Debtors’ Revolt?

Tuesday, 08/11/2009 - 10:54 am by Marshall Auerback | 5 Comments

The big banks have gotten plenty of help with their debts. But what about struggling households and non-financial institutions? Roosevelt Institute Braintruster Marshall Auerback investigates.

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, healthcare, 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.” In other words, even the feds might not be able to help.

The approach to financial reform that the Obama Administration has hitherto adopted 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. Yet, 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 suggests it would not take much to engender a situation where the country experienced a widespread debt revulsion. It might come to that, given the reluctance to embrace decent alternatives, of which there were ample historical precedents from which Obama’s economic advisors could have drawn.

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 have done 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.

The reason we apparently do not adopt this alternative approach is because the banks wanted to avoid price discovery on their “legacy assets” by all means possible. They do not want the world knowing how many toxic assets they really have on their books and certainly do not want to illuminate the scale of these losses (which might show them to be effectively insolvent), as this would expose the TARP recipients to receivership and restructuring via the FDIC, thereby breaking up their power once and for all

Given current realities, an FDIC style reorganization and restructuring will not happen, barring a secondary relapse in economic activity. Which might leave the American public to take matters into their own hands via outright debt repudiation. There is a reason why there was a historical tradition of debt jubilees every 50 years and usury laws.

Maybe inflation is the modern version of these two tools to manage the effects of the dead hand of the rentiers, albeit in a more incremental fashion, but outright debt repudiation is more likely today, given the absence of any kind of inflationary pressures.

In many respects, the Argentina example of 2001 is instructive. True, the economics are not completely analogous here because Argentina repudiated foreign debt to get out of an externally imposed debt inflation, whereas here we are discussing the crushing burden of domestic debt on the part of the US household sector. Still, in many ways, the ultimate effect is the same and Argentina’s repudiation could well have the implications for the US, were American households to embrace a similar tactic.

This is where the Argentina example of 2001 is instructive. I agree that the economics are not completely analogous here because Argentina repudiated foreign debt to get out of an externally imposed debt deflation, whereas here we are discussing the crushing burden of domestic debt on the part of the US household sector. Still, in many ways, the ultimate effect is the same and Argentina’s repudiation could well have implications were American households to embrace a similar tactic.

After Argentina abandoned the dollar peg, the peso collapsed, leaving the country with a horribly burdensome deflationary foreign debt repayment program foisted on it by the IMF (yet again making the world safe for US investment banks at the expense of everybody else) as a condition for further economic assistance.

But then President Nelson Kirchner threatened to forego debt repayment to the country’s foreign creditors in the event that the IMF continued to insist on being repaid in a manner which didn’t deflate the country into the ground.

In effect, Kirchner called the bluff of the IMF and he won. Argentina repudiated its debts and immediately started to grow again, led by exports from a vastly depreciated peso. The IMF continued to insist that Argentina would remain cut off from the foreign debt markets whilst the country refused to repay its foreign debts. But the threat was exposed for the hollow one it was: the reality was that Argentina didn’t need to subject themselves to the poisoned chalice which the IMF was offering as a condition of obtaining yet more foreign credit.

(As an aside, a government’s ability to spend and service its debt is only unlimited if the payments are made in the government’s own sovereign currency, which makes the whole notion of Argentina borrowing in dollars - thereby adding an unnecessary external constraint on growth - nonsensical as a future growth strategy.)

By the same token, if the American household sector repudiates debt by living in the house until the sheriff shows up without paying a mortgage, and then paying rent once they get kicked out, banks will then do what - shut new credit off to the private sector? Already done. In the meantime, the household sector (like Argentina when it repudiated its foreign debt) will have just increased the discretionary income and wiped the liability side of its balance sheet. Then it is just a matter of Mr. Geithner figuring out another way to stress test the banks back into Treasury Department seals of approval, and voila, presto change!

Or maybe a debt repudiation of the magnitude we envisage might force President Obama to stop diddling around with the Rubinite wing of the Democrats and embrace an approach which prevents US households from losing wealth of an amount equal to the negative equity they have in their respective homes, while the banks write down their assets to market.

Ironically, by overplaying their hand, the banks might be forcing the households to adopt an approach that will ultimately weaken the banks and expose them as the emperor with no clothes. They will take huge hits to their capital if faced with widespread debt repudiation. Now, I expect you’ll get a host of lawsuits and the very essence of the law of contract will come under attack if this scenario occurs, but the average American household might feel he has no choice and Obama might accommodate himself to these populist winds as he did in the Chrysler case, in effect overturning years of established bankruptcy law with no particular political cost to himself. At the very least, the more effectively people create a sense of urgency and crisis via these kinds of actions, the easier it will be for the President to push for progressive legislation, which overturns years of destructive policy making and finally delivers the change that many of us thought we were voting for last November.

Roosevelt Institute Braintruster Marshall Auerback is a market analyst and commentator.