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Krugman: Household Debt is the Problem, not the Banking System

Regular readers of Pragcap are well aware of my position on why the economy has been weak and why I think it is likely to remain relatively weak.  The monetary system revolves around bank money or inside money.  That is, when the economy is strong, people are taking out loans, investing, purchasing goods and services, etc.  I discussed the importance of this back in 2008 before I had formally come across Richard Koo’s work where he formally called this idea the “Balance Sheet Recession” and long before we ever came up with Monetary Realism and the importance of understanding why “inside money” rules the monetary roost:

“So, the government has a partially correct solution. Not the BEST solution, but it gets to the core of the credit issues. They will essentially trade the bad paper for good paper and it will alleviate many of the pressures on the banks. As I have written here many times the banks are the lifeblood of the system.  I like to think of the banks as the oil in the engine.  If you run out oil the system begins to break down and eventually the engine stops running.  You can’t have a healthy functioning economy if the banks aren’t lending.  Unfortunately, because this won’t fix any problems at the household level it won’t induce any borrowing.  So, it’s a clever way to resolve the banking crisis, however, it doesn’t fix the root of the problem which is at the household level.  So, again I ask – is this a “bailout”?   You bet your ass it is.   Unfortunately, it’s not a bailout of the entire system.  It’s just a bailout of the banking system.  And their problems are merely a symptom of much bigger problems at the household level.”

I’ve written a lot of stupid things here over the last 4 years.  This wasn’t one of them.  This was the very essence of our entire economic problem.  The household credit crisis was the single most important understanding of the entire financial crisis.  It was the root of the entire disease that spread through the banking system and the rest of the economy like a virus.  If you understood that the household debt crisis was the root cause of the crisis you understood how to fix it.  Fix the household balance sheets and fix the crisis (or at least soften the blow).  But instead, we mainly worked under the theory that the credit markets were broken because the banks were broken.  So we focused our efforts on fixing the banks.  We thought this was a banking crisis.  As Paul Krugman noted the other day this really isn’t a “financial crisis” (via Paul Krugman):

“Yet the economy remains depressed, with recovery far from complete. My current modeling approach stresses the overhang of household debt as an explanation; it’s not about the financial system any more.

By the way, way back when, when I was worrying about Japan, I quarreled with the common argument at the time that Japan’s problem was “zombie banks”, and that once the banks had been recapitalized all would be well. They were, and it wasn’t, and much the same has been true for us now.

So Dean and I agree; maybe I shouldn’t use the term “financial crisis” at all, but it’s the terminology people know.”

I’d go even further.  In fact, I probably never should have adopted Koo’s BSR terminology as it’s too vague.  This is and always was a household debt crisis.  It’s nice to use terminology people know, but had we all referred to this crisis as a household debt crisis it might have gone a long way in helping people better understand the root cause and perhaps even help politicians in formulating policy geared more towards fixing the root of the problem….

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