What's the Best Policy for a "Balance Sheet" Recession?

[ERICOPOLY]

Are all tax cuts created equal?  The Bush example was one where they just handed out cash. 

 

How about a tax cut that reduces the incentive to pay down debt?  Interest on consumer debt, for example, is not tax-deductible anymore (it used to be).  Simply putting that tax deduction back in action would reduce the attractiveness of debt retirement for consumers. 

 

That's not to say it would work, but I'm trying to question the simplistic example of the Bush tax rebate which is held as a rebuttal for all tax cuts of any kind.  He pretty much makes that argument, and I think he hasn't been very convincing.

[SharperDingaan]

 

Much of the reason for the Japanese experience dragging on so long was the refusal to write-off debt, as insisting on debt repayment by force feeding public sector borrowing (koo approach); meant that it took years for private sector liabilities to decline.

 

As debt repayment, & no new borrowing, dramatically increases regulatory capital; there is a growing & more than ample capacity to write off/restructure bad debt. Furthermore there is no income loss if the debtors are forced to issue warrants as part of the price.

 

Do this with AIG & you'll have new owners. Whether you'd do it or not depends on what AIG's existing interests put your way, to persuade you that its a bad idea.

 

SD

[ERICOPOLY]

Investors don't like bank assets inflated by mark-to-model.  The government could boost bank asset valuations by reducing the tax rate on mortgage interest (would raise the market prices of such assets).

 

That's another tax cut that isn't of the form of the Bush cash giveaways.  It gets banks better capitalized and therefore reduces the pain of deleveraging.

 

And it doesn't just favor banks.  Little grandma and grandpa retirees benefit as their savings aand pension assets can be invested at the favorable tax rates too.

[txlaw]

I'm trying to question the simplistic example of the Bush tax rebate which is held as a rebuttal for all tax cuts of any kind.  He pretty much makes that argument, and I think he hasn't been very convincing.

 

Well, tax deductions, tax credits, and tax rate changes, are very different than rebates.  Cash for clunkers was not a tax cut, but it was effectively giving money back to consumers to recirculate into the economy.  Credits for putting in energy efficient fixtures are also directly circulated back into the economy.

 

I don't think Koo would be against those sorts of policies -- in other words, I don't think he thinks that all tax policies are equal.  But he was very much against the Bush tax rebate, which just handed cash over to people without any sort of requirement or incentive for them to recirculate the cash.  I might be wrong on this though; people who have read Koo's book would have a better idea of whether he would only go with government spending.

 

Much of the reason for the Japanese experience dragging on so long was the refusal to write-off debt, as insisting on debt repayment by force feeding public sector borrowing (koo approach); meant that it took years for private sector liabilities to decline.

 

As debt repayment, & no new borrowing, dramatically increases regulatory capital; there is a growing & more than ample capacity to write off/restructure bad debt. Furthermore there is no income loss if the debtors are forced to issue warrants as part of the price.

 

Do this with AIG & you'll have new owners. Whether you'd do it or not depends on what AIG's existing interests put your way, to persuade you that its a bad idea.

 

SD

 

This goes to my point regarding why the U.S. may indeed be different than Japan.  We are more likely to cram down creditors and to institute programs to modify loans than Japan (I think).  Furthermore, lenders in the U.S. capital markets may be more willing to do debt exchanges and take ownership stakes because they are less risk averse than Japanese lenders.

 

If so, then what we might be seeing is a repeat of Japan but on an accelerated timescale. 

[ERICOPOLY]

He rather clearly is hanging his hat on the Bush tax rebate as evidence that no tax cuts work.

 

I will quote from page 19 of the document attached at the beginning of this discussion: 

http://cornerofberkshireandfairfax.ca/forum/index.php?action=dlattach;topic=1923.0;attach=194

 

 

Why not tax cuts? Politicians love tax cuts.

I like to have tax cuts myself. But from a macroeconomic

perspective, when the private sector

is minimizing debt because of a balance sheet

problem, if you give them a tax cut, they’ll be

more than happy to use that tax cut to pay down

their debt or rebuild the savings that they have

ignored for so long. But they’re unlikely to

spend it. If you remember George Bush’s tax cut

of last summer —

 

That’s exactly what happened to it.

Yes. Something like 88% of the rebate checks

were used to pay down debt or rebuild savings.

Only 12% went into new consumption. So I

would argue that tax cuts under the current circumstances

are the most inefficient way to

expand the economy for the given amount of

budget deficit.

[Dynamic]

I've also just picked up my economic knowledge via the internet, but think I've distilled enough that makes sense and discarded a lot that doesn't work or is unhelpful for gaining understanding or is specific to certain types of economic condition but otherwise fails to account for things.

 

2)  Assertion:  the economy's main issue is that there is too much private debt

 

Yes, but also that the balance sheet is out of whack because of the current market value (rather than carrying value) of the assets against which those debts are balanced. So the new uninflated/depressed market value of those assets is also a major concern, causing people/firms to irrationally* pay down debt (*according to conventional economic wisdom it's irrational, given that interest rates are near-zero, though Koo explained a very plausible rationale at the micro level)

 

Now, my question is why wouldn't you want to get back to health as quickly as possible?  That would seem to be debt retirement.  If in a "do nothing" scenario GDP shrinks as people pay down debt, then in a "tax cut only scenario" perhaps GDP shrinks less given that people have new funds with which to pay the debt down.  So if GDP is shrinking less, then why can't the remainder be made up in form of stimulus spending?  Instead of this approach, he seems to be advocating only stimulus spending.

 

In addition to the severe short-term pain mentioned by Zorro, the do-nothing scenario would probably see more money go out of circulation (a crucial part of Koo's thesis) as it sits on the bank's books remaining unlent-against. If I recall correctly, Koo said that this reduces money in circulation and thus reduces GDP, thus causing people to become more fearful and reduce asset prices (e.g. property market valuations) further. This, he said, would increase the incentive to go on paying down debt rather taking on more debt at supposedly cheap rates.

 

I'm inclined to look at this unlent money from another angle, which I'd suggest might reveal some underlying truths. This effect reverses the money-creation role of fractional reserve banks that exist in the economy we have (see centered text below), causing money-destruction instead, thus reducing the money supply (meaning cash plus credit), which means the same as "deflation of the money supply" (which does not necessarily imply a reduction in the consumer price index, in case you locked in on the word deflation alone and used its modern meaning - see below). This would actually increase the value of dollars in their asset-purchasing power, commensurately reducing the nominal-dollar value of assets further, while the debts remain constant in nominal-dollar terms, thus making the balance sheet problem worse, and increasing the incentive to pay down debt even more! So do-nothing might be worse, given that we have fractional reserve banking.

 

It's easy to think that surely a piece of real-estate must have an intrinsic value that can't keep going down like that, and indeed it may not vary so much in real value, but then the intrinsic value needs to be measured in constant dollars, not dollars that are getting more-valuable-by-the-month thanks to the money-destruction going on by the debt pay-down and deposit increases at the banks!

 

To clarify, in an economy like we have today, fractional-reserve banks (as opposed to savings-and-loan style banks) have a "money-creation" role in that they are allowed to lend out a multiple of what they hold in deposits, effectively printing new currency. Money creation is not value-creation, I should add, as it inflates the money supply, reducing the value of each nominal dollar/euro/pound/yen rather like a stock split reduces the value of each share, thus redistributing the value away from people holding cash (unlike a stock-split where the holders receive commensurately more shares to compensate). In reverse, as banks hold more deposits and have a reducing loan book, previously created money is no longer in circulation - i.e. fractional reserve bankng results in "money-destruction". This is "deflation of the money supply". I use that phrase in full, because the terms "inflation" and "deflation" which originally meant this, have been bastardized to refer instead to their most common effects on prices, without recognizing the cause of price change has its roots in the money supply.

 

In an economy like we have now, companies overall may be able to save costs yet increase or sustain prices in nominal dollars to restore profitability and help pay down debt, so we might have, for a time, deflation of the money supply accompanied by an increase in the consumer price index, which people might call "inflation" (only in the modern bastardized meaning of the term), and fail to understand the stagnation of GDP (in nominal dollars) that accompanies it, which may well be caused by "deflation of the money supply", meaning that 'real GDP' may be growing in constant dollars while it appears stagnant in nominal dollars. That's a possible Austrian-theory or Austrian business cycle theory style explanation of stagflation, a portmanteau word coined from stagnation and inflation. To call it 'stagcreasing' would reflect the price increasing with stagnation, yet doesn't sound so nice, though it would remove that misunderstood term of inflation or deflation.

 

Anyhow, Koo's idea (as used in Japan) is that the government could borrow from the fractional reserve banks at attractive rates in an amount at the usual multiple of excess deposits that fractional-reserving allows. In my way of thinking, this reverses the money-destruction role of the banks during a balance-sheet recession with an equal and opposite amount of money re-creation, thus ensuring that the supply and value of nominal dollars (cash+credit in the system) remains roughly of constant amount and thus constant purchasing power. People and business leaders think in nominal dollars (or yuan, or yen or euros or pounds), not in constant-dollars, so maintenance of the money supply may avoid too many erroneous capital allocation decisions that could be caused by varying dollar purchasing power.

 

This fiscal stimulus should approximately sustain the nominal valuations of real-estate assets and the like, ploughing the re-created money into the economy via the private-sector firms who are providing work and materials for the public good in exchange for the fiscal spending money, sustaining GDP in nominal-dollar terms through the trickle-down effect and reducing unemployment (by sustaining total production), while providing or improving public assets that ought to be of benefit to the economy for some years to come, and may in part be ripe for sale in future years, helping to pay down government debt in future, especially when interest rates aren't so favourable to such investments.

 

Certainly, realigning some of the productive capacity of a nation to producing for government projects is a distortion of free-market economic signals carried by free money flow. But then, so is a debt-fueled boom, so were the bail-outs and so is a do-nothing hangover with an abnormally concentrated level of debt pay-down and saving. Regardless of whether the first-order distortion is less or more than any other course of action, the second-order effects and beyond caused by trickle down spending of that money through the spending and consumption of the people thus employed and the profits/dividends of firms carrying out and supplying the projects ought to be relatively normally distributed in supplying for the varied consumption of these perfectly normal people, so the overall distortion of the economy might be less than usual, especially while home-building and the like are in major decline. The spending keeps many of the small and large businesses who are close to the public occupied in providing goods and services to them, and the people thus employed or earning profits thereby will be able to spend those in normal patterns also. The businesses most remote from public spending who can't adapt to supplying the fiscal stimulus projects will be those that suffer most decline, just as in any recession. Others, perhaps in certain raw materials may be unexpectedly buoyed by fiscal stimulus, only to decline when the stimulus is eventually withdrawn.

 

I note that in Charlie Munger's interview for Stanford Law (reposted on these forums a few days ago) he was talking about how Japan engaged in fiscal spending to maintain employment and GDP during their collapse, and certainly you'll hardly find a pothole on a mountain let alone in a Tokyo street. He seemed to be clear that that sort of fiscal stimulus would do more good than harm in the USA, and now I understand a lot of where he's coming from, thanks to Koo.

[ERICOPOLY]

Yes, but also that the balance sheet is out of whack because of the current market value (rather than carrying value) of the assets against which those debts are balanced. So the new uninflated/depressed market value of those assets is also a major concern, causing people/firms to irrationally* pay down debt (*according to conventional economic wisdom it's irrational, given that interest rates are near-zero, though Koo explained a very plausible rationale at the micro level)

 

I agree.  To that problem specifically I think a tax policy can help. 

 

Brainstorm a little bit about what our financial institutions would look like tomorrow if Congress acted today to cut all tax on domestic consumer loan interest and domestic mortgage interest.  In other words, put them on an even footing with tax-free muni bonds.  The market values for their assets would soar. 

 

Tax-free status brings down market interest rates for consumer loans (reflating the prices for consumer goods, making businesses confident to resume hiring).

 

This is not the same thing as the Bush tax rebate -- not at all.

 

 

[txlaw]

He rather clearly is hanging his hat on the Bush tax rebate as evidence that no tax cuts work.

 

I will quote from page 19 of the document attached at the beginning of this discussion: 

http://cornerofberkshireandfairfax.ca/forum/index.php?action=dlattach;topic=1923.0;attach=194

 

 

I'll say it again.  There is a distinction between "tax cuts" and "tax policies" (aka, "tax expenditures").

 

"Tax expenditures" -- like a mortgage interest deduction, a consumer loan interest deduction, or a tax credit for installing energy efficient windows -- are substitutes for direct government spending.  They effectuate government policy in an indirect way and can be a more surgical way to sustain or increase demand.

 

"Tax cuts" -- like a pure cash rebate or an across the board lowering of the tax rates -- are what Koo is clearly against because they leave complete discretion to the tax cut beneficiary to allocate that cash.  When everyone is focused on debt minimization, too much of the cash handed back to tax payers leaks out of the system.

 

We don't know for sure whether Koo is against targeted "tax expenditures" based on the interview.

[Dynamic]

Yes, but also that the balance sheet is out of whack because of the current market value...

 

I agree.  To that problem specifically I think a tax policy can help.  {deletia}

 

I suspected you were on the same page there, from what you'd said.

 

Yes, I guess you're right (I'm not 100% au fait with US taxation, being in England/UK where in the 1980s we had Mortgage Interest Relief At Source - MIRAS - later withdrawn, which reduced the monthly interest bill, rather than having to wait to reclaim from the tax return), and such policies may reduce the public's need to save rather than spend, especially if asset prices do rise, thus supplying a secondary boost to businesses that benefit from consumer spending, and presumably a rise in sales taxes (local in the US?).

 

I can certainly see that should reduce the number of mortgage delinquencies and defaults, and so may remove some repossessions from the housing market. Prices may rise from a reduction of supply and a possible increase in demand (through greater affordability, although fear and tight credit standards will hold back feverish demand from returning). The supply, I believe, includes a rather large overhang from excess housing build that Warren Buffett has mentioned in BRK's Chairman's Letter 2008, published Feb 2009, so supply-demand might not shift quite so much. If it prevents the dollar from appreciating in purchasing power so much, the nominal dollar value of housing assets should avoid decline.

 

I don't suppose it would help businesses directly with their balance sheet problems, because commercial interest costs are usually deductable from profits for corporation tax purposes in most countries. If it led to higher consumer spending there would be secondary benefits to business.

 

If business debt is a major component of the credit side of the equation, potentially the "money-destruction" process would continue through lack of takers for loans, but at a lower level. Perhaps the government could partly offset that process through borrowing from the banks both to offset the lost revenue from tax-breaks and to provide fiscal stimulus (including help to municipalities) in sufficient measure to sustain the circulating money supply (cash plus credit).

 

I'm not 100% convinced that market values of housing would immediately soar in response to your proposal (I can't see a definite mechanism of cause and effect to account for soaring), but it wouldn't do any harm, and should help lift them somewhat (which may feed back to provide a positive mood among potential homebuyers).

 

There's also the possibility that existing mortgagees would use the amount by which their interest payments had effectively declined to overpay on their mortgage (if allowed without penalty by the terms of the mortgage) or to increase their savings, being still-fearful, rather than to boost spending. If so, this still isn't 100% effective in solving the declining rate of borrowing, which was Koo's criticism of the Bush tax cuts too. (I'm aware that US mortgages are typically very different from UK mortgages in their terms, especially fixed rates for the duration, which is rare in Britain, so you may spot errors, and feel free to point them out)

 

Tax relief on home improvements and household energy-efficiency improvements should fully produce consumer spending with long term benefits and improvements in intrinsic house value and market value as it directly encourages spending, rather than money (or savings) to do with as you wish.

[Dynamic]

We don't know for sure whether Koo is against targeted "tax expenditures" based on the interview.

 

I guess that's another reason to try to focus our thinking on what happens in the micro level regarding incentives to spend/consume versus pay down debt.

 

And at macro level, it's important to consider what happens to the money supply as a result. Koo implies we need to avoid a shrinking money supply, and my take is that a shrinking money supply, with increased purchasing power per dollar, would reduce the nominal-dollar value of assets and increase the constant-dollar value of nominally-fixed dollar-denominated debts, thus making the incentive to repair the balance sheet greater, exacerbating the lack of spending and investment).

 

So, I guess the basic prescription is fiscal stimulus sufficient to counteract the excess savings (thus maintaining the money supply or possibly slightly expanding it, if indeed lending to government requires lower capital adequacy ratios at the fractional reserve banks). Modest expansion of money supply has the effect of reducing each debt in constant dollars, and increasing asset values in nominal dollars, thanks to their reduced purchasing power. The money supply is inflated, but "inflation" is wrongly used today to refer to its usual effect on prices, not the cause. Excessive inflation of money supply must be avoided as it undermines confidence and can lead to disastrous hyperinflation. This spending trickles down and sustains GDP in nominal dollar (which are roughly constant-dollars, given the stable money supply).

 

Any macro-level means to reduce the level of excess saving and improve people's balance sheets at the micro level will reduce the quantity and/or duration of government fiscal stimulus required by shifting the stimulus spending to the public's own spending financed via government incentives, many of which will provide long term paybacks (which makes it easier to sell to the public). Energy efficiency and R&D tax breaks can provide long-term advantages to businesses too, if the business can see the advantages outweigh the need to pay-down debt.

 

So I think Koo says, you're gonna need fiscal stimulus in any case. By all means do anything else to encourage more normal spending and less excessive debt pay-downand/or or improved asset values at the micro level, which may themselves reduce the scale of fiscal stimulus required to keep the money supply in balance. (Though he doesn't talk about money supply as much as I do!).

 

On a side note, debt-for-equity swaps suggested for balance sheet repair imply a need to admit the impaired value of assets (measured in nominal dollars), which might be hard. Then again, big-bath corporate accounting has its advanatges for quoted companies in future earnings statements, if GAAP rules allow it. But swapping debt for equity will dilute shareholders with a real current cost to each of them that may not be offset by a boost in earnings once calculated on a per-share basis over more shares. That isn't the case when writing down goodwill on expensive acquisitions or writing down excessive inventory in a big hit, and if everyone wants to swap debt for equity at the same time, would the lenders really accept that much equity?

[ERICOPOLY]

Dynamic,

I wouldn't anticipate a soaring in housing prices.

 

The assets I anticipate soaring would be the loans themselves.  I think banks would be able to sell their existing inventory at prices far higher than they can fetch at the present.  A tax-exempt bond is worth more than a taxable one.  Likewise, if we were to remove the tax exempt status from municipal bonds their market values would plunge.

 

The point behind granting tax-exempt status to municipal bonds in the first place was to provide states&municipalities with low-cost funding.

 

The Fed has tried dropping rates close to zero & tried buying back treasuries to bring the yield down.  People think we are out of ammo when it comes to driving down the market rates that consumers face but not by a longshot.  We know it's not the case because we know how effective tax-exempt status has been for municipalities.

 

I would imagine securitization market might liven up more than just a little bit in response -- banks get liquid again.

 

 

 

 

 

 

 

[Dynamic]

Thanks Ericopoly - the loans themselves. I see what you mean.

 

Would that competition in the tax free part of the marketplace impact on the desirability of municipal bonds, do you think?

 

I'm not sure about one part of the mechanism and exactly how US mortgage securitization works. If banks sell on their loan book as securities, receiving cash in return, I'd guess this improves their balance sheets and frees them up to lend more freely, lowering their creditworthiness requirements at little, thus increasing demand for housing, and when the new debt is issued, that's money creation, right? The only question is, would the banks sell on their loans as securities if the cash received is less than the purchase price of the houses when purchased or the money that was lent, presumably crystallising a loss on the P&L account and a write down on the balance sheet? Aren't most 2007-8 mortgages in negative equity, and aren't these still carried by the original lending banks who couldn't securitize? How many other mortgages are retained with the original lender? It might still make sense to crystallise a loss if the cash received lets you lend a multiple of that cash profitably to willing borrowers.

 

[ERICOPOLY]

Would that competition in the tax free part of the marketplace impact on the desirability of municipal bonds, do you think?

 

Yes I would expect this to hurt the demand for municipal debt somewhat.

 

 

I'm not sure about one part of the mechanism and exactly how US mortgage securitization works. If banks sell on their loan book as securities, receiving cash in return, I'd guess this improves their balance sheets and frees them up to lend more freely, lowering their creditworthiness requirements at little, thus increasing demand for housing, and when the new debt is issued, that's money creation, right? The only question is, would the banks sell on their loans as securities if the cash received is less than the purchase price of the houses when purchased or the money that was lent, presumably crystallising a loss on the P&L account and a write down on the balance sheet? Aren't most 2007-8 mortgages in negative equity, and aren't these still carried by the original lending banks who couldn't securitize? How many other mortgages are retained with the original lender? It might still make sense to crystallise a loss if the cash received lets you lend a multiple of that cash profitably to willing borrowers.

 

 

Investors already do not trust their mark-to-model valuations for a lot of these loans, knowing the real market price is lower.  Confidence is restored by a significant degree as the real market price is suddenly substantially higher that before.  They still might choose not to sell them, but the mark-to-model valuation has more credibility than it had the day before.  The intrinsic value of the loans is higher -- tax free cash flows being worth more than taxable ones.

 

They can cherry pick what they sell.  Some of their loans are not underwater -- the loans underwritten in the past 12 months for example.  They can sell these for large capital gains above where they are presently marked on the books.

[Packer16]

I just watched Koo's speech at the CFA conference and had a question that maybe someone can answer.  From what I hear he appears to be a tactician without an exit strategy.  He said to continue gov't spending until the private sector returns with demand.  This has never historically succeeded.  This can be a long period of time and has not even occurred in Japan (at least yet).  Is the end result that at some point the Japanese debt is going to have to be written-down and the bondholders will be the losers?  What is the alternatives or exit strategies for the large amount of debt?  If you look at history there is only one debt pile that has been gown out of and that was the post Napolianic debt of the UK.  This was when the UK had a huge competitive and mercantile advantage over all others and was thus able to do this.  All other times debt piles were either reduced via default or inflation.  Niall Ferguson also had a really interesting historical perspectives which shows what has worked and not want might work.

 

Packer

[ubuy2wron]

I just watched Koo's speech at the CFA conference and had a question that maybe someone can answer.  From what I hear he appears to be a tactician without an exit strategy.  He said to continue gov't spending until the private sector returns with demand.  This has never historically succeeded.  This can be a long period of time and has not even occurred in Japan (at least yet).  Is the end result that at some point the Japanese debt is going to have to be written-down and the bondholders will be the losers?  What is the alternatives or exit strategies for the large amount of debt?  If you look at history there is only one debt pile that has been gown out of and that was the post Napolianic debt of the UK.  This was when the UK had a huge competitive and mercantile advantage over all others and was thus able to do this.  All other times debt piles were either reduced via default or inflation.  Niall Ferguson also had a really interesting historical perspectives which shows what has worked and not want might work.

 

Packer

 

I think the post WW-2 period of all most all western nations are examples of growth in a high tax high debt environment. I for one am more than a little tired of hearing commentators speak about govt. expenditures being wastefull and not creating any real jobs. The economy really does not care where consumption occurs or wages are created, clearly building tanks was a better use of tax payers money in 1943 than filling pot-holes as losing a war has some pretty dramatic short- term negative consequences.

The entire WW-2 and post period however was one of rapidly increasing tax rates high personal savings rates a huge increase in govt spending and then after the War was over an explosion of consumer spending. I actualy believe the Bp disaster will have a stimulative effect on the economy. It will cause unemployment rates to decline in the Gulf states

[Packer16]

You are correct but the US was able to grow because there were no competitors standing after the war.  The US relied on both growth and inflation.  The UK is an example of an inflation only situation (which is where I think most of the developing world is). 

 

I have no doubt the gov't creates jobs but at what cost?  I think the best way to think about debt financed growth is borrowing growth from the future to get it today.  (This is Grantham's idea not mine) The only problem is that as debt increases, the effectiveness declines. There is a great chart in the current Economist which shows the declining effects of a $ increase in debt on economic growth.  In addition, I think looking at how the market prices your debt cannot be used to measure how much debt is too much as the debt spirals start out small and rise in a non-linear fashion.  Also, in the Economist there is a chart that shows all the world's debt situation.  It shows the the US and UK are not to far behind the PIGS.  Historically, what has happened in the situation is the bondholders (who in most cases are foreigners) get hosed by restructuring of the debt.   

[txlaw]

Packer, I don't know what Koo would say, but I think the answer to your question is a combination of reduced government spending, higher taxes, and debt monetization.   

 

But not yet, as Augustine would say.  That should occur over the long run. 

 

I'm a big fan of Jeremy Grantham, but I would disagree with the notion that government spending is always  borrowing growth from the future.  If the money borrowed is used to set up the economy so that future generations have good economic prospects, you are getting a good return by borrowing and spending today.  I think Jeremy Grantham has actually advocated something along these lines at one point, specifically in the context of an energy policy.