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This is the title of a new paper by Paul Krugman and Gauti Eggertsson of the NY Fed. Krugman writes about this paper on his blog:

The usual disclaimers apply to the paper: it represents Gauti's and my views, not those of the NY Fed. For those who haven't been following, Gauti has really been taking the lead in trying to model policy when interest rates are up against the zero lower bound; what we're doing here is trying to apply his expertise to the problem of how to think about what happens in a "Minsky moment," when everyone decides that debt is too high.

The summary of what this paper is about can be found at VoxEU:

If there is a single word that appears most frequently in discussions of the economic problems now afflicting both the US and Europe, that word is surely "debt." Between 2000 and 2008, household debt rose from 96% of US personal income to 128%; meanwhile, in Britain it rose from 105% to 160%, and in Spain from 69% to 130%. Sharply rising debt, it's widely argued, set the stage for the crisis, and the overhang of debt continues to act as a drag on recovery.

It follows that the level of debt matters only because the distribution of that debt matters, because highly indebted players face different constraints from players with low debt. And this means that all debt isn't created equal -- which is why borrowing by some actors now can help cure problems created by excess borrowing by other actors in the past. This becomes very clear in our analysis. In the model, deficit-financed government spending can, at least in principle, allow the economy to avoid unemployment and deflation while highly indebted private-sector agents repair their balance sheets, and the government can pay down its debts once the deleveraging crisis is past.

And here's Krugman again from his blog:

But the policies that can prevent that gratuitous slump -- a commitment to higher inflation over the medium term, and/or deficit spending -- run right up against ingrained prejudices. The foundations for the shock were laid by a long period of relative stability, especially low inflation; it's very hard for policy makers to accept that what was good in 2000 or even 2007 is no longer at all good now that Minsky has struck. And everyone has just seen the punishment for too much debt; asking others to run up debt to help fix the problem, even though it's right, is unavoidably a tough sell.

Tough sell indeed, especially in the face how England is handling their recession, with massive cutbacks in their national fiscal policy.

One of the issues facing debtors in this environment is the lowering of debt ceilings for certain players in the economy. Some entities or individuals aren't affected, though, and Krugman's model says that those entities (including governments) need to borrow and spend more because they can. Most economic models weigh equally two entities with an identical amount of debt, even though one entity (say, a household) can no longer borrow more money while another household can take out a 2nd mortgage because they have a bigger line of credit (even though they both owe the same nominal amount). Krugman's model attempts to separate these two entities to show how debt is not created equally.

And yet, we see those debt ceilings being lowered further, with Fannie Mae (which guarantees 28% of the entire mortgage market in the U.S. - a whopping $3.2 trillion in residential mortgages) set to announce new guidelines next month:

Fannie Mae is getting tougher on debt-to-income ratios, or the amount of a borrower's gross monthly income that goes toward paying off all debts. The maximum ratio for those seeking a conventional mortgage will drop to 45 percent from 55 percent under the new guidelines.

So there you have it! Fannie Mae, which is controlled by the Federal Government, is lowering further the debt threshold for households. Instead of taking on debt that represents up to 55% of one's income, starting December 13th, you'll only be able to borrow up to 45% of your income.

And the de-leveraging crises continues, Paul Krugman economic model or no Paul Krugman model.

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