Financial News, a Dow Jones Company., 6th December 2010
It is extremely important that the next recession be delayed for as long as possible to enable America, Britain, Ireland, Spain, Portugal, Italy, Greece – and now Belgium – to re-establish equilibrium between personal, corporate and government debt levels. This could take some time and will require international foreign exchange co-operation which is so far absent and political decisions unlikely to win votes.
The key long-term problem, which has been steadily getting worse since the end of World War II, has been the rise in private sector debt. This has taken different forms in different countries. In Japan it was concentrated in the corporate sector and in recent years non–financial companies at least have been improving their balance sheets. In the US private sector debt has risen, relative to GDP, by five times over the past 60 years and has been common to both households and business. Although investment banks often claim that US companies have reduced their debt levels, the official data published in the Flow of Funds Accounts show that non-financial corporate leverage is at record levels.
The world’s leaders have not yet taken any significant steps to deal with the structural problems which led to the recent crisis and world recession. We still have large international current account imbalances, excessive private sector debt and overpriced assets. Not only do these threats remain but, in responding to the last crisis with near zero interest rates and massive fiscal deficits, we have reduced our capacity to respond to the next crisis.
The fundamental cause that has driven up private sector debt in the US has been economic policy. Whenever private sector defaults seemed to be on the rise, fiscal and monetary stimuli were introduced, occasionally buttressed by direct bail-outs. As a result there has been no underlying rise in the rate of defaults, at least until recently, despite the rise in debt. While taxpayers have not guaranteed the risks involved in individual debtors, they have provided creditors with insurance that lending risks in aggregate will remain subdued and, in doing so, have encouraged the massive rise in private sector debt.
Ireland has shown how dangerous this can be. Before the crisis broke, Ireland had low public sector debt together with external trade and budget surpluses. But it had massive debts in its private sector. When asset prices collapsed in 2008, debtors expected to have to repay their debts, but to be unable to borrow more, while creditors doubted whether they would be repaid. The government stepped in to guarantee the banks in the probably justified fear that the collapse of confidence would have otherwise led to a depression. It can be argued that the government need not have gone so far and made matters worse than they need have been. But the real problem was the massive debt in the private sector, rather than the action taken by the government when the crisis broke.
If we are to avoid similar problems in the future and in much larger countries, we need to reduce private sector debt levels. At the same time we need to contain the rise in debts of the public sector by cutting back on government deficits. For the world as a whole, this process can only happen if there is an exactly equal and painful reduction in the cash surpluses of the private sector. For individual countries the pain can be modified by passing it on to foreigners, so countries are competing to lower their exchange rates. In aggregate there can be no winners but, as the debt problems are largely confined to the developed world, the imbalances would be eased if the major currencies could be devalued relative to those of emerging economies.
For equilibrium the real exchange rates of rapidly growing economies need to rise in real terms. As a result of the past failure to make such an adjustment, G5 currencies need a substantial one-off real devaluation and then, to adjust for the difference in relative growth, they will need a steady continuing devaluation vis-à-vis the rest of the world. These adjustments can only be achieved by some combination of nominal increases in the renmimbi and other developing economy currencies against all G5 exchange rates and lower inflation in G5 countries than elsewhere.
As equilibrium conditions are themselves constantly changing, economies need to adjust all the time and, provided the adjustments are not violent, they can be achieved without marked disruption. Various combinations of nominal changes in exchange rates and relative inflation are possible. But only one avoids the need for dramatic change and is thus likely to be compatible with stable recovery. This route requires a moderate appreciation of the nominal exchange rates of developing economies, relative to G5 currencies, combined with moderate inflation in the developing economies and moderate deflation in the G5.
Other combinations either require rapid rises in exchange rates or rapid inflation in developing economies. They are therefore unlikely to be achieved without widespread economic disruption leading probably to another recession.
Economic policy should therefore be directed towards mild nominal exchange rate appreciation and mild inflation in developing countries, with mild deflation in G5 countries. In this context the Federal Reserve plans to increase its programme of quantitative easing is most unfortunate. Both the method and the aims of this policy increase the risks of instability in the world economy. Fortunately, they may not succeed.
The Federal Reserve’s aim is to raise US inflation, when mild deflation is desirable. If this were to be successful, it would increase the need for rapid inflation or rapid nominal exchange rate appreciation in the developing economies. Buying assets is also destabilising. Asset prices were driven up by the previous bout of quantitative easing and it is wrong to rate the risks that would follow from US deflation above the risks, which are already large, of another sharp fall in asset prices.
The whole approach is politically aggressive. The ideal combination of rising nominal exchange rates with mild inflation in developing economies, combined with mild deflation in developed ones, is more likely to come from a compromise between Chinese and US policies than by aggravating current disagreements.
There are many policies which could encourage a reduction in private sector debt. The most obvious would be to stop the stupid practice of allowing interest to be treated as an expense for corporation tax. We could also reduce the risks that current debt levels hold for the economy by demanding much higher equity ratios for banks in place of the Basel III regulations, which Irish experience has already shown to be totally inadequate.
But reducing private sector debt without crisis is a long and slow process and, in the mean time, it is important to postpone the next recession for several years. That the Federal Reserve should act to destabilise the world economy is thus both sad and worrying.
————————–
This article first appeared in Financial News.
http://www.efinancialnews.com