Is Debt Overhang What's Preventing a Strong Recovery?

Don’t expect stronger growth, some say, until deleveraging is complete.

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And the $900 that the household spent? It becomes someone else's income, of course. But if that someone also saves 10 percent that won't be borrowed, total spending is $810. That $810 in income for another 10-percent saver begets only $730 in spending, and so forth in an ever-decreasing cycle.

Koo is careful to note the difference between a balance-sheet recession, which is largely impervious to monetary-policy fixes, and a financial crisis, which isn't. Alas, Koo notes, the Great Recession has involved both. What recovery there has been since 2008, he says, is the result of monetary authorities deploying an arsenal of weapons (capital injections, guarantees, asset purchases, and so forth) against the financial crisis sparked by what he calls the "policy mistake" of letting Lehman Bros. collapse.

But the balance-sheet problem is not so easily remedied. Speaking at a conference in Berlin in April, Koo noted that the U.S. monetary base had more or less tripled since mid-2008, and yet M2 ("money in circulation") had barely risen and credit available to the private sector was actually down.

"Why do we get these results?" asked Koo. "Because the private sector is no longer maximizing profits; they are actually minimizing debt."

Put more technically, the money multiplier—the process that turns a dollar deposit into more than a dollar of loans—"is actually negative at the margin," Koo told his Berlin audience. Private-sector deleveraging is "the key difference between an ordinary recession and one that can produce a lost decade," Koo wrote in a 2011 paper.

What breaks the cycle? The private sector, left to its own devices, can deleverage to the point where borrowing becomes attractive again. But that process produces lots of economic carnage, as aggregate spending falls to some irreducible level. "In fact, [Fisher's] discussion of debt-deflation doesn't really have much of a mechanism for recovery at all, without intervention," notes Brock University economist Robert Dimand, a student of Fisher.

What government can do in the meantime is supplant the borrowing and spending that the private sector has relinquished—though here, of course, the constraints become as much political as economic.

Whatever the government does, it has become accepted wisdom that deleveraging after a financial crisis is a long, painful process. President Obama took up the refrain recently when he told a Cleveland audience that what we're experiencing today is "not your normal recession. Throughout history, it has typically taken countries up to 10 years to recover from financial crises of this magnitude."

Obama's critics, like former Republican Sen. Phil Gramm—a champion of financial deregulation—say he's just trying to whitewash the results of failed policies.

But the weight of evidence seems to favor the president. Exhibit A for most economists is the work of Harvard's Kenneth Rogoff and Carmen Reinhart, who after surveying 20-Century financial crises around the world, 15 of them postwar, famously argued that the United States is following a familiar pattern: A huge build-up of leverage for a decade or so, an inevitable crash, then a decline in leverage comparable in size to the preceding expansion.

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Elaborating, Reinhart and her economist husband, Vincent Reinhart, wrote in 2010 that post-financial-crisis unemployment in advanced countries rose by a median of five percentage points, and in 10 of the 15 postwar crises never fell back to pre-crisis levels.

Real, per-capita GDP fell by an average of 1 percentage point in the decade following a financial crisis. The typical postwar U.S. recession lasted less than a year, and within two years, GDP regained lost ground and returned to the long-term growth trend. After the typical postwar financial crisis, by contrast, the economy has required an average of four and a half years to reclaim pre-crisis output levels.

Of course, to say that deleveraging is the key factor governing the speed of recovery is not to say that it's the only factor. There's the euro crisis, electoral uncertainty, the fiscal cliff, and many other things.