero interest rate may not be low enough. So a large deleveraging shock can easily push the economy into a liquidity trap. ...If debts are specified in nominal terms and a deleveraging shock leads to falling prices, the real burden of debt rises – and so does the forced decline in debtors’ spending, reinforcing the original shock. One implication of the Fisher debt effect is that in the aftermath of a deleveraging shock the aggregate demand curve is likely to be upward, not downward-sloping. That is, a lower price level will actually reduce demand for goods and services.

More broadly, large deleveraging shocks land the economy in a world of topsy-turvy, where many of the usual rules no longer apply. The traditional but long-neglected paradox of thrift – in which attempts to save more end up reducing aggregate savings – is joined by the “paradox of toil” – in which increased potential output reduces actual output, and the “paradox of flexibility” – in which a greater willingness of workers to accept wage cuts actually increases unemployment.

...ebt is often invoked as a reason to dismiss calls for expansionary fiscal policy as a response to unemployment; you can’t solve a problem created by debt by running up even more debt, say the critics. Households borrowed too much, say many people; now you want the government to borrow even more?

What's wrong with that argument? It assumes, implicitly, that debt is debt – that it doesn't matter who owes the money. Yet that can't be right; if it were, debt wouldn't be a problem in the first place. After all, to a first approximation debt is money we owe to ourselves – yes, the US has debt to China etc., but that's not at the heart of the problem. Ignoring the foreign component, or looking at the world as a whole, the overall level of debt makes no difference to aggregate net worth – one person's liability is another person's asset.

It follows that the level of debt matters only because the distribution of that debt matters, because highly indebted players face different constraints from players with low debt. And this means that all debt isn't created equal – which is why borrowing by some actors now can help cure problems created by excess borrowing by other actors in the past. This becomes very clear in our analysis. In the model, deficit-financed government spending can, at least in principle, allow the economy to avoid unemployment and deflation while highly indebted private-sector agents repair their balance sheets, and the government can pay down its debts once the deleveraging crisis is past.