Balance Sheet Recession

Everybody's talking about the balance sheet recession today, as we find Paul Krugman, Brad DeLong and Matthew Yglesias discussing William Galston's piece for The New Republic.

Delong and Krugman are both ticked off that Galston seems to have called out liberal economists for not saying something that both of them in fact said several times, starting a good while ago - that the US and the world are suffering from a "Balance Sheet Recession."

So what is a balance sheet recession? In plain English, a balance sheet recession is when households suddenly become unable to continue spending money because they owe too much money against too few assets.

The reason I want to highlight this is because this is intimately connected with the discussion we've been having at Yglesias' place about monetary policy. As I've noted before, banks always lend when they can find creditworthy borrowers at prevailing interest rates and never otherwise. You can increase the supply of creditworthy borrowers by lowering the interest rate, but you can't increase it beyond a certain point because households that have strained balance sheets aren't creditworthy at ANY positive interest rate.

To fix a balance sheet recesssion, you have to fix household balance sheets. You can do that in a lot of ways. One way is directly, via mortgage modification which would work immediately, another is by deficit spending which operates on a bit of a lag.

At current rates, as Galston notes, at the current rate of deleveraging it's going to be a LONG time before we're back to normal levels of household indebtedness. That means a long recession. If you want to jumpstart the recovery you have to repair those balance sheets faster. Regardless of who said what when, maybe now we can all agree that this is the current situation and start discussing how to approach it.

Matt actually gets us started:

[T]he best resolution would be to set a higher Nominal GDP growth target and clarify that the Fed is willing to accommodate Reagan-era levels of inflation if that’s what’s necessary to achieve it.

I don't actually think that would work (the Fed can set whatever target inflation rate it wants, but it can't actually cause that inflation to happen), but bravo to Matt for pointing us in the right direction - toward solving the problem instead of arguing over who diagnosed it first.

In my view the best resolution would be to send everyone a $500 check every month until we get back to a normal level of household indebtedness. This program would cost 150 billion dollars a month. That's a lot! It wouldn't pay for itself. It would increase the deficit! It might even cause INFLATION!!!!!!one!1! It would also repair the balance sheets, and the economy.

Not the best sales pitch, I know. But it has the advantage of being completely accurate.