Nikkei Veritas – Market Eye column, 17th May 2010
It is generally believed that the massive bankruptcies that occurred after the Wall Street collapse of 1929 were a major cause of the great depression that followed in the 1930s. As a result governments and central banks have sought to prevent another surge in bankruptcies and in the defaults on debt which they involve. Defaults still occur, but economic policy has been designed to limit them to a few at a time. There is still good reason to avoid lending to exceptionally risky people and businesses, but the criterion is a relative one. The risks of lending to those who have an average level of debt have not risen, even though that average has been rising.
The natural result has been that debt levels have risen steadily. In the US, total private sector debt has risen by nearly five times relative to GDP since 1952, from just over 57% to 278%. This has made the economy more fragile. We reached a point at which many of those who lend had begun to worry that they won’t be repaid. They therefore felt less wealthy and started to cut back on their spending. At the same time companies found it more difficult to borrow and reduced their investment expenditure. This produced the recession and, as the level of debt in the economy had risen to such a high level, it was a particularly severe one.
We are now recovering from the worst recession since the 1930s. It would have been worse if governments had not deliberately run huge deficits, as these acted to support demand. The rise in government deficits also had the effect of shifting debt from the private to the public sector. The shift has been so great that markets are now becoming worried that in future defaults will not be limited to the individuals and companies. It is increasingly understood that lending to the public sector also has its dangers.
The risks involved in lending to countries are of two sorts. If the government borrows in someone else’s currency, as happens within the Eurozone, then the country may be unable to pay its debts and will default. But this risk does not apply to governments which borrow in their own currency, as happens with Japan, the UK and the US. The equivalent risk for lenders to these countries is that they will find that inflation reduces the real value of their assets.
The fundamental cause of our current problems has been the success of economic policies designed to prevent a surge in bankruptcies. Their success has meant that lending did not seem to have become more risky, even though debt levels have risen so dramatically. We seem to have reached the limit of this policy. The world economy has become very fragile and to return to a reasonable prospect of long-term stability we need to reduce debt levels. But if we try to move too quickly we will have not have stability even in the short-term, as we will produce an even more severe recession than the recent one.
There are several ways by which the level of debt can be reduced. On an individual basis it can be reduced by repaying borrowing out of income. But this isn’t satisfactory in aggregate because the reduction in spending produces a recession. Debt can also be reduced by inflation, but this is also unacceptable. The only satisfactory way to reduce debt is to replace it with equity.
Companies can replace debt with equity in a number of ways. The most straightforward is by issuing new shares and repaying debt. This can be done more slowly by paying low dividends and financing new investment from profits rather than borrowing. Individuals can’t issue shares but, like companies, they can go bankrupt. Bankruptcy reduces debt, but the banks have to make up the losses by issuing new share issues or reducing dividends.
If we look at this process as a whole, we can see how we have reached our current troubled situation and how we must get out of it. One, perhaps surprising, conclusion is that we have had too few bankruptcies in the past and must have more in the future. To reduce the risks that this involves we need to encourage companies, and particularly banks, to make frequent and large issues of new equity.