by Elliott Morss
Most of the time, I think like a Keynesian. That means when the US unemployment rate is over 7%, government policy should stimulate the economy: use the available monetary and fiscal policy tools to generate income and create jobs. But what do I really know? Not enough to ignore what others are saying.
The most respectable argument against the Keynesian solution is the need to deleverage: the US has to reduce the excessive debt level it built up over the last 20 years before meaningful recovery can take place. According to this view, increasing the government debt level will just delay the start a real recovery.
The McKinsey Global Institute did an excellent study documenting the need for deleveraging. Their primary findings:
- Leverage levels are still very high in some sectors of several countries—and this is a global problem, not just a U.S. one.
- Empirically, a long period of deleveraging nearly always follows a major financial crisis.
- Deleveraging episodes are painful, lasting six to seven years on average and reducing the ratio of debt to GDP by 25 percent. GDP typically contracts during the first several years and then recovers.
- Today, the household sectors of several countries have a high likelihood of deleveraging. If this happens, consumption growth will likely be slower than the precrisis trend, and spending patterns will shift. Consumer-facing businesses have already seen a shift in spending toward value-oriented goods and away from luxury goods, and this new pattern may persist while households repair their balance sheets. Business leaders will need flexibility to respond to such shifts.
What should government policy be in such circumstances? Kenneth Rogoff argued succinctly in a recent article:
“…the real problem is that the global economy is badly overleveraged, and there is no quick escape without a scheme to transfer wealth from creditors to debtors, either through defaults, financial repression, or inflation.”
I have problems with Rogoff’s suggestion. Read on.
A Scheme to Transfer Wealth from Creditors to Debtors
The world has changed and I might be old-fashioned. But I don’t like even the sound of this scheme. Someone borrows money from someone else, and Rogoff wants the creditor to forgive the debt. We hear it frequently in the press: “oh those poor people who got talked into mortgages they could not afford, credit cards with high charges, and student loans they could never repay”.
I don’t buy it. Most borrowers are literate, and when they make a foolish financial decisions, they should have to live with them. How many more pages have to be read to people applying for mortgages to insure they understand what they are doing? And students going to college: I would hope they are literate enough to read the fine print in their loan agreements.
So what is the real problem here? Many borrowers figure they can take out mortgages/loans they will not have to repay. If they really get in trouble, let them file for bankruptcy.
The US government bailed out banks that made foolish credit guarantees to one another. A very bad precedent. And, as I have noted, the US banking system is just as precarious now as it was before the bailout.
Whose Debts Are We Talking About Forgiving?
The McKinsey study referenced above presented some very interesting data on debt by sector and the likelihood of deleveraging in coming years. These data are highlighted for selected countries in the following graph.
In the US, households and not governments are the real problem. From 2001 thru 2007, household debt grew by 10% annually. At the end of 2007, it stood at $14.4 trillion. By the end of first quarter in 2011 it had fallen 3.5% to $13.9 trillion.
Table 1 provides data on net government debt per capita for selected countries. The US is in the middle of the pack, suggesting that severe austerity need not start immediately.
Deleveraging Via Inflation and Other Means
Rogoff points out that deleveraging can occur through inflation. But there is another vehicle for deleveraging: GDP growth. Either one does it. I offer an example: suppose your debt is $150 billion and your GDP is $100 billion. That gives you a debt to GDP ratio of 150%. Suppose that over the next 5 years, the debt remains the same but nominal GDP grows 5% annually, either because of inflation or real GDP growth. In 5 years, you will have deleveraged down to a debt burden of 123%. In ten years, the debt will be down to only 97% of GDP.
What To Do?
OK. Let’s accept that household deleveraging has to occur. Might not a government stimulus package (fiscal policy) and another round of quantitative easing from the Federal Reserve help out?
A stimulus package in the form of a job-creating increase in expenditures will increase GDP, and a follow-on increase in spending by those put to work will also help. It is highly unlikely
this stimulus would cause any inflation inasmuch as there is so much idle capacity in the US.
Another round of quantitative easing would probably work in just the opposite way. That is, a further Fed purchase of Treasuries is not likely to increase employment. But the further “printing of dollars” is quite likely to weaken the dollar in global markets, thereby causing inflation.
My conclusion? If deleveraging is needed, stimulatory monetary and fiscal policies should accelerate the process.
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by Elliott Morss
by Elliott Morss