-- 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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Mr. Kemp -
I enjoyed your article, but you leave an important question unanswered– why has the stock of credit expanded so rapidly?
The simplistic textbook answer is “savings”. I would suggest that a better answer is imbalances in the real economy fueled credit expansion. If our (US) trading partners recycle surpluses of 6% of GDP, and if wealthy households are saving 9% or more of GDP (keep in mind that in 2005 the top 1% of households received 24% of income), then that’s a lot of money flowing through the financial system - a wall of liquidity or a global savings glut if you will.
Some of the money financed business expansion, but most financed deficit spending and/or leveraged investing on Wall Street. The stage was set for the subsequent collapse and rapid deleveraging.
Regards,
Brian Shriver
funy how things Ron Paul was talking about 5 years ago are starting to resonate everywhere. The problem is the whole prsperity the last 30 years was a debt based pyramid scheme; the bottom level now is too big to expand any longer and it is caving in on itself. The only jobs being created will be federal jobs at teh same time the tax base is dissapearing. The states are the next ones to line up for a bailout; the rest of the world will ditch the dollar and you can imagine how fast the printing presses are going to run. Watch ike the good doctor said gold will go through the roof as they have no choice but ot monetize the debt.
Great column!!! Many of us have expected this.
Have a care with commodities. In terms of real value, contraction may continue even with inflation (conflation!), so make sure you’ll have a buyer.
Big Al is right on. A couple of additional points, however:
1. In 2007 the level of leverage in the economy as a percentage of GDP was almost double the level in 1929. As Mr Kemp and others note, this leverage has to be squeezed out, and Mr Kemp ably describes the unpalatable choices. As to how we got there in each case, that\’s a long discussion in itself, but suffice it to say the causes were essentially the same; excessive speculation facilitated by men lending other people\’s money and collecting commissions (aka incentive bonuses) for doing so.
2. In 1929, we made the choice (not necessarily intentional) to lower leverage by reducing spending, increasing taxes which caused deflation and led to a depression-
by comparison, Germany decided to print money to pay off debts and that led to hyperinflation and fall of govt. Either way, they reduced leverage in the economy.
3. More recently, in the latin american debt crisis of 1980s, Brazil, Argentina, et al had similar problem– lots of debt (public and private) made possible by easy lending by US and other intl banks, and not sufficient GDP to pay it off. They ran the printing presses, and sure enough, they had hyperinflation and stagnation for 10 years until the lenders finally realized they had no choice but to reorganize those countries by writing off debt. OUr situation is not exactly the same (yet anyway) in that we still have the unique ability to borrow and repay our debts in dollars — but as Adam Smith says below, that could change quickly if the dollar loses its reserve status.
4. Now, in 2007-08 - the Fed/Treasury is so concerned with avoiding a 1929 type depression (which is Bernanke\’s area of academic expertise) that it is risking long term disaster by causing hyperinflation and all the consequences spelled out by Adam Smith.
5. Adam Smith talks as if we have a choice to avoid hyperinflation — right now, as painful as it may get, unless we stop all the govt programs intended to save a few entities and individual homeowners and instead start accepting some recessionary pain in the way of bankruptcies, failed banks and unemployment — we have no choice, we will face a very ugly situation of hyperinflation that is infinitely worse.
6. I\’d be very interested in how we can achieve what Big Al calls a combination of inflation and bankruptcies to reduce the level of debt– therein lies our best hope. FEd /Treasury should be thinking about getting banks to write down debt and sell assets at their marked down prices; they can\’t ask our foreign creditors to give us a break and write down USTs like we did for latin america in the 80s, but 10-12% inflation might come close to doing the same thing. Still it would take years, but what else can we do?
Why has nobody asked the question: “What happened to all the money?”. Surely, money can’t just disappeared into think air! Well, the answer is: all the money has been flowing out of the country into China and other major exporting nations. The present strategy by the Government to ensure that Banks loan more money to businesses and individuals so that spending will increase and the GDP will grow again is short-sighted. This will be good only for nice statistcal readings. In fact, asking dept-laden businesses and individuals to take on more loans is to ensure the bubble grows bigger and postponing the problems that we are seeing now to a few years later and maybe if luck plays out, one or two generations later.
To boost infrastruture development and spend more tax payers’ money to create jobs is good. But ultimately, when the newly re-employed start getting their salary and start spending again, where does the money goes to? To the the countries where we import most of our goods from.
So, as much as I hate to say the dreaded word, it is necessary. A little less of free-trade would be good. The government may need to erect some barriers to foreign goods entering the country so that some of the money stays within the country. In short, to be protectionist. It is not such a dirty word after all considering the the US is the major consumer and goods-importing nation of the world.
Who will gurantee all this debt? Derivatives in the credit default category is $62 trillion alone. Bankruptcy is not in the cards. it would set off a daisy chain of events unheralded in this world. Get ready for GLOBAL WEIMER monetary fiscal insanity. GOT GOLD?
Re-inflation is the answer to save debtors. Note I didn’t say “hyperinflation.” It seems blog posts jump to the extreme. It’s obvious that the government is working towards re-inflation, just as obvious as the banking crisis was 5 years ago.
So, debtors will win and savers will lose. This is the opposite of the past decade. Since we can *expect* inflation, we can take advantage of that fact by: 1. buying hard assets like metals, 2. buying currencies not experiencing inflation, 3. taking out a boatload of low interest rate debt now so that you can pay it back later with inflated dollars, 4. earn money in foreign currencies. By the way, equities should rise with inflation, if the number of shares are held constant.
Inflation is devastating to people who don’t understand it, just like leverage was crushing to those who didn’t understand it. Be informed, and you can prosper.
I am in essential agreement with Mr Kemp. As the construction of this catastrophe involved many parties over many years, and is essentially reflective of the culture itself, the allocation of blame is an exercise best left to historians – it is a luxury we can ill afford at present.
The debt burden is unsustainable, the present attempts at wishful thinking aside, and will, one way or another, in real if not in nominal terms, be written down. I would argue that Mr Kemp is essentially correct in that it must, realistically, involve a combination of explicit write-offs or bankruptcies as well as inflation or other form(s) of devaluation. Relying on either one or the other of these rather than a combination would likely prove catastrophic in very short order. I would argue that it is vitally important to move radically, and decisively, to mitigate the situation to the degree possible (which is slight).
I would argue for:
1) Expedited forms of bankruptcy, both corporate and personal, with broad latitude to trustees.
2) The explicit rather than the present implicit nationalization of the very large banks which are, at present, in fact, bankrupt.
3) The creation of one or more national banks, perhaps on the carcasses of the nationalized existing very large banks (after their toxic debts have first or in parallel been written down in bankruptcy.
4) Preparation of a move to a replacement currency or a parallel currency, backed by specie so that it may be possible amidst the carnage and destruction to begin to move forward.
5) These central moves to be accompanied by large government spending programs of the sort presently contemplated so as to some degree minimize the pain on those most vulnerable.
Everyone talks about inflation being a high probability. The problem is that it should have already happened. What has been happening is almost anti-intuitive…. enormous amounts of money being poured into the world’s largest debt entity - the U.S. governmment. It is indeed almost Alice In Wonderlandish….people feel safest with their money where the debt is the greatest. And is Bernard Madoff the REAL mad hatter? And has the Cheshire cat shown itself yet…up to now perhaps only partly.
Thanks you W. May you and the folks who you allowed to do this to our country find a warm spot in hell.
God I rember being a kid and thinking reaganomics was screwing my future. At least he was tanking the Soviets with all that economic destruction. These fools were just profitering off us.
If inflation rises than the price of oil that was so recently so very destructive will rise also as will all imports and commodities. Hybrid-economies like China will also have the advantage that they can control their monetary values better than the completely free markets can. Can’t you just see the new waves of foreclosures and bankruoptcies? Didn’t Bush Sr once say that Reaganomics was all “smoke and Mirrors”. He hardly gets mentioned anymore. He was clairvoyant.
Isn’t inflation just what happens when a country goes into decline? Vietnam was followed by a stiff inflation as I vaguely recall. The Italian Lira - became a tiny denomination after that country was defeating in WWII. It used to be a pound of something maybe only a Medici could remember when. And we don’t have the discipline of the Germans who made their Mark a standard of value in spite of total defeat. We’re not able to be that European or class dominated.
What happens to the costs of the social services safety nets? Sound like they will develope a great many gaping holes. And all of this at a time when business would like to grow more competitive in a much cheaper world labor market and the last thing they want to pay is higher taxes. Even those on pension plans and 401k’s will be watching them vaporize even faster now.
Lets not kid ourselves, we will become a third world country in fact while the newer economies with a lot more eager and younger worker force will become the astronomically larger economic super powers. And they will do it almost overnight. They will become independent of the US dollar faster than we will become independent of their production. What happens when Japan and China get nervous about our shrinking currency and start cashing in their biilons in US government securities and put their surplus wealth into other countries?
In spite of Obama’s lovely words the reality is so much more ruthless. And no one is treated with more disrespect and contempt than the formerly mighty.
There will be no cheap or painless fix. Somehow that retribution one commenter wants so eagerly will be settled on us all and it is simply because we live here and use the funny money.
What Adam Smith said
He should be writing these articles.
Urban you are so right! We are mired in this economic crisis because of greed, corruption, incompetence and “Free Trade” at the highest levels of business and government. There is no other cause whatsoever. When money is put on the table morality goes out the window.
What happened to our anti-trust laws?
I’ve experienced what inflation does to a country first hand. Next came a war that wiped out everything in the country. It was easy to stir people to turn on the minorities in the country - they were desperate. So, be careful what you wish for.
Glad to hear someone finally calling it a DEBT CRISIS.
This is more classical economics, free trade BS . This is what Alan Greenspan said he would do to solve this problem , you know the guy who created the whole mess in the first place. To solve the problem look at the trade defecit , the income gap , and deregulation and privatization. Thats where the jobs went, thats where the money went, and thats where the infrastructure went. You want to find hte crooks follow the money .
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Oh, there’s only a couple of minor problems with inflation as panacea for all our ills: first of all: which global investor (in the right mind) would ever invest in ever-inflatable (actually: deflatable) US-denominated government paper under a 20% annual inflation rate scenario? I certainly would not.
Would China continue buying our Treasuries for the sole purpose of replenishing our ever-bailing-out Treasury under a 20% inflation scenario?!? Yeah, but only if one and a half billion Chinese people suddenly went completely irrational, masochistic and/or self-destructive. Alas, I see no signs of Chinese leadership going poco loco any time soon.
And, oh…another minor problem. Inflation would eviscerate, if not completely euthanize US Dollar as the global-dominating currency of choice. That would be the end of America’s consume-everything-now-pay-everything-la ter economy, as nobody would be accepting our currency, except - perhaps - as a butt of jokes. That Venezuelan oil from Hugo Chavez would have to be paid in (suddenly very expensive) Venezuelan Bolivars, not with the piles of of suddenly worthless Dollars. This would hurt real bad — and not only our national pride.
And don’t even get me started on the price of imports. All of a sudden, all those cheap made-in-China imports (which means: 100% of everything in our stores, from soy milk to toys to electronic gadgets to hand mirrors and plastic tchotchkes to disposable umbrellas to contaminated pet food) would become dramatically more expensive: Flat-screen TV’s? New Car? Home renovation — hell, no! Not even a hope! Now OR in the foreseeable future, if ever! In this scenario, we are starring at the frighteningly real possibility of USA becoming a new Cuba or Zimbabwe.
And than, there is minor, shall we say, psychological component here. Inflation breeds insecurity, fears, economic paranoia. Money is dumped as soon as it is earned, prices change on a weekly, if not daily, basis; producers hold on to their stock rather than sell it for worthless money, shortages abound; economy suffers critical supply disruptions etc, etc, etc.
The reality is that there is absolutely NO cure for our ills. Neither good, nor bad, nor ugly. None whatsoever. Except, perhaps, one small sliver of hope, which has not been tried in 230 years: to once and for give up any and all hope of solving our domestic economic problems with a major global military conflict, and to then sit down with our archenemies for a brain-storming global economic session. And - Lo! - you might find them at least as reasonable as we are. America’s economy is not America’s problem anymore: we have outsourced our mismanagement and incompetence to the rest of the planet. This is the problem that needs to be tackled on a global level, and our New President will have to do a little pride-swallowing if he wants to help this country (by the way, the odds of this happening are about zero).
So much for the inflation as a chemotherapy for the economy. A humble suggestion: let’s try reasonable approach and have a radical surgery instead. It will hurt less. And the patient might actually survive, along with the rest of the world.
Bankrupty for failed businesses should have been the solution last year. When bad businesses fail, good ones quickly buy their assets and produce better returns. Capitalism should be a self healing system. By intervening and providing any kind of financial support, America has failed the ideal of free markets, and will have significantly lengthened the healing process. Chicken Little Ben Bernanke was also the worst possible choice; prophesies in the markets tend to become self fulfilling.
Oh how you have vindicated me, thank you!! I was making the argument for “forced hyperinflation” to a friend who works as a government auditor and he felt that it was not a viable path to follow. Glad to hear that I’m not the only one…