Huge expansions in credit followed by crises and attempts to manage the aftermath have become a feature of the world economy. Today the US and Britain may be escaping from the crises that hit seven years ago. But the euro zone is mired in post-crisis stagnation and China is struggling with the debt it built up in its attempt to offset the loss of export earnings after the crisis hit in 2008.
Without an unsustainable credit boom somewhere, the world economy seems incapable of generating growth in demand sufficient to absorb potential supply. It looks like a law of the conservation of credit booms.
Consider the past quarter century: a credit boom in Japan that collapsed after 1990; a credit boom in Asian emerging economies that collapsed in 1997; a credit boom in the north Atlantic economies that collapsed after 2007; and finally one in China. Each is greeted as a new era of prosperity, then collapse into crisis and post-crisis malaise.
The authors of a fascinating new report, Deleveraging: What Deleveraging? , do not entertain my dystopian hypothesis. They consider these credit cycles to be essentially independent events. Yet the report is invaluable. It brings out clearly the limited nature of post-crisis deleveraging, the plight of the euro zone and the big challenges now facing China.
Deleveraging the West
If you look at the world as a whole, there has been no aggregate deleveraging since 2008. The same holds for the high-income economies, viewed as a single bloc. Financial sectors have deleveraged in the US and Britain, however; so, too, have households in the US and, to a lesser degree, Britain. Liabilities of households have even converged between the US and the euro zone as a whole.
Meanwhile, public debt has risen sharply. That financial crises lead to jumps in fiscal deficits was one of the most important findings of This Time is Different by Harvard's Kenneth Rogoff and Carmen Reinhart. Since the crisis, the ratio of public debt to gross domestic product has jumped by 46 percentage points in the UK and 40 points in the US, against 26 points in the euro zone.
Since 2007 the ratio of total debt, excluding the financial sector, has jumped by 72 percentage points in China, to 220 per cent of GDP. One can debate whether this level is sustainable. One cannot debate whether such a rapid rate of rise is sustainable; it cannot possibly be so. The rise in debt has to halt with possibly significantly more adverse effects on China’s rate of growth than today’s consensus expects.
Credit cycles matter because they frequently prove so damaging. The report divides possible outcomes into three categories: in “type 1”, such as Sweden in the early 1990s, the level of output falls, never to regain its pre-crisis trend, but the growth rate recovers; in the more damaging “type 2”, as in Japan since the 1990s, there is no absolute fall in output, but potential growth falls far short of the pre-crisis rate; finally, in “type 3”, as in the euro zone now and probably the US and UK, there is both a fall in output and a permanent fall in potential growth.
Permanent loss of growth
Several possible reasons exist for such permanent losses of output and growth. One is that the pre-crisis trend was unsustainable. Another is the damage to confidence, investment and innovation from a financial crisis. But among the most important is the debt overhang. As the report shows, deleveraging is hard. Mass bankruptcy, as in the 1930s, is devastating. But working out of debt is likely to generate a vicious circle from high debt to low growth and back to even higher debt.
Today, long-term interest rates are low in high-income economies. In the euro zone this is largely due to the promise by Mario Draghi, the European Central Bank president, in July 2012 to do "whatever it takes". Unfortunately, the growth of nominal GDP in the euro zone is also dismal: inflation is ultra-low and real GDP is growing weakly.
Incredibly, the euro zone seems to be waiting for the Godot of global demand to float it off into growth and consequential debt sustainability. That might work for the small countries. It is not going to work for all of them.
Post-crisis management
Managing the post-crisis predicament requires a combination of prompt recognition of losses, recapitalisation of the banking sector and strongly supportive fiscal and monetary policies (where feasible) to sustain economic growth. The aim should be to use both blades of the scissors: direct debt reduction and recapitalisation on the one hand and strong economic growth on the other. The US has come closest to getting this combination right.
Yet the biggest lesson of these crises is not to let debt run ahead of the long-term capacity of an economy to support it in the first place. The hope is that macroprudential policy will achieve this outcome. Well, one can always hope.
These credit booms did not come out of nowhere. They are the outcome of the policies adopted to sustain demand as previous bubbles collapsed, usually elsewhere in the world economy. That is what has happened to China. We need to escape from this grim and apparently relentless cycle. But for now, we have made a Faustian bargain with private sector-driven credit booms. A great deal more trouble surely lies ahead. – Copyright The Financial Times Limited 2014 martin.wolf@ft.com
