What matters is not so much the money supply or the T-bill interest rate, but the availability of credit, and the terms at which credit is made available…. An increase in credit availability may not lead to more spending on produced goods, but increased prices for land or other fixed assets; it can go to increased margins associated with increases in speculative activity; or it may go to spending abroad rather than at home (Stiglitz (2016)).
One of the first legal codes — the Code of Hammurabi, enacted in 1772 BC — advocated some debt relief to debtors in the event of a natural disaster: “If any one owe a debt for a loan, and a storm prostrates the grain, or the harvest fail, or the grain does not grow for lack of water, in that year he need not give his creditor any grain, he washes his debt-tablet in water and pays no rent for this year (Mian and Sufi (2014))”.
Mian and Sufi (2014), in response to the Great Financial Crisis (GFC), suggested some kind of debt relief for households in the US context. Not doing so, they argued, could lead to millions of foreclosures which no market would be able to absorb. By contrast, providing some form of debt relief could enable a household to re-fix its mortgage interest rate at a new and lower prevailing interest rate, allowing it to extend the maturity of its debt; in other words, providing some flexibility in the face of a macroeconomic event or shock (meaning that no moral hazard is involved). Usually, there is no contingency in a typical debt contract that, for example, says that following an aggregate negative macroeconomic shock, the risk will be distributed (and shared) differently.
Moreover, we now have strong evidence that those households that could somehow fix their mortgages at new and lower interest rates following the GFC fared better in terms of disclosure and consumption figures. The California Foreclosure Prevention Laws (CFPLs), for example, which encouraged banks or other mortgage lenders to modify mortgage loans by increasing the required time and pecuniary costs of foreclosure, have prevented some 330,000 foreclosures in California. Even the most conservative estimates suggest that these policies increased house prices by 5 per cent and, in doing so, created US$250 billion of housing wealth in California. Based on this evidence, the CFPLs were much more effective than the US Government’s Home Affordable Modification Program (HAMP) in mitigating foreclosures and stabilising housing markets.
The ‘state-contingency’ in debt contracts has been an active research topic by academics such as Arvind Krishnamurthy of Stanford University. Recently, Jon Steinsson (University of California, Berkeley) proposed a rent/mortgage repayment freeze in response to the COVID-19 economic meltdown. Related or unrelated to Steinsson’s call, a number of countries have actually introduced some kind of debt relief (or deferral) for households and firms: both New Zealand and Malaysia implemented a six-months holiday period for any existing debt for households and firms.
While Mian and Sufi’s work mostly talked about debt relief for households, the present crisis calls for some action on the firms’ side as well. The ‘relief’ on the firms’ side would ease the constraints of firms, thereby enabling them to hoard workers more readily than they would otherwise be able to do. In fact, a number of countries included firms in their public policy responses. Recently, Giroud and Mueller (2019, p. 273) showed that “…financial constraints impair firms’ ability to engage in labour hoarding. That is, firms with weak balance sheets cut more jobs in response to a decline in consumer demand than they would have in the absence of financial constraints”. Again, a debt holiday might include ‘conditionality’ on hoarding labour. Some countries are doing this in a more systematic way: in Germany, labour hoarding is heavily subsidised by the government through an unemployment insurance fund.
This classic forbearance — don’t force needless foreclosures — is well calibrated to the emergency at hand and does not create too many adverse incentives along the way. No, we don’t have the federal government forgive every mortgage, either directly or forcing banks to swallow the losses, or all student loans or all credit card debt. Federal resources are limited and a grand piñata debt jubilee is not needed and undoubtedly damaging in its own right.
Mark Calabria, Director of the US Federal Housing Finance Agency, announced a noteworthy policy response. People who are in financial trouble because of the coronavirus can stop paying their mortgages. They have to contact their lender, but the process doesn’t require endless paperwork. Such an action won’t be reported to credit bureaus. They still have to pay eventually. People who were already behind at least won’t be kicked out of their houses. And people who are renting houses can get the same forbearance if their renters can’t pay.
The ‘terms and condition’, ‘state-contingent debt contracts’ or debt holidays we talked about are different from more traditional policy tools. In terms of the latter, macroeconomists believe that the source of the shock matters, in the sense that different shocks require different policy responses. The analysis is quite straightforward in case of a demand shock, but more difficult when it comes to a supply shock. The perfidious nature of COVID-19 is that it combines elements of both of these shocks, and perhaps also a third one, related to confidence/uncertainty. This makes the determination of an ‘appropriate’ response by the policymakers extremely challenging.
Priority must be to ensure that firms stay alive and workers can remain employed — and collect their paychecks — even if quarantined, furloughed or forced to stay home to look after dependents. Temporary layoff assistance is a key component. Without it, it is unclear whether public health advisories can even be followed. Moreover, households need to be able to make basic payments (rent, utilities, mortgages, insurance, etc.).
What has attracted little attention so far is a growing clamour for more microeconomic responses, which we summarise by ‘terms and conditions’. These are the terms of conditions in debt contracts, employment contracts or state assistance in the case of a macro shock. They constitute more direct interventions in the prevailing terms and conditions of existing contracts, such as wages, rents, mortgage/loan repayments, tax and social security contributions, bonuses, etc. This growing number of ‘alternative’ responses could — and maybe should — become regular tools for policymakers going forward.
It is often said that monetary policy has come to the end of the road and that governments are reluctant to employ fiscal policy. Some of the ideas suggested in this blog about altering the terms and conditions of regulatory requirements, market practices and international standards might provide a feasible third way of addressing many of the issues in a quick and manageable manner. At a minimum, they can supplement and support the more traditional policy responses.
The bottom line, we argue, is that there are a few lessons we learnt from the GFC that might be helpful in stopping large-scale foreclosures, keeping employment steady as much as possible and reducing the sharp decline in household spending. In short, there are a few central lessons from the GFC that may be very relevant to COVID-19 era policymaking. A number of countries are moving in this direction.