How the government rebuilt household balance sheets

By Felix Salmon
December 22, 2010
Mark Thoma makes a familiar complaint: that the government's response to what he characterizes as a "balance sheet recession" has done wonders for the balance sheets of banks, but much less for the balance sheets of the population as a whole.

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Mark Thoma makes a familiar complaint: that the government’s response to what he characterizes as a “balance sheet recession” has done wonders for the balance sheets of banks, but much less for the balance sheets of the population as a whole. What the government should have done, he says, is “use fiscal policy to help households make up for losses from the recession”:

For households, the collapse of a housing bubble, which also tends to cause a stock market crash, results in a decline in home equity as well as the loss of retirement and education savings. When combined with the loss of jobs due to the recession, and the fact the debts do not decline with the fall in asset values, the effect on balance sheets can be devastating – much larger than, say, the balance sheet impact of an oil price shock…

Policy has done a good job of preventing even worse problems from developing by rebuilding financial sector balance sheets through the bank bailout and other means.

But household balance sheets have not received as much attention. We could have helped households rebuild their balance sheets, and this would have helped banks by lowering the default rate on loans. Instead, we left households to mostly solve their problems on their own, and then helped banks when households could not repay what they owed.

Mark doesn’t go into any detail on exactly how the government should have done “a better job of helping households”. But it seems to me that, quietly and largely invisibly, it’s actually done exactly that.

Balance sheets have two sides, of course: assets and liabilities. And I suspect that what Mark might have in mind here is attacking the liability side of things, through pushing principal reduction on mortgages or allowing them to be reduced in bankruptcy.

But there’s a problem with trying to reduce liabilities: when the markets lose faith in credit instruments, as we saw during the crisis, the repercussions can reverberate around all markets and all countries. So governments around the world made a conscious decision to keep most bondholders whole, while injecting new capital and diluting equity holders in their attempt to shore up balance sheets.

And that’s pretty much what the government has done with the household sector too. The asset side of a typical household balance sheet is mostly home equity, and there has been a concerted attempt by the government to shore up property values — by reducing mortgage rates to all-time lows, of course, and also by dragooning various public entities (Frannie, FHA, etc) into funding substantially all mortgages being written. Without this public-sector support, banks would write many fewer mortgages at much higher interest rates, and prices would be a lot lower than they are now.

Other household assets have also been boosted by US monetary policy — stocks have been surging, as have bonds, gold, and just about any other financial asset that households might hold. And if the Fed could find a way to accept motherhood and apple pie as worthy collateral at its discount window, it surely would have done so by now.

As a result, household balance sheets are probably healthier now than they would have been if a program of cutting household liabilities, including principal reduction on mortgages, had kept investors nervous about the health of the banking system and of the economy as a whole.

The problem with this strategy, of course, is that debts are still high and real, while asset values can go down as easily as they went up. The financial crisis afforded a once-in-a-generation opportunity for an across-the-board deleveraging of the economy: a move away from treacherous debt and towards equity. We flubbed that chance, and systemic tail risk is much higher now as a result. But so are the markets.

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