Debtor's Revolt?

Once all the TARPs are tidied up and the quarterly profits no longer a revelation, American consumers will still be swaddled in debt. What's to stop them from just walking away from it -- and who's to say, if the banks keep this kind of behavior up, we don't want them to?

In The Holy Grail of Macroeconomics, an account of post-bubble Japan, Richard C. Koo illustrates that highly-indebted corporations with depressed asset holdings and a positive cash flow will embark on sustained debt repayment until their balance sheets are healthy once again. He argues that this happened in Japan over the last two decades and also happened in the U.S. over the four years of the Great Depression. This ongoing debt repayment created decades of economic stagnation, particularly because the fiscal response was so fitful and inconsistently applied.

But does it follow that sustained debt repayment will be the response of a household sector in the U.S. with destroyed asset holdings and high debt? To our way of thinking, it is unclear. This is especially the case with respect to mortgage indebtedness; U. S. households have non-recourse mortgage loans and can walk away from their debts rather than pay them down.

Public opinion polls reveal that Americans are angry about the current economic, health care, housing and environmental crises. Polls also document that a significant majority of Americans want the federal government to do something to fix these problems. But you've also got the makings of a huge neo-populist anger brewing, largely because (in the words of Frank Rich), "What disturbs Americans of all ideological persuasions is the fear that almost everything, not just government, is fixed or manipulated by some powerful hidden hand, from commercial transactions as trivial as the sales of prime concert tickets to cultural forces as pervasive as the news media."

The approach to financial reform that we have adopted so far is a classic illustration of this problem. Financial institutions are now back to business as usual and have provided limited help to the non-financial sector. In fact, some of them are clearly committed to worsen households' financial position and have oriented their activity toward this end in order to maximize their profitability. They have received commitments from the taxpayer totaling $23.7 trillion.

On the other side, households and other non-financial institutions, whose dire finance is at the heart of the crisis, have received very limited help. Loan modifications programs and fiscal measures to raise their income and restore their creditworthiness have been too small to deal with the massive size of their financial problems, as we discussed in an earlier post. All of this should suggest that it would not take that much to create a situation where you have a widespread debt revulsion. It might come to that, given the paucity of decent alternatives, of which there were ample historical precedents.

Consider the case of German reunification in 1989. If you recall, the East Germans, like their West German counterparts, had banks with deposit liabilities and loans to firms. With unification, Est marks and D-marks were converted at 1-to-1, so all those firms now owed DM and the households had DM deposits. The old East German banks would have been instantly bankrupt since their assets went to zero on a commercial "mark to market" basis. Had things been left there, it would have meant that the households lost all their deposits-not a good political or economic solution. So the answer was to merge the East and West German banks, but the West German banks were not about to take on all those deposits against the bad assets, so the Government gave the banks special issue of government debt of an amount equal to the deposits to balance the books and give the bank some additional asset income.

How to fill the gap today? So far we have been letting the banks swap the assets at more or less full value for treasury securities from the Fed while we do nothing for the households. Yet both have notional losses that we don't want to recognize until the household walks and then we have to. The alternative would be to have the government absorb the difference, but by issuing, say, 50-year bonds to the banks against the banks writing down the loans.

For the rest of the story and more from Marshall Auerback's ideas, view the complete post at NewDeal2.0.