From Frederick Taylor’s The Downfall of Money:
In the end, no one really got their money, not even the Americans. Germany used the American loans it received under the 1924 Dawes plan to pay reparations to the French and the British, who in turn used the money to service their own debts to the USA. Then, during the Great Depression, all the major powers, including Germany, France and Britain, effectively defaulted on what they owed to America, and into the bargain the Germans defaulted on reparations.
This reminded me of one of Tyler Cowen’s mantras, that we are not as wealthy as we thought we were. His implied model of recent economic events is that we had illusory wealth during the housing bubble and then reality bites. Some random thoughts:
1. Taylor’s picture of the 1920s suggests a possible wealth-illusion story for the Great Depression. The Germans did not think that they were going to pay anywhere near the full amount of reparations, so they did not count that full amount in their liabilities. However, the Allies were counting on receiving the full amount of reparations (as my previous post on the book indicates, the citizens were led to expect even more than the political leaders were really going to try to collect). In effect, reparations were being double-counted as aggregate wealth, with consumers in the Allied countries counting them as assets but without offsetting liabilities in German households. Then, around 1930, Allied households finally marked down their wealth, and you had the Great Depression.
2. Macroeconomists know that Keynesian fiscal policy effectiveness depends on wealth illusion. The question “Are government bonds net wealth?” must be answered “yes” in order for deficit spending to raise aggregate demand. Otherwise, if Barro-Ricardian equivalence holds (so that the increased wealth of the holders of government bonds is offset by the decreased wealth of households who have marked up their future tax liabilities), then deficits are not clearly expansionary.
3. In theory, wealth illusions do not have to be destabilizing. Economic activity does not have to rise and fall just because people have higher or lower perceptions of wealth. Complete wage and price flexibility would be sufficient to maintain full employment. I am not sure that complete wage and price flexibility is even necessary. However, in practice it seems likely that wealth illusions would prove to be destabilizing.
4. From a PSST perspective, one can imagine all sorts of patterns of trade that depend on perceptions of wealth. When wealth illusions break down, it is not as if all households take an equally proportionate hit. Some households lose more than others. For example, when the housing bubble broke, people who had a lot of their (illusory) wealth in housing lost more than people who did not. So when (illusory) wealth is redistributed, old patterns of specialization and trade become unsustainable, and there will be unemployment until new patterns are established.
5. One could argue that the increase in government debt financed by quantitative easing is fostering a wealth illusion in countries where it is taking place. Indeed, that is in some sense the intent–see point (2). Perhaps we should be more worried than we are about how the process of unwinding this wealth illusion can be accomplished without pain. Actually, I am plenty worried about it.
A very simple story of wealth illusion works through asset-valuation shocks to the consumption smoothing model.
Let’s say you have your expected paths of salary, retirement years, and asset valuations and you consumption smooth with a high savings rate.
All of a sudden your forecast for the future equity you have in your home spikes. It’s a windfall like winning the lottery. You readjust your consumption to a new, higher level, and your savings rate goes down.
Indeed, if the bank agrees with you, your savings rate can go negative, because you are able to access credit against your unexpected equity windfall and conduct Mortgage Equity Withdrawal. For several years during the bubble, MEW represented fully 9% of all disposable income! See here. That’s quite a boost!
Today, equity rebuilding is a -3% drag (vs. the Great Moderation trend), and at the recession low point it touched -7% (so a maximum consumption swing of almost a sixth of disposable income in only 4 years.) The higher savings rate is consistent with a negative shock to expected equity.
It may also be consistent with a negative shock to expected real interest rates that one can get on one’s savings. And there is also the matter of a large bump of the population being in the baby-boom near-retirement age cohort, which means they have less time to adjust and must make more severe adjustments to their consumption levels.
So, Positive-but-false-wealth-shock through politically-motivated relaxation of underwriting standards and an easy-credit-fueled asset bubble, ability to bring forward future consumption through the credit channel, and then a negative-wealth-shock correction means that on an individual basis, one’s consumption after the boom-bust must be less than the pre-bubble trend to make up for the mistakenly excess consumption enjoyed during the boom.
Yes, the story is somewhat over-simplistic. But it’s also not too bad in my opinion. Personally, though I knew there was plenty of home-equity LOC activity going on, I was shocked to learn how massive a percentage of disposable income the swing in MEW represented.
If you haven’t already read it, you’d probably enjoy Garet Garett’s “A Bubble That Broke the World.” It’s a very well written contemporary account of these 1920s delusions of wealth.
As long as debt financed (government-expenditure based) stimulus is temporary the multiplier will be close to 1 in NGM.
You didn’t mention ngdp level targetting even in passing! I think it would fit well in point 3.
Complete wage and price flexibility would not be sufficient to restore full employment. Wage and prices are income flows while assets and debts are wealth stocks and changes in the latter will affect the former. Assets and debts make them inflexible, but inflexibilty prevents wages and prices from total implosion rather than producing equilibrium.
I like the post – the 1920s tell us quite a lot about the risks we face today.
But I, too, am not quite with you on #3. You could modify to “In (mainstream macro) theory, wealth illusions do not have to be destabilizing,” which sums up its deficiencies. Macro theory should never have been taken in a direction that ignores such a basic cause of the business cycle and especially of the biggest cycles (e.g. 1920s/30s and 2000s) that are most important for us to understand.
Even with wage & price flexibility, it’s pretty clear that wealth illusion and other real life behaviors lead to misallocations that need to be corrected and pull us below full employment. With more sensible theories, mainstream theorists wouldn’t be so surprised when activity rises and falls based on these factors.