Debt, deleveraging, and the liquidity trap

Paul Krugman, 18 November 2010

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If there is a single word that appears most frequently in discussions of the economic problems now afflicting both the US and Europe, that word is surely “debt.” Between 2000 and 2008, household debt rose from 96% of US personal income to 128%; meanwhile, in Britain it rose from 105% to 160%, and in Spain from 69% to 130%. Sharply rising debt, it’s widely argued, set the stage for the crisis, and the overhang of debt continues to act as a drag on recovery.

The lack of formal theory

The current preoccupation with debt harks back to a long tradition in economic analysis, from Fisher’s (1933) theory of debt deflation to Minsky’s (1986) back-in-vogue work on financial instability to Koo’s (2008) concept of balance-sheet recessions. Yet despite the prominence of debt in popular discussion of our current economic difficulties and the long tradition of invoking debt as a key factor in major economic contractions, there is a surprising lack of models – especially models of monetary and fiscal policy – of economic policy that correspond at all closely to the concerns about debt that dominate practical discourse. Even now, 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.

New work that I’ve done with Gauti Eggertsson (Eggertsson and Krugman 2010) seeks to provide a simple framework that remedies this failing. Minimal as the framework is, I believe that it yields important insights into the problems the world economy faces right now – and it suggests that much of the conventional wisdom governing actual policy is wrong-headed under current conditions.

The model’s economic logic

We envision an economy very much along the lines of standard New Keynesian models – but 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.

Fisher’s (1933) notion of debt deflation emerges immediately and naturally from this analysis. 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.

Where our approach really seems to offer clarification, however, is in the analysis of fiscal policy.

Implications for fiscal policy

In the current policy debate, debt 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.

In short, one gains a much clearer view of the problems now facing the world, and their potential solutions, if one takes the role of debt and the constraints faced by debtors seriously. And yes, this analysis does suggest that the current conventional wisdom about what policymakers should be doing is almost completely wrong.

References

Eggertsson, Gauti and Krugman, Paul (2010), “Debt, Deleveraging, and the Liquidity Trap”, mimeo

Fisher, Irving, (1933), “The Debt-Deflation Theory of Great Depressions,” Econometrica, Vol. 1, no. 4.

Koo, Richard (2008), The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession, Wiley.

Minsky, Hyman (1986), Stabilizing an Unstable Economy, New Haven: Yale University Press.

 

Topics: Macroeconomic policy
Tags: debt, fiscal deficits, global crisis

Paul Krugman
Professor of Economics, Nobel Laureate, and CEPR Research Fellow

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