Tuesday, March 6, 2012
Macro and Micro: The Case of Balance Sheet Recessions
To continue some random thoughts about the role of microeconomics in macro, consider the notion of a balance sheet recession. Like most others who came to see this as an essential ingredient of the current crisis, my route was via the financial balances framework—for instance, the Wynne Godley version. I saw the problem in aggregate/net terms: the US household sector in the mid 00's was running up unsustainable debt loads, especially through the medium of the housing bubble.
This is a purely macroeconomic perspective, and one can go a long way with it. Nevertheless, one can go even further by filling out some of the microeconomic aspects.
One that has attracted a lot of attention is the role of inequality between households. This takes us from net to gross balances: the accumulation of large debts among some households adds fragility and eventually drag to the system notwithstanding the net wealth accumulation of other households. The inequality/debt nexus has been examined at a purely macro level, but to dig further we would need to disentangle the threads: which households in particular are going into hock, what motivates them to do this, how are collateral constraints imposed or lifted, etc. Even with statistical controls, aggregate analysis can only point to association, not causal pathways.
But there are other micro aspects to household balances that are worth exploring. Some that occur to me are:
1. How can we call the turn? Through what channels do debtors come to revise downward or upward their reference point for when debt is “too much”? Most debtors, after all, do not experience default. What persuades them to shift from debt accumulation to deleveraging? And what persuades them that they have paid down enough debt and can begin borrowing again?
2. Related to the first question, is the tendency toward overshooting symmetrical? That is, we know debtors tend to overshoot on the way up, leading to the fabled Wiley Coyote moment. Is there also a tendency to pay down beyond the level needed for debt sustainability? If so, there might be interventions that could moderate the contractionary impetus of balance sheet recessions without impinging on needed adjustment.
3. For policy purposes, and here we enter the realm of the Lucas Critique, we should want to know the extent to which household perceptions of actual and desired leverage are intertemporal: do people think about their financial situation only in its immediate state, or do they incorporate some notion of permanent income? If the latter, do temporary fiscal infusions provide less perceived balance sheet relief than the raw numbers would suggest? Are these effects of different magnitude for different households? Note that these questions are entirely empirical and can’t be addressed through armchair speculation, no matter how many clever wrinkles one adds to a textbook intertemporal optimization model.
What I hope this example demonstrates is that it is possible to see a large role for microeconomic research in macroeconomics without making metaphysical claims about foundations or demanding ritual obeisance to general equilibrium. In fact, freeing macro from these constraints is also freeing micro.