Finding the exit

How you think we might get out of our current economic problems has something to do with how you think we got into them in the first place.

Let me begin by noting several remarkable trends that accelerated dramatically over the last decade. The first is a steady decline in the saving rate, which actually became negative briefly during the phenomenal debt accumulation of 2005.


The second is the climbing ratio of household mortgage debt to GDP.


The third is the drop in the equity stake of households in their homes.


What caused these dramatic changes? Certainly one factor that contributed to the trend in all three series over the last decade was the extension of bigger mortgages to households that traditionally would not have qualified. For example, Ashcraft and Schuermann (2007) noted that of the $2.7 trillion in new household mortgages that were originated in 2005, 22% went to subprime borrowers, 14% to alt-A, and 21% to jumbo loans.

Fed Chair Ben Bernanke in 2007 attributed this increase in access to mortgage borrowing to technological improvements in the lending process:

the expansion [in subprime mortgage lending was] spurred in large part by innovations that reduced the costs for lenders of assessing and pricing risks. In particular, technological advances facilitated credit scoring by making it easier for lenders to collect and disseminate information on the creditworthiness of prospective borrowers. In addition, lenders developed new techniques for using this information to determine underwriting standards, set interest rates, and manage their risks.

Presumably one of the things we can agree upon today is that Bernanke’s analysis on this matter was incorrect. These new loans weren’t smarter and better, but stunningly stupid. Here’s the characterization I offered in 2007:

mortgages with no downpayment, negative amortization, no investigation or documentation of the borrowers’ ability to repay, and loans to households who had demonstrated problems managing simple credit card debt.

Why does this matter for what we do next? One view of the current situation is that the core problem at the moment is that consumers are too frightened to spend and banks too hamstrung to lend. If that was your view, you might think that the goal of policy is to spur households back into borrowing and banks back into lending. But when I look at the three graphs above, my reaction is that it’s neither feasible nor desirable to return to the ratios as they stood in 2005. The low saving and high leverage that we saw in 2005 were an anomalous departure from the likely sustainable steady-state values, and there will be no road that leads back to those from here.

If that’s the case, then resuming economic growth requires replacing spending on consumption and residential fixed investment with nonresidential investment and net exports. But charting a course for how to get there is profoundly challenging– what firm would want to invest in the current environment, and which country is in a position to increase their purchases from us?

So Plan B, at least in the interim, would seem to be an increase in the fraction of GDP devoted to government investment.

Originally published at Econbrowser and reproduced here with the author’s permission.

2 Responses to "Finding the exit"

  1. Anonymous   December 16, 2008 at 8:46 am

    this is a short brilliant piece unlike anything i have read. thank you.

  2. HowardA   December 16, 2008 at 8:31 pm

    Robert Reich today offers his prediction of the new economic landscape. Here’s a hint: less consumer consumption; more governmental programs; intentional, long term, deficits.