Policy responses to debt overhang: Asset price support

The role of sectoral balance sheets, and their linkages, is used oftentimes to explain the euro area crisis and the sluggish recovery. Richard Koo's holy grail narrative of balance sheet recessions experiences a post-academic renaissance. A recent Vox piece by Jorda, Schularick, and Taylor adds to the empirical analysis in this field. (Let me forgive them to cite the infamous 90 percent public debt-to-GDP threshold.)

Their research shows that in advanced economies, balance sheets of the household and financial sectors empirically play a pivotal role in explaining the outbreak of crises and the speed of recovery. Strong government balance sheets, i.e. low public debt and a healthy structural balance (also coined "fiscal space"), help to mitigate a shock.

These are all useful empirical insights, but what are the mechanics which need to be understood to develolp effective policy responses? This is yet less clear. This blog argues for the importance to prevent asset price undershooting, using the example of the recent household debt crises in Ireland, Spain, and--to a lesser degree--the UK and US.

In these countries, households thrive to deleverage, i.e., shrink and repair their balance sheets from a debt load which exceeded 100 percent of GDP. Agents save instead of spend, in turn depressing incomes and output. For instance, household savings rates since 2007 jumped by 4-5 percentage points in Ireland and the UK. House price declines of 50 percent in Ireland, 30 percent in Spain, and 20 percent in the US have spread negative equity which in turn induced mortgage default, crippling the banking system.

The usual policy response of bank stress tests, bank recapitalization and the like has ensured banks are mostly sound and well capitalized. Also, interest rates, the core monetary policy tool, has in part helped households' debt burden to become more affordable and reduce defaults. But many banks couldn't benefit from lower rates, owing to impaired monetary transmission channels.

So... what other policies are needed?

Direct debt relief would help but in many cases is unaffordable. While household debt relief following the Great Depression or in the fairly small mortgage sector in Iceland worked, the public purse is too small for such a policy response in places like Spain, Ireland, and the Netherlands where household debt is higher and public debt not low. If markets see such a policy as undermining public debt sustainability and demand higher risk premia, banks' funding conditions usually worsen as well, offsetting the benefit of such policy.

What looks more promising is a financial policy that buffers asset prices which, given the size of balance sheets, could have a very wideranging effect. Generally, market prices often get depressed amid thin trading in the aftermath of popped price bubbles, and it takes little to avoid asset prices to undershoot their fundamental levels. This will prevent damage from balance sheets of all agents holding that asset. Thus, in countries with a high degree of home ownership, a policy that carefully avoids excessive house price slumps can bring broad benefits to households' balance sheets.

In general, this line of argument supports asset purchases. Yet, not all assets can in any practical way be purchased by central banks (think houses). Thus, there is also a role for regulatory policy to be used to support asset prices. Procyclical tightening of prudential and tax rules, such as in the Netherlands, is not what I mean.