Jun 24th 2010
Cutting the debt back to more acceptable levels is both hard and unappealing, since it may involve years of austerity and slow economic growth. It also requires some tough political decisions. If being able to borrow makes people feel richer (however illusory the sensation), having to repay the debt makes them feel poorer. They resent the sacrifices involved, especially if they are imposed by outsiders. This is particularly true in democracies. In a referendum Icelanders voted overwhelmingly against a debt repayment deal with Britain and the Netherlands.
Dani Rodrik, an economist at Harvard, has talked of a “trilemma” in which countries aiming for the three goals of deep economic integration with the rest of the world, national sovereignty and democratic politics can achieve two of them but not all three. Left to themselves, voters will resist the sacrifices needed to remain competitive in a system of deep economic integration, and nation states are constantly erecting barriers to international trade. One way of eliminating those barriers would be to set up some sort of global federal government. Another would be to install a “free-market Stalin”—a figure in the mould of Chile’s Augusto Pinochet—who would force his country’s citizens to accept the constraints of the global market, including debt repayment. Neither option is appealing.
The citizens of Europe may now be realising that debt transfers power from the borrower to the creditor. The first world war destroyed Britain’s credit position and ushered in the era of American financial dominance. Now the debt burden reflects the shift in the balance of economic power from rich countries to developing ones. It is striking that on average developed countries now have a higher debt burden than emerging nations. Investors have certainly noticed, and have poured money into emerging-market bonds funds over the past year. Developing countries also have more chance of outgrowing their debt burdens. According to Tony Crescenzi of PIMCO, investors are asking themselves, “Would I rather lend money to nations whose debt burden is worsening, or to nations where it is improving?”
This pattern of debt is the opposite of what you might expect. At the level of individual consumers, people tend to borrow when they are young because they are hoping for higher incomes in the future. As they reach middle age they start to pay off their debts and save for retirement. By extension, rich countries with their greying populations should be saving whereas younger, fast-growing developing countries should be borrowing heavily. But in fact it is the other way round.
This is not unalloyed joy for the creditor nations. Once the exposure of a creditor to a borrower gets sufficiently large, the two sink or swim together. The relationship between China and America has been described as vendor financing, in which the Chinese lend the Americans the money to buy their cheap manufactured goods; a collapse in American demand would cause substantial unemployment (and social unrest) in China.
The longstanding system of vendor financing may have encouraged the rich world to concentrate on consumption rather than investment and to enjoy the resulting “artificial” growth, like a child on a sugar high. Richard Koo, who wrote a book about the Japanese recession, “The Holy Grail of Macroeconomics”, refers to a debt-financed boom as “cherry-blossom” economics. He recounts the tale of the two brothers who bought a barrel of sake to sell to revellers at Japan’s cherry-blossom festival. But instead of taking money from the thirsty crowd, each brother charged the other for a cup of sake, then used the proceeds to buy a cup for himself, and so on. The brothers ended the day drunk and empty-handed.
Jeremy Grantham of GMO, a fund-management group, is a detached and cynical observer of the financial and economic scene. The way he sees it, “all debt seems to do is bring growth forward a little. If you get people to spend 1% more than their income every year, after 20 years they are going backwards because interest expense is eating up more of their salary.”
Robert Bergqvist, chief economist at SEB Group in Sweden, is equally pessimistic. “The leverage-led growth model is dead,” he says. “Households and corporates can increase borrowing and enhance today’s consumption and investments but that requires that we can assume higher future incomes and expected returns and/or rising asset values. And this is not certain.”
Running out of ammunition
The debt burden may also have had a distorting effect on economic policy. In the 1960s and 1970s governments grappled with a wage-price spiral in which demands for higher wages forced companies to increase their prices, which in turn triggered demands for higher wages. The past two decades have seen a debt-interest rate spiral. It starts off with the private sector borrowing a lot of money. This is followed by a crisis in which the central bank cuts interest rates to help borrowers. That encourages the private sector to borrow more, which makes it all the more imperative for central banks to come to the rescue when the next crisis comes along. With short-term interest rates now at 1% or less in America, Britain, Japan and the euro zone, this process cannot go any further.
If the 1960s and 1970s produced consumer inflation, the debt-interest rate spiral created asset inflation. In 2000 this pushed share prices to unprecedented peaks; indeed many stockmarkets have yet to regain the levels they reached a decade ago. Now the support of asset prices has entered a new stage, with central banks buying assets (in particular, government and mortgage-backed bonds) directly to boost the financial sector.
Indeed, that sector was the biggest beneficiary of this spiral. Before the credit crunch it generated some 35% of all domestic profits in America. A highly sophisticated society would be expected to spend quite a lot on finance, but that figure still looked too high. “We have been transferring aggregate income and wealth to the financial-services industry. All this financial activity is just a deadweight on the system,” says Mr Grantham.
During the debt boom the optimists argued that the huge growth in derivatives did not add to risk in the system because every buyer was matched by a seller. Nobody drew attention to the fact that with each new instrument the finance sector took a cut in the form of a fee, or the spread between buying and selling prices. As derivative was piled on derivative, debt on debt, the cut got ever larger.
Financial profits may have artificially boosted the government’s revenues across a range of items, from corporate profits to capital gains and taxes on bonuses. Some of that revenue may now be lost for good. Mr Koo points out in his book that whereas in 1990 Japanese tax receipts were ¥60 trillion ($416 billion), in 2005 they had come down to only ¥49 trillion, even though Japan’s nominal GDP was 13% higher. When revenues were booming, governments thought they would keep coming and increased their spending accordingly. Now it is hard to see how the gap can be closed.
The vast amount of debt at every level also raises the question whether the pool of savings is large enough to absorb it all. In the early 2000s there was no problem. Central banks and sovereign-wealth funds in the emerging economies seemed only too happy to recycle their current-account surpluses into the government bonds of rich countries. This forced down bond yields and tempted rich-world investors to look for better returns by buying mortgage-backed and high-yield corporate bonds.
All that changed with the credit crunch. Suddenly the business sector found it very difficult to borrow. By contrast, governments found it easy because their debt was seen as safe. But once economies start expanding again, business and governments may start competing for the same pool of savings and the public sector may “crowd out” the private one. As the Greek crisis has shown, countries which want to dip into that pool would do well to keep their finances in order.
If attracting international investors is too hard, governments will be tempted to lean on their domestic savers. Theo Zemek, who heads the fixed-income division at AXA, a giant insurance company, reckons that a combination of regulatory and accounting changes will encourage banks and insurance companies to buy more bonds, and ageing populations in the rich world will also want to hold more assets that produce fixed incomes.
Historical factors such as legal, tax and monetary policy have provided incentives for consumers, companies and (crucially) the finance sector to pile on debt. The level of debt has become untenable, but the options for reducing it are not enticing.
Here’s how not to do it
One example not to follow is Japan, which has suffered a long period of stagnation accompanied by ever-rising government-debt-to-GDP ratios. This has proved sustainable only because of the country’s strong external position; it owes its debt to its own institutions.
For nations that owe money to foreigners, a long period of stagnation is likely to lead to at least partial default. This may be the eventual outcome in Greece, despite the recent rescue package put together by the IMF and the EU. Ms Reinhart and Mr Rogoff argue that the world is due for a wave of sovereign defaults, which are common after serious financial crises.
Another undesirable model is to inflate the debt away, as has often happened in the past. At the extreme, as in Germany in the 1920s, central banks “monetise” the debt, simply printing the money to allow the government to pay its bills. Some regard quantitative easing—in which central banks create money to buy financial assets, mainly government bonds—as monetisation by another name. But many countries may find this difficult, especially if they have a lot of short-term debt. Dhaval Joshi of RAB Capital, a hedge fund, explains that 53% of government debt will have to be rolled over by 2012, for example. If investors think inflation is set to rise, they will demand higher yields, increasing the cost of servicing the debt.
Stagnate, default, inflate—they all seem equally grim. The best solution for rich countries is to work off their debts through economic growth. That may be harder for some than for others, given that many countries’ workforces are set to level out or shrink as their populations age. It will be all the more important for such countries to pursue structural reforms that will increase productivity.
But outgrowing debt is not easy: the McKinsey study found that, out of 32 cases of deleveraging following a financial crisis that it examined, only one was driven by growth. America, which has a younger workforce than Europe or Japan, might still manage it. But for many other countries the hole they have dug for themselves may already be too deep.
An interactive chart allows you to compare how the debt burden varies across 14 countries and to examine different types of borrowing
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