The Bennett Newsletter
“Debt” dominates discussion of Western World economic problems. Eurozone debt threatens that bloc’s very existence. The US debt-ceiling debate flirts with the world’s reserve currency default. The UK and Japan are gloomily swamped by debt. Although debt is at the forefront of discussion, there is a very belated realization that debt is undermining the recovery, and that deleveraging has hardly begun.
An Economist article “You ain’t seen nothing yet” (July 7) used research by the McKinsey Global Institute to explain that debt had stopped rising but deleveraging is “just starting”. McKinsey’s also explain that economies usually contract in the deleveraging process.
Readers of this column will be aware that debt is a drag on growth, and that most projections of growth are wildly optimistic ( NBR June 3) but the Economist has just realised that “marking down America’s economic outlook has become a depressing routine”. The Federal Reserve projected a 4% growth rate this year but now projects 2.8%. The Bank of England projected 4% p.a. too, but 1.5% seems more likely for this year.
Bewildered economists.
Nobel Prize-winning Paul Krugman says in an academic paper [http://www.princeton.edu/~pkrugman/debt_deleveraging_ge_pk.pdf]
“Given both the prominence of debt in popular discussion of our current economic difficulties and the long tradition of invoking debt as a key factor in major economic contractions, one might have expected debt to be at the heart of most mainstream macroeconomic models– especially the analysis of monetary and fiscal policy. Perhaps somewhat surprisingly, however, it is quite common to abstract altogether from this feature of the economy1”
He also says economist’s models treat everyone alike, but he is working on models that have creditors and debtors.
Fortunately there are other traditions. In the 1930’s Irving Fisher argued that the depression caused a vicious circle in which falling prices increased the real burden of debt. Fisher was ignored by contemporaries for several reasons: most people already believed that a balanced or budget surplus was necessary. Moreover, Keynes challenged this orthodoxy by calling for budget deficits; and Keynes won the day. Fisher was ignored too because he dropped a terrible clanger: just before the 1929 stock market crash he claimed prices had reached “a permanently high plateau”.
Debt-Deflation
Fisher then developed a theory of economic crises called “debt-deflation” which connected crises and burst credit bubbles. I turned to his theory in the 1990’s in order to better understand the persistent deflation in Japan after its massive 1989 bubble burst. I argued Japan could not recover until it cleaned up its balance sheets.
I believe we have avoided deflation since because of the resolute actions of the central banks in rescuing failing institutions and providing cheap credit. But the West will not recover until debt is manageable.
According to Fisher, a bubble collapse is followed by:
• Debt liquidation and distress selling.
• Contraction of the money supply as bank loans are paid off.
• A fall in the level of asset prices.
• A still greater fall in the net worth of businesses, precipitating bankruptcies.
• A fall in profits.
• A reduction in output, in trade and in employment.
• Pessimism and loss of confidence.
• Hoarding of money.
• A fall in nominal interest rates and a rise in deflation adjusted interest rates
Economists are now reconsidering the debt mountain. This is strange as I introduced readers long ago to the thought of Carmen Reinhart and Kenneth Rogoff’s book, “This Time is Different”, which catalogued 250 financial crises over 800 years, and all economists should have read it. The authors specifically say “Highly leveraged economies seldom survive for ever, particularly if leverage continues to grow unchecked”. Moreover, the longer we try to put off the pain, the worse the total pain will be.
Care Needed
Deleveraging can bring a recession, even a deep deflationary recession. The Western world has escaped so far because deleveraging has not begun. It will. Care will be necessary to avoid a deep recession. This is not easy to do as most governments have already applied as much stimulus as they dare, and have few bullets left in their treasuries.
The US has made the most progress in lowering private sector debt. US mortgage law has helped: under-water borrowers can merely post house keys back to the bank; elsewhere the lender still has an obligation to the bank for the full mortgage. US private debt has yielded to consumer repayments and many mortgage defaults and write-downs.
The Economist has a four lesson prescription for deleveraging that sounds plausible. The first is the need for orderly write downs at both state and private levels. Next, growth is essential to bring down the weight of debt, so the implication is to avoid marked retrenchment. It believes America is making a mistake by combining public-sector austerity with robust private-sector deleveraging. Third, it calls for an export boom to stimulate growth and reduce external deficits in the former bubble countries. But it would be mad for the UK to turn its back on finance and subsidize manufacturing. The final lesson is realism: debt reduction will hold back the rich world’s economies “for several more years. Get used to it”.
The Economist’s prescription is for Clayton’s deleveraging. This is painless; except for those that forego some debt. Citizens enjoy low-cost credit, very small state spending cuts, all countries increase their exports simultaneously ( logically impossible). The Brits keep the sacred cow of London’s vaunted finance and avoid the mess of manufacturing, and China plays the role of Captain Oates and consumes more of its own goods and competes less in exports. No one pays back borrowed money. McKinsey says there is 6-7 years of pain, so my message to the Economist is “Get real”.
http://www.mckinsey.com/mgi/publications/debt_and_deleveraging/index.asp
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