This is why I still think tax cuts need to be part of a recovery package, and that it's okay if those tax cuts are saved:
The faster household balance sheets are repaired, the faster the recession will end.
That's not to say that tax cuts are a substitute for using policy to stimulate aggregate demand, something that is best accomplished through government spending, though well-targeted tax cuts can be effective too (but practically, the political process makes the "well-targeted" part difficult to achieve). Tax cuts that allow balance sheet rebuilding are complements to policies to stimulate the economy and should come on top of those policies, not in place of them.
Here's more from Pedro Amaral of the Cleveland Fed (the graph above is from this article):
Households' Balance Sheets and the Recovery, by Pedro Amaral: ... In a previous Trends article I pointed out that the current recovery and the previous one are weak in the context of past recessions. ... The reasons for the sluggish pace of the two latest recoveries are to be found in the ... effect of the downturns on households' balance sheets.
The chart ... shows the behavior of households' (and nonprofit organizations') net worth in the last six recessions. It is apparent that in the last two the damage to households' balance sheets was both deeper with and more protracted than in the previous episodes. What was behind the drop in the latest recession? During this period, liabilities were roughly constant, so the drop happened because of declines in asset values caused by the real-estate collapse and the subsequent depreciation in financial assets. In the 2000 recession the drop was due to the stock market collapse. In contrast, in the twin recessions of the early 1980s, net worth never decreased, and in the early 1990s it dropped only about 2 percent.
The drops in household net worth help explain the protracted recoveries after the last two recessions. ... If there is to be a solid recovery, consumption needs to increase at a substantially higher rate than the 1.7 percent it has averaged over the last year. But households are not going to start consuming at substantially higher rates until they have fixed their balance sheet problems. This is why the savings rate has been so high lately... In previous recessions, since net worth did not fall by a substantial amount, this was not a problem. As incomes started growing again, consumption followed suit. ...
Finally, note that this figure hides a lot of heterogeneity in terms of asset holdings across households. At the peak that preceded the most recent recession, real estate represented roughly a third of total household assets, while most of the remainder was in the form of other financial assets (stocks, bonds and related derivatives). Households at the very top of the income scale hold a disproportionate amount of wealth in the form of these financial assets, which in turn means that the vast majority of households have most of their wealth in the form of housing. Since real-estate-related assets declined by 30 percent from peak to trough (compared to a 22 percent decline in other financial assets), the decline shown in the graph, as large as it seems, actually underestimates the losses most households suffered.The sooner households get their balance sheets repaired, the better. Unfortunately, unlike the large banks, the government can't intervene and directly repair balance sheets on an individual basis, but it can use policy to implement tax cut and other programs that help with this problem. For example, Joe Stiglitz would like to see mortgage debt written down for households:
In short, government policies to support the housing market not only have failed to fix the problem, but are prolonging the deleveraging process and creating the conditions for Japanese-style malaise. ...
Corporations have learned how to take bad news in stride, write down losses, and move on, but our governments have not. For one out of four US mortgages, the debt exceeds the home's value. Evictions merely create more homeless people and more vacant homes. What is needed is a quick write-down of the value of the mortgages. Banks will have to recognize the losses and, if necessary, find the additional capital to meet reserve requirements.
This, of course, will be painful for banks, but their pain will be nothing in comparison to the suffering they have inflicted on people throughout the rest of the global economy.That doesn't help on the asset side, households would still need help rebuilding retirement, education and other savings funds, but by reducing debt loads households can obtain the asset levels they desire much faster.
Japan made the mistake of allowing balance sheet problems for both households and banks to linger and the result was a prolonged recession. We seem to have gotten the message about banks, though not fully -- the problems are not being resolved as fast as I'd like to see -- but the message that households need just as much attention seems to be harder for policymakers to get.
We need policies to stimulate demand, and on top of that, we also need policies that accelerate balance sheet repair. One without the other gives up important synergies, and prolongs either the length or the depth of our problems.
Update: After posting this, I realized I should have said something about distributional issues, and it's coming up in comments. The point that the problem is largest for the middle class and blow is hinted at in the last paragraph of the quote above from the original Cleveland Fed article, but I didn't make it explicit enough. I was intending to update this post to include this, but fortunately Mike Rorty covers this issue in a follow-up post to this one, so let me send you there: The Distribution of Households' Balance Sheets and the Recovery.