Sticky Prices

When the Economy Is Bad, Debt Gets Worse

Only growth or inflation can make the problem go away.

Jacquelyn Martin / AP Photo

One of the best arguments for the existence of a higher education bubble is simply the massive increase in debt, accompanied by a run-up in prices. This is, of course, particularly worrying in a down market, when students are burdened by debt that has become a lot harder to pay. And especially so in this economy, when the students who entered graduate school in order to “ride out the recession” are emerging on the other side to find that unemployment is still over 8%. Garrett Jones, who as far as I know began his blogging career as a guest blogger at my old home, and is now newly ensconced in permanent digs at EconLog, writes that debt is a sticky price—very sticky:

Why bother explaining the root causes of gluts when so many think they can see a glut by just looking out the window? Because gluts conflict with one of the best ideas economists have ever had: That surpluses—of workers, of unsold homes, of cars rusting on the lot—push down prices and move the product out the door.

Surpluses set in motion a process that ends the glut: Just watch the last half hour of a garage sale.

Any force strong enough to fight against the power of prices should be a strong force indeed, strong enough for all to see. But when economists talk about the “frictions” that keep gluts alive, we usually talk about “sticky prices” and “sticky wages” and cultural norms and public sector unions and a few other forces. Strong forces, yes, and forces I believe in, but stronger than creative destruction and supply and demand? For years on end?

Here’s my favorite friction, one that exists by force of contract, not because of worker sociology: Debt. Debt in the household, debt in the firm, and—for state and local governments at least—government debt. Irving Fisher beheld debt destroying a deflating economy, and he wrote an excellent paper about it in Econometrica v.1 back in 1933—a theory of depressions better than anything I’ve seen in Keynes’s General Theory.

Formal debt obligations can, by their nature, only be adjusted after a lot of tedious wrangling. This makes the money cheaper to borrow, but when the economy is contracting, the expense becomes clear: you may get stuck in an obligation that you can neither renegotiate, nor pay.

Student loan debt is particularly sticky, because you can’t even bankrupt the stuff—at least not unless you can convince a judge that you’re basically permanently and totally disabled. That not only deprives you of a formal means of lowering the “price” of your past borrowing, but also means that you probably won’t get much out of the informal negotiations that often take place between creditors and borrowers. Student loan companies have no incentive to settle for less than you owe, because they can keep hounding you for the money until you die.

Inflation eases the problem of any sticky price, and it does the same for debt: if inflation is high enough, you can pay off that $100k loan bill with a job at Starbucks. Hence the enthusiasm for more expansionary monetary policy.

However, a few cautious notes. The first is that the only thing which eases the debt burden is unexpected inflation; if it’s inflected, the lenders will just charge you more for the benefit of borrowing. (My ex-boyfriend lived in the apartment underneath a nice retired teacher who had plowed her whole nut into treasuries at the exact moment that Paul Volcker was raising interest rates into the stratosphere in order to crack inflation. I made him go upstairs and explain to her what was going to happen to her finances when she had to roll those notes over. As I recall, the gist of her response was that hopefully she would die before it became an issue.)

Unexpected inflation, however, is hell on savers. When the economy shrinks and someone has to take a loss, you’re deciding to transfer money from the folks who saved to the people who borrowed. And fair enough, you can argue that the savers are richer (it’s true). But we should also recall that often the savers are pension funds—including public sector pension funds, whose losses (or lower-than-expected returns) get transferred to us. Or our parents, who now need an apartment in the basement because the return on their nest egg is so much smaller than they expected. I notice that the enthusiasm for much higher inflation seems to be highest among commentators whose parents are not yet facing retirement. It’s quite easy to say that asset owners need to tighten their belt in order to prevent the tragedy of higher unemployment. It’s somewhat more difficult to tell your mother that she needs to sell her house for the same reason.

Of course, this is the reality when growth is lower than expected: someone has to take the loss. Who should is a sort of… sticky question.