Wednesday, June 8, 2011

Creditor-Debtor Politics

. Wednesday, June 8, 2011

There's been some good discussion of this report by Robert Kuttner, explaining the political battle between creditors and debtors. Kuttner starts off:

Economic history is filled with bouts of financial euphoria followed by painful mornings after. When nations awake saddled with debts incurred to finance wars, episodes of failed speculation, or grand projects that haven’t paid off, they have two choices. Either the creditor class prevails at the expense of everyone else, or governments find ways to reduce the debt burden so that the productive power of the economy can recover.

Creditors—the rentier class in classic usage—are usually the wealthy and the powerful. Debtors, almost by definition, have scant resources or power. The “money issue” of 19th century America, about whether credit would be cheap or dear, was also a battle between growth and austerity.

And concludes:

These issues are treated as either impossibly technical or as non-debatable. They are neither. We need to democratize the money issue once again.

I like this framing because it moves us past lax psychological explanations ("pain caucus"), willful ignorance ("economists have unlearned what Say and Mill knew"), and hard-money/anti-debtor moralizing. It gets us to what's really important, which is the political dynamic of creditor-debtor relations, and the fact that different groups have different preferences over policies which are motivated by their interests. In other words, we're talking about political economy, which I obviously think is a step in the right direction. As I argued in my anti-econ rant from a few weeks back, talking about optimal policy makes little sense when you start from the assumption that there is not optimal policy; that policy is about distribution.

And there's a lot of research in IPE and CPE linking governments controlled by left parties to higher inflation, indicating that interest-based explanations work pretty well*. See, eg, this classic 1977 study by Hibbs, and this article by Franzese on how central bank independence is a myth. There's a lot of stuff since then too (see cites on the first page of this article on trade by Milner and Judkins).

Here's Krugman:

I don’t mean to suggest that it’s all cynical; my experience is that there are relatively few people who consciously keep a secret set of intellectual books, who preach Neanderthal goldbuggism because it’s in their interests while rereading Keynes by dead of night to figure out what’s really happening. Instead, people generally manage to believe whatever is in their interests. ...

Still, thinking of what’s happening as the rule of rentiers, who are getting their interests served at the expense of the real economy, helps make sense of the situation.

In a follow-up, he took a rough cut at figuring out who belongs in which group. Yglesias notes that older people, who are out of the labor market, have fewer debts, and have more financial assets that could lose value via inflation, are another interested group. And, of course, older Americans tend to vote more often than younger votes.

Steve Randy Waldman picked up on the financial political economy angle:

Banks, after all, are not only creditors. They are also the economy’s biggest debtors. In theory, bank loyalties ought to be mixed. On the one hand, banks prefer deflationary, zero-forgiveness tight-money policies, to maximize the real value of their assets and of the lending spread from which they draw profits and bonuses. On the other hand, troubled banks are very happy to support loose money and expansionary policy, even at risk of inflation. For bank managers and shareholders, it is bad to have the value of past loans eroded by inflation. But it is much worse to lose their franchises entirely, to have their wealth, prestige, and freedom put at risk in the aftermath of an explicit bank failure. When banks are in trouble, they are perfectly happy to support all manner of expansionary policy, as long as short-term interest rates are kept low. Even a broad-based inflation helps troubled banks twice over, by increasing borrowers incomes and by steepening the yield curve. Increased incomes ensure that loans will be repaid in nominal terms, preventing insolvency due to credit losses. A steep yield curve permits banks to recapitalize themselves via maturity transformation, using deposits to purchase Treasury notes while the central bank promises to hold short rates low for a few years.

But banks’ interests are aligned with those of debtors only to the degree that banks, like debtors, are at risk of real insolvency. When we committed to a policy of “no more Lehmans”, when we made clear via TARP and TGLP and the Fed’s alphabet soup that big banks would have funding on demand and on easy terms, when we modified accounting standards to eliminate the risk that bad loans on the books would translate to failures, when we funded their recapitalization on the sly, we changed banks. We transformed them from nervous debtors into pure rentiers, who see a lot more upside in squeezing borrowers than in eliminating a crippling debt overhang. And since banks are, shall we say, not entirely disenfranchised among policymakers, we increased the difficulty of making policy that includes accommodations between creditors and debtors, accommodations that permit the economy to move forward rather than stare back over its shoulder, nervously and greedily, at a gigantic pile of old debt.

This dynamic is part of what drives the results I found in this paper, discussed here and here, except I added in politics of central banking and regulation as well. One implication is that regulatory central banks essentially have no choice but to provide easy money to banks during downturns. Banks know they'll have access to these funds when needed, so they act more riskily during booms. It's monetary moral hazard**. In other words, I believe this same rentier/debtor politics can make financial crises more likely.

There is another element to this. Increased inflation in the US will narrow the real exchange rate adjustment that is boosting American competitiveness relative to exporting countries like China. To the extent that we want to boost employment through exporting, increased inflation could prolong that process. And if the problem is not just immediate unemployment, but medium-run global rebalancing, then it might not be as simple as "poor want inflation, rich want deflation".

This political cleavage is what the current austerity/stimulus battles are about, in both Europe and the US. I previously surveyed some of the IPE literature on this question, discussing its findings in relation to the eurozone, here.

*Sometimes these are phrased in terms of resolving the Phillips curve tradeoff in one direction or the other. More recent econ work has questioned the validity of the Phillips curve, but that doesn't necessarily imply that the perceived politics changes. This isn't my area of substantive expertise, and I understand that there's a bit of controversy in the comparative literature, but I believe the implications for monetary politics hold up pretty well.

**Note that we haven't seen the ECB behave this way, at least not on the level of the Fed, which is why the political battles in Europe are over fiscal transfers.


Dan Nexon said...

See also Mark Blyth's Great Transformations

Kindred Winecoff said...

Yeah, I've referenced Blyth several times before on the blog, and almost got into him here but this was already getting long. I actually deleted a paragraph that was mostly about his work. Needless to say, I'm looking forward to his Austerity book, whenever it comes out.

Creditor-Debtor Politics




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