Financial News, a Dow Jones Company. , 28th June 2010
Since the end of World War II there has been a dramatic and seemingly unstoppable rise in debt. In the US the ratio of private sector debt to GDP has risen by five times. There has been no evidence that this has been accompanied by any long-term increase in debt defaults. From time to time, when demand has slackened, defaults have risen on a cyclical basis, but governments and central banks have acted promptly to ensure that these periods have been short-lived and as painless as possible. Without pain there has been no constraint on the growth of debt. While lenders have suffered from individual bankruptcies, the state has in effect provided insurance that there will be no general increase in the risks of lending.
By insuring lenders against a general rise in default, governments have made private sector debt a contingent liability of the state and, to a significant extent, this contingent liability has recently become an actual one. So long as lenders were confident that governments and central banks would intervene to prevent the rising debt levels from increasing the level of default, the level of debt continued to rise and, as it rose, so did the risks of economic disruption. A rise in defaults has a negative effect on confidence and thus on demand in the economy; by dampening down the impact of small rises in defaults, the long-term risks rose with the growth of debt. A helpful analogy has been made with forest fires, where success in preventing small fires has been shown to increase the risks of large, really devastating ones.
When the economy weakens lenders worry about getting paid and debtors think that it will be more difficult to refinance their loans. There is then a general wish to try to reduce debt levels. The greater the level of debt in the economy, the greater will be the attempts to reduce it and the negative impact on demand. Individual people and companies can improve their balance sheets either by repaying debt out of cash flow or by swapping debt for equity. In aggregate, however, attempts by the private sector to repay debt out of cash flow are self-defeating. The attempt requires intended (ex-ante) savings to exceed intended (ex-ante) investment and, since the two must be equal (ex-post), the attempts have to be thwarted at the national level. This can either occur through a fall in incomes and output or through a matching fiscal deficit (i.e. negative savings by the public sector). Preventing a recession caused by the attempts of the private sector to repay debt involves switching the build up of debt from the private to the public sector and this has recently occurred. It was clearly sensible on this occasion to use fiscal policy to avoid a catastrophic recession, but it is not a weapon capable of being used without limit and evidence grows daily that we are running up against those limits, as bond markets become increasingly nervous about the risks of sovereign lending.
This poses a challenge for the economic management of the world economy. One aspect of this is that we need to avoid for as long as possible another lurch into recession. Another is that we must seek to reduce the vulnerability of the world economy by reversing the build up of debt. As we reach the limits of credibility for sovereign debt, we must aim for a way to reduce private sector debt other than by switching it to the public sector. We must also expect that the risks of lending to the private sector will be higher than they have been in the past. While there has not been an implicit taxpayers’ guarantee for the specific risks involved in lending to the private sector, there has been effective action to prevent the aggregate losses from rising, despite the rise in aggregate debt. It is as if banks and other lenders had been able to take out, for free, credit default insurance limiting their aggregate losses on any reasonably diversified portfolio. There has therefore been a steady rise in moral hazard, which is the perverse impact on behaviour that arises from inappropriate forms of insurance. (This is why you cannot take out insurance against poverty or being found guilty of a criminal offence .)
We are surely running up against the limits of debt, not only in the private but also in the public sector. History suggests that national debt levels can reach even higher levels than those prevalent today without default, but a clear danger point is reached when the cost of paying interest on the existing debt is as great as the likely growth of the economy. If, for example, an economy has to pay 3% real interest and has net debt equal to 100% of its GDP, then if the economy grows at less than 3% p.a., the country has to run a fiscal surplus, excluding debt servicing costs, in order to prevent the ratio of debt/GDP from escalating. The IMF calculates that G7 countries by the end of 2010 will have debt ratios of 118% of GDP. The trend growth rate of G7 countries is, at best, around 2.5% p.a., and so we can no longer deleverage the private sector by switching debt onto the public sector. We must therefore turn to other ways. One of the two possibilities is to rely on more equity and less debt for financing investment. The other is to transfer wealth from debt owners to equity owners through inflation.
There are several possible methods whereby a switch to equity financing can be made. In the corporate sector this can be achieved by lower dividend pay-outs and having new issues rather than buy-backs. It is also possible to reduce debt levels through having many more bankruptcies than we have had in the past. This will often need to be financed by replacing the losses made by banks, insurance companies and pension funds through additions to their equity.
Both these processes are likely to be negative for aggregate share prices. It would of course be sensible for governments to encourage this process by changes in the tax system. It is absurd to encourage debt by making interest an allowable expense for corporation tax, as it is generally, or indeed for income tax, as mortgage interest is in the US. A reform of corporation tax to change this would be a major step towards reducing the vulnerability of the economy in the future.
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This article first appeared in Financial News.
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