I was delighted to see, in Paul Krugman’s post – ‘What Janet Yellen – And Everyone Else – Got Wrong’ – that he now identifies ‘the debt overhang’ as the reason this economic downturn has persisted for so long.
The best explanation, I think, lies in the debt overhang. For the most part, even those who correctly diagnosed a housing bubble failed to notice or at least to acknowledge the importance of the sharp rise in household debt that accompanied the bubble. And I would argue that this debt overhang has held back spending even though financial markets are operating more or less normally again. In short, getting the bubble right, while no small thing, wasn’t enough; Yellen (and many other people, myself included) underestimated the fragility of the financial system, but also the importance of household debt.
This is progress: economists are starting to acknowledge the importance of private debt in macroeconomics. There’s just one feature of his post I’ll quibble with: the proposition that “Yellen and Everyone Else” got this wrong before the crisis. There was at least one economist who did get it right, and who did so long before the crisis erupted.
He was Arthur Cecil Pigou, and–in the spirit of Krugman’s (‘Non-prophet Economics’), that “we should first of all be evaluating models, not individuals… we’re looking for the right economic framework, not the dismal Nostradamus”, then Pigou clearly gave us the right economic framework, two years before the crisis began. In 1927, to be precise.
