-- John Kemp is a Reuters columnist. The opinions expressed are his own. –
The United States and the United Kingdom stand on the brink of the largest debt crisis in history.
While both governments experiment with quantitative easing, bad banks to absorb non-performing loans, and state guarantees to restart bank lending, the only real way out is some combination of widespread corporate default, debt write-downs and inflation to reduce the burden of debt to more manageable levels. Everything else is window-dressing.
To understand the scale of the problem, and why it leaves so few options for policymakers, take a look at Chart 1 (https://customers.reuters.com/d/graphics/USDEBT1.pdf), which shows the growth in the real economy (measured by nominal GDP) and the financial sector (measured by total credit market instruments outstanding) since 1952.
In 1952, the United States was emerging from the Second World War and the conflict in Korea with a strong economy, and fairly low debt, split between a relatively large government debt (amounting to 68 percent of GDP) and a relatively small private sector one (just 60 percent of GDP).
Over the next 23 years, the volume of debt increased, but the rise was broadly in line with growth in the rest of the economy, so the overall ratio of total debts to GDP changed little, from 128 percent in 1952 to 155 percent in 1975.
The only real change was in the composition. Private debts increased (7.8 times) more rapidly than public ones (1.5 times). As a result, there was a marked shift in the debt stock from public debt (just 37 percent of GDP in 1975) towards private sector obligations (117 percent). But this was not unusual. It should be seen as a return to more normal patterns of debt issuance after the wartime period in which the government commandeered resources for the war effort and rationed borrowing by the private sector.
From the 1970s onward, however, the economy has undergone two profound structural shifts. First, the economy as a whole has become much more indebted. Output rose eight times between 1975 and 2007. But the total volume of debt rose a staggering 20 times, more than twice as fast. The total debt-to-GDP ratio surged from 155 percent to 355 percent.
Second, almost all this extra debt has come from the private sector. Take a look at Chart 2 (https://customers.reuters.com/d/graphics/USDEBT2.pdf). Despite acres of newsprint devoted to the federal budget deficit over the last thirty years, public debt at all levels has risen only 11.5 times since 1975. This is slightly faster than the eight-fold increase in nominal GDP over the same period, but government debt has still only risen from 37 percent of GDP to 52 percent.
Instead, the real debt explosion has come from the private sector. Private debt outstanding has risen an enormous 22 times, three times faster than the economy as a whole, and fast enough to take the ratio of private debt to GDP from 117 percent to 303 percent in a little over thirty years.
For the most part, policymakers have been comfortable with rising private debt levels. Officials have cited a wide range of reasons why the economy can safely operate with much higher levels of debt than before, including improvements in macroeconomic management that have muted the business cycle and led to lower inflation and interest rates. But there is a suspicion that tolerance for private rather than public sector debt simply reflected an ideological preference.
THE DEBT MOUNTAIN
The data in Table 1 (https://customers.reuters.com/d/graphics/USDEBT3.pdf) makes clear the rise in private sector debt had become unsustainable. In the 1960s and 1970s, total debt was rising at roughly the same rate as nominal GDP. By 2000-2007, total debt was rising almost twice as fast as output, with the rapid issuance all coming from the private sector, as well as state and local governments.
This created a dangerous interdependence between GDP growth (which could only be sustained by massive borrowing and rapid increases in the volume of debt) and the debt stock (which could only be serviced if the economy continued its swift and uninterrupted expansion).
The resulting debt was only sustainable so long as economic conditions remained extremely favorable. The sheer volume of private-sector obligations the economy was carrying implied an increasing vulnerability to any shock that changed the terms on which financing was available, or altered the underlying GDP cash flows.
The proximate trigger of the debt crisis was the deterioration in lending standards and rise in default rates on subprime mortgage loans. But the widening divergence revealed in the charts suggests a crisis had become inevitable sooner or later. If not subprime lending, there would have been some other trigger.
WRONGHEADED POLICIES
The charts strongly suggest the necessary condition for resolving the debt crisis is a reduction in the outstanding volume of debt, an increase in nominal GDP, or some combination of the two, to reduce the debt-to-GDP ratio to a more sustainable level.
From this perspective, it is clear many of the existing policies being pursued in the United States and the United Kingdom will not resolve the crisis because they do not lower the debt ratio.
In particular, having governments buy distressed assets from the banks, or provide loan guarantees, is not an effective solution. It does not reduce the volume of debt, or force recognition of losses. It merely re-denominates private sector obligations to be met by households and firms as public ones to be met by the taxpayer.
This type of debt swap would make sense if the problem was liquidity rather than solvency. But in current circumstances, taxpayers are being asked to shoulder some or all of the cost of defaults, rather than provide a temporarily liquidity bridge.
In some ways, government is better placed to absorb losses than individual banks and investors, because it can spread them across a larger base of taxpayers. But in the current crisis, the volume of debts that potentially need to be refinanced is so large it will stretch even the tax and debt-raising resources of the state, and risks crowding out other spending.
Trying to cut debt by reducing consumption and investment, lowering wages, boosting saving and paying down debt out of current income is unlikely to be effective either. The resulting retrenchment would lead to sharp falls in both real output and the price level, depressing nominal GDP. Government retrenchment simply intensified the depression during the early 1930s. Private sector retrenchment and wage cuts will do the same in the 2000s.
BANKRUPTCY OR INFLATION
The solution must be some combination of policies to reduce the level of debt or raise nominal GDP. The simplest way to reduce debt is through bankruptcy, in which some or all of debts are deemed unrecoverable and are simply extinguished, ceasing to exist.
Bankruptcy would ensure the cost of resolving the debt crisis falls where it belongs. Investor portfolios and pension funds would take a severe but one-time hit. Healthy businesses would survive, minus the encumbrance of debt.
But widespread bankruptcies are probably socially and politically unacceptable. The alternative is some mechanism for refinancing debt on terms which are more favorable to borrowers (replacing short term debt at higher rates with longer-dated paper at lower ones).
The final option is to raise nominal GDP so it becomes easier to finance debt payments from augmented cashflow. But counter-cyclical policies to sustain GDP will not be enough. Governments in both the United States and the United Kingdom need to raise nominal GDP and debt-service capacity, not simply sustain it.
There is not much government can do to accelerate the real rate of growth. The remaining option is to tolerate, even encourage, a faster rate of inflation to improve debt-service capacity. Even more than debt nationalisation, inflation is the ultimate way to spread the costs of debt workout across the
widest possible section of the population.
The need to work down real debt and boost cash flow provides the motive, while the massive liquidity injections into the financial system provide the means. The stage is set for a long period of slow growth as debts are worked down and a rise in inflation in the medium term.
For previous columns by John Kemp, click here.
Lack of savings alone is not what created the problem in the first place. As the article states, its a combination of lack of savings and a huge increase in debt. If people didnt save, but also didnt increase their debt, the difference in GDP to debt would be negligible, and the GDP would arguably go up. But if people continue to increase debt, the GDP will stagnate or drop, as the debt spins continually out of control.
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I think some of us may be missing the author’s point. What he’s really saying is devaluation of the dollar. Your dollar will now buy half or one fourth what it used to. This has been performed successfully, albiet painfully in several countries. Its not a pretty picture. Ten dollar a carton milk anyone?
I believe that the fundamental underlying causes must be addressed and rectified in order to correct this catastrophe. That should start with identification of misfeasance, malfeasance and nonfeasance in business and government. Next comes confiscation of all assets related to such criminal, fraudulent or even deceptive behavior. These confiscated funds can go into central bankruptcy receivership account to be distributed to the injured parties including mortgagees, taxpayers, pensioners, and yes, victimized investors. It is criminal mismanagement that has led to this disaster. Whatever happened to the rule of law?
@ bill.
You are deceived if you think high inflation will work to your benefit. Any inflation we get now, will be very destructive. We went through this process in the 70’s and devalaution, is a painful process.
Stagflation is coming where there will be a glut of unemployed, leading to deflation of flat wages, because of oversupply. And Inflation of core goods and commodities, because of the further debasement of the currency. In addition what drives this economy, is tvs,football games, video games, movies, luxury goods, hannah montana all things that are not necessary for survival, as such business will continue to fail as the economy adjusts to the new realities.
If you think your salary will go up. Wrong, look at Argentina, where they had a decent economy that was crushed by debt, forced a devaluation of the currency and has lead to high prices of all goods, even food (they are among top 10 food producers in the world ). It has sent half the population into poverty with high rates of starvation. We are talking about a country with the largest middle class in South America wiped out over a period of months.
The bottom line, is there is no way out of this without more pain. I disagree with the writer who thinks debt forgiveness is an option. This problem isnt just too much debt, its a problem with having the wrong system. We have built an economy over that last 20 years that only fucntions by borrowing against the next 50 years of production. This economy needs to be destroyed and rebuilt.
We are going to get our medicine as a nation, and the transformation will be multi-generational.
Great article! I’ve been praying that inflation would reduce the value of my 80000 dollar student loan debt for quite some time.
While the diagnosis is accurate the cure is only as affective in as much as getting the patient to walk but a few steps before he drops dead.
How do you let a little inflation out of the bag with so much debt already in the air. Within this environment are economic prospects lead by expectations and both are divisible by fear. With such a debt burden inflation expectations will grow into unbridled fear leading to a debt collapse.
Who in this audience believes government authorities can manage inflation expectations? This problem has grown beyond Paul Volkers methodology of reigning in inflation.
The world MUST turn 30 years of greed into rational action. Investors (debt and stock) must accept a historical low level of returns for some time to come in order to restore liquidity to the worlds economic system.
As several commenters have said, inflation may create more problems than it solves. Defaults are the answer. Current FDIC plans for the creation of a national bank, alias “aggregation bank”, to oversee bank credit defaults is the appropriate means. Banks are now being asked to reveal their loans and credit structures in preparation for this now.
Nice article!
Lobbying for inflation is definately short sighted though…you make a VERY incorrect assumption that your salary would go up in a time of inflation. I think if you look at salary/inflation history you will find that salaries do not go up in a synchronized curve with inflation, but stay rather stagnant (especially in times of financial distress, when employers make a point to pay people even LESS). This is one of the reasons debt has skyrocketed so out of control, people HAVE to borrow enormous amounts to keep their standard of living equivalent, while salaries don’t increase and money value is effectively depressed.
I am unemployed and the advice I am getting from people is ‘be ready to take a pay cut if you want a job’…problem is of course that I CAN’T take a pay cut and still pay all my debts. Even though I have perfect credit, I will end up defaulting on all or part (and lets be real, if I am forced to default, I will default on EVERYTHING I can because the damage will be the same as defaulting on part) if I am forced to take the cut that was suggested (40% pay cut).
If inflation does happen, not only will you be stuck at your current salary, but you will be unable to meet your basic needs, such as food costs. I have to admit that I was PRETTY excited when I first thought of inflating my debts away but when you look at the reality of the situation, you realize it is pretty grim and scary picture. Why do you think the government/fed is trying to walk that line of inflation/hyperinflation so delicately? Falling too far either direction, would be a disaster of historic proportions.
It would also behoove us to realize that what are government is advocating is that we ‘get back to borrowing’…insisting that there is a liquidity crisis and that it could be resolved if we would just borrow more…which, at this point in my life I find rather unpalatable.
Also, it is not banks that have stopped lending…America has been propped up by Chinese lending for so long that when they stopped lending, banks had no reserve to continue business as usual. Look at bank reserves in 2008, they dropped to NOTHING when the money stopped and the banking industry’s ‘duck, duck, goose game stopped’…
Poor American taxpayer…not only are they COMPLETELY strapped with the debt that they already owe…but the government bought all the bad loans and expects us to effectively ‘double pay’ our way out of this mess…I have kind of a bad feeling about exactly how THAT is going to work.
We’re pretty much doomed to repeat history until someone steps in and takes action on the root of the cause. This guy nailed it: runaway debt. It is too easy for a debtor to escape debt in this country. How many people do you think would abuse credit and over-extend themselves if their irresponsibility was actually a crime? Indeed, what’s the difference between the guy who walks away from $50,000 in unsecured credit card debt and the guy that robs a bank for $50,000? Answer, one goes to prison, and the other sits in “debt timeout” for 7 years until his scarlet letter disappears from his credit history. Then, it’s off to the races again.
There is a word for it: thievery. And those knuckleheads who pile our mailboxes with offers of easy credit are just as bad. They’re encouraging the problem.
It’s disgusting, and for all this talk of “hope” and “change”, I won’t believe a word until there are some real consequences for being a thief. And, “house arrest” for some punk like Bernard Madoff is not a real consequence.
Lack of savings alone is not what created the problem in the first place. As the article states, its a combination of lack of savings and a huge increase in debt. If people didnt save, but also didnt increase their debt, the difference in GDP to debt would be negligible, and the GDP would arguably go up. But if people continue to increase debt, the GDP will stagnate or drop, as the debt spins continually out of control.
Well I think the author touched on the solution. Bankruptcies.
Having been through a fortune 500 Chapter 11 re-org I can say that they make sense economically but are stressful on workers. Most people don’t know what it means and think it means job losses. In reality Chapter 11 can mean big retention bonuses and job security.
Any other solution just repackages the debt under another name or owner. The debt does not go away. Chapter 11 effectively cancels the debt and a healthier company emerges with a new management team. Typically most staff keep their jobs and only management changes.
Bankruptcies are a vital part of the economy. Why on earth failing companies are “bailed out” by tax payers is beyond me. It is a corporate problem (except fanny and freddy) so it needs stay a corporate problem.
History will judge the bailouts to just delay and exacerbate the problem. At some point the boil has to be drained of puss. The longer you leave it the worse it gets.
I’m not sure why the author focuses uniquely on the UK and US, much of the rest of the world is also in the same shape. Japan still suffers under the weight of the public debt they have from the 90s.
I also don’t understand his rationale for saying that inflation is politically acceptable but bankruptcy is not. I do agree with his analysis however and some day of reckoning in one way or another is inevitable.
I have lived through inflation and hyperinflation, several times. It is absolutely devastating for the economy and for consumption. The only reason that we haven’t crashed into an abyss at this point is deflationary processes. Even a minimal inflation now will kill the mass market. When an economy experience inflation, the real income lags real cost, i.e. the person above with the mortgage, hoping for inflation, should know that either his bank will change the loan contract in order to adjust its income with higher pace of inflation, or most likely - new mortgage clients will completely disappear, since banks will offer very high and adjustable only interest rates. Stimulus for loaners will be zero, and people will need to effectively buy cash property. In such situation property price always lowers a lot. Thus, that would be the very end of the broad house market. Ten years later will come social unrest, i.e. revolutions :). Believe me, you don’t really want that.
So, for me, the dilemma is this: do we want to rebuild the economy based on mass consumption, or not. Choosing not will bring us back in the Middle Ages, just with the difference of having modern technolies.
I support the author analysis, finally something publicly states that the mortgage bubble was a trigger, not the cause. The cause is the immerse shift of wealth from broad public to small percentage of the society, thus mass consumption for a while was feed by debt, and finally collapsed. We need very quick and aggresive shift of wealth, without the inflation though. The very similar thing happened in the World War Two, when higher income tax rate was 80-90%. That effectively was a shift of wealth from the higher tax margins through state consumption of military products to lower tax payers in 5-6 years. That put end of the Great Depression, some 25 years after it started. Now, the only differense is that most of manufacture is outsourced to Asia, and Asia will liekly bear the worst of current Depression - it is just a matter of time to start there.
Probably the very same effect of the war expenses would have huge infrastructure expenses, broad health care system, broad educational system and STEEPER taxes. Now, I don’t see how exactly wealthier people /these include retirement fund holders, small investor, etc./ will agree to have their wealth axed 75-80%. If that doesn’t happen, from my life experience, two ways are possible - cataclism, or hyperinflation and cataclism after that.
Don’t take me wrong. I am optimistic, and I am sure as a young man I can survive in any condition, and use these condition to gain wealth. Still, my principle is democracy and broad welfare, and our conservative political wings should understand that they’ve gone way too far.
Great article which penetrates to the heart. Pity about the inflation solution
John Kemp does not identify the level of inflation necessary to solve the problem. Low levels of inflation (up to 5%/annum) have seen us get into this mess. They are already factored in. So, we must be talking about 10%+ to make an impact.
That, effectively, is confiscating any savings locked in at low interest rates and reneging in relation to foreign creditors.
Too bad? No, the solution could be worse than the problem because:
(i) High inflation (especially if unexpected) discourages savings - and lack of saving is the cause of the problem in the first place.
(ii) Upsetting foreign creditors will lead to their withdrawal from the dollar, adding fuel to the crisis and pushing high inflation toward hyper-inflation.
Impressive article. They have to inflate and they know it. That is why all currencies are doomed. First we will get deflation, maybe for a year but after that all hell comes.
I guess by having high inflation the governments are forcing people to spend their savings otherwise all that money will be worth nothing! This is what we are continually told to do by them. Those on fixed incomes are really in trouble unless they protect themsleves. We really have got ourselves up a creek without a paddle.
So if everything you paid for this month increased by 100 percent, and the national debt rises dramatically, you are better off precisely because of what? Too many folks are tinking around with text books rather than dealing with tangibles. That is part of the hopelessness of all of this. Those that got us into this mess who can think ahead even a few steps want to (get paid to) get us out.
Great article! Arguing for inflation is heresy but really the best antidote. A period of managed inflation would reduce the debt wagon and put it back on track. The question is how to increase inflation while avoiding that it spins out of control.
with inftation alone may be it is a solution. But what instead of inflation you have hyperinflation, with output or production, tending to zero, and prices to infinity?????”’
If I were a bank I would certainly stop lending money. I would lose on the buying power of my assets and on the decline in market value from higher future rates. The present risk would be extraordinary. So if you like to see the U.S. economy crippled, I would print money like a drunken sailor and inflate to the moon. Financially engineering inflation demonstrates a lack of causal understanding indicative of the exiting Bush administration.
Inflation is really the only way out of this mess. For example if my 30 year mortgage debt requires me to pay $2000 a month and I make $4000 a month- then that is tough. But if inflation goes wild and I start making $6000 a month because everything else goes up 50% –my business is making more because the product it is selling is selling for 50% more etc. than in a way I’m still making the same amount. BUT…my mortgage is still just $2000 a month, which is now managable.
The biggest problem with inflation is the people on fixed incomes. They better have some assets that will appreciate like a house etc.
Plus one of the real cool things about big time inflation is that I may actually get to live in a million dollar house. I’ve always wanted to live in a million dollar house so bring on inflation.
Astonishing analysis, to the very heart of the mess. It would be a real good thing if many of those decision takers learn about it. I really don’t know how there is still doubt of what did we wrong,
It is clear what the problem was: much more than a few bad mortgages. In the last two decades or maybe more the world grew lending without fundamentals and rationale. Every business made it so (the financial way). Of course when there is water in the sea you don’t know who is swimming without swimsuit, but you realize that when the wave pass.
Lending is an art, in which risk management is a core competence and tight credit management a fundamental. Everyone with a minimal credit background knows that there is no interest rate that could compensate high risk of default. But many didn’t take this and the output has yet to be seen…