Austerity - Austerity Sequence

Austerity Sequence

Several economists have argued that an appropriate strategy when an economy is faced with unusually high private debt levels is to exchange private debts for public debts initially, then cut government debt via an austerity strategy once the economy recovers. Applying an austerity strategy to a struggling economy can be counter-productive according to Keynesian theory described above.

For example, the private sector may become highly indebted, such as when a housing bubble bursts. Housing prices fall while the mortgage obligations remain fixed, leading to "underwater" homeowners unable to consume at sufficient levels to drive economic growth. A banking crisis can result, as defaulting homeowners result in banks unable to lend or stay in business, which slows the economy and worsens unemployment. These effects can become self-reinforcing, creating a downward economic spiral. This spiral is at the core of the subprime mortgage crisis in the U.S. and the European sovereign debt crisis.

Economist Amir Sufi at the University of Chicago argued in July 2011 that a high level of household debt was holding back the U.S. economy. Households focused on paying down private debt are not able to consume at historical levels. He advocated mortgage write-downs and other debt-related solutions to re-invigorate the economy when household debt levels are exceptionally high.

Economists Joseph Stiglitz and Mark Zandi both advocated significant mortgage refinancing or write-downs during August 2012. This could be financed by the government taking on additional debt in the short-run as a form of stimulus. The government would borrow at a very low interest rate and create an entity to purchase mortgages, receiving a higher interest rate from mortgages it refinances. Losses due to mortgage principal write-downs would be shared between the government and financial institutions, with the government losses offset by the interest rate differential.

The International Monetary Fund (IMF) reported in April 2012: "Household debt soared in the years leading up to the Great Recession. In advanced economies, during the five years preceding 2007, the ratio of household debt to income rose by an average of 39 percentage points, to 138 percent. In Denmark, Iceland, Ireland, the Netherlands, and Norway, debt peaked at more than 200 percent of household income. A surge in household debt to historic highs also occurred in emerging economies such as Estonia, Hungary, Latvia, and Lithuania. The concurrent boom in both house prices and the stock market meant that household debt relative to assets held broadly stable, which masked households’ growing exposure to a sharp fall in asset prices. When house prices declined, ushering in the global financial crisis, many households saw their wealth shrink relative to their debt, and, with less income and more unemployment, found it harder to meet mortgage payments. By the end of 2011, real house prices had fallen from their peak by about 41% in Ireland, 29% in Iceland, 23% in Spain and the United States, and 21% in Denmark. Household defaults, underwater mortgages (where the loan balance exceeds the house value), foreclosures, and fire sales are now endemic to a number of economies. Household deleveraging by paying off debts or defaulting on them has begun in some countries. It has been most pronounced in the United States, where about two-thirds of the debt reduction reflects defaults." These countries might also benefit from household debt reduction policies involving exchanging private debt for public debt.