-- 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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First, we must look at what GDP means. I can be sitting around a job which pays a salary but may be twiddling my thumbs or attending never ending and mostly useless meetings, but since I am earning a salary, my activity or more precisely, inactivity would also be a part of the GDP. Our economy has become what it is, is because we place an undue importance on the “service sector”.
If an economy has a greater contribution from the “service sector” than from activity which produces goods to meet necessary and luxury goods, then the effective cost of the goods produced has logically been less efficient. For example, most government and private bureaucracies not involved in the making of goods actually decrease the value of their “labor” as far as GDP is concerned.
Great observations in this editorial but, never mentioned is the role of the trade deficit, now a cumulative $9.2 trillion since our last surplus in 1975, all of which has been financed by a sell-off of American assets. The trade deficit is the reason for the explosion in debt, so the first step in correcting it is to restore a balance of trade. This nation desperately needs to abandon the ill-advised experiment in free trade that began in 1947 with the signing of GATT, and return to the trade policies successfully employed by this nation for the first 171 years of our history to assure a balance of trade.
An excellent analysis, missing just one thing. The current move to nationalise the private loans of which you speak should lower their cost, freeing up cash. I imagine that a sensible view for central bankers is that this should go to reducing the debt pile. I rather suspected that politicians may have other ideas for it. In any event, the some of the inflation and default foreseen in your article is inevitable. In my view it would be best to be open about it so that inflation expectations can be properly managed. Haven’t seen anyone else with this analysis before now, so well done.
For some reason I retained a copy of page 15 of the Monday January 14th, 2008 European edition of the WSJ (its not aways just for wrapping fish and chips)that contained the following worrying advice from the breakingview.com column.
The piece considered whether the US government could lose its triple-A credit rating and imagined that a martian viewing the scenario would focus on the possible withdrawel of the “exhorbitant privilege”, i.e. Giscard D’Estaing’s phrase for the US’ ability to sell unlimited dollar denominated debt to foreigners. The column notes that a falling dollar keeps the total debt from growing by pushing up the value of US assets denominated in foreign currencies, and then it adds:
“Better yet, the US can shrink the real value of the foreign debt on its own. It just has to let inflation rip”.
Please NO! It will be like the book of Job.
A solution to the herding greed of capitalism is not socialism, or state intervention, but more free market capitalism. Free market capitalism depends upon transparency, a free flow of information and taking responsibility for bad calls. Cartels, black pools and off balance sheet conduits and SPVs have encouraged the development of a self destructive culture, highlighted some years ago by Frank Partnoy in his torchlight book F.I.A.S.C.O The system needs transparency and competition as they are the only real regulators. For every loser there should be a winner. Did not only the regulators, but also all the competition fall asleap on their watch? No. There can not just be losers, who all need tax payers’ bailouts. Tax funds should be used to assist new start ups, new regional banks and new mutal banking and lending organisations, not to guarantee the mistakes of the fallen.
Eventually the course that would be set by Andrew Mellon must prevail. The twist is that putting underwater residential mortgage holder bail outs are inevitable given the collapse in real estate asset values, but it must be funded and that is where death duties come in. Those that clipped the ticket on debt must pay, and the old world money that went along for the ride is equally complicit in the erosion of regulatory, political and academic institutions. Making them pay equally on an ad valorem basis will see impetus rather than rhetoric behind the moral hazard imperative.
The meltdown of the financial services industry has already obliterated trillions of dollars of economic value.
Part of John’s ’solution’ advocates a second wave of wealth destruction through hyper inflation. This means that whatever money you have managed to salvage from the credit crunch economic meltdown will be devalued as the prices of goods and services rise.
I agree with John’s point that companies that have allowed their management to plunder and squander their resources should be go bankrupt and in the process terminate piles of debt.
In the case of failing and failed banks the government should buy these entities from the liquidators after the debts have been extinguished. The next step would be for Government to terminate the independence of the central bank and for control monetary policy and printing money to be restored to the State.
During last one decade all major crises came from the USA and its major allies like UK. They consider themselves most civilized and master of things like finance and humanity.
But if we anylize things deeply, we would find that most cruel and dis-honest people live in these two countries, for example Bush and Madof.
Extrapolating John Kemp’s analysis, this looks like an extension of the recent Icelandic model / experience to the mainstream economies…
Most of Mr.Kemp’s analyses are right on but the final play may not be a combination of bankruptcy and/or inflation. I agree that the current debt level is not servicable but simply declaring bankruptcy will not solve it because CDS market will ensure that we will not have a single medium or large size bank left standing the minute we force a couple of big ones into declaring bankruptcy. We can not start nationalizing them all because than government would end up doing 90% of banking and trading. We all know that’s not possible. On the other hand, creating inflation is hard too, because money put into banks are not coming into markets. Effectively, money multiplier is 0 instead of being 10. So real money is shrinking at an unprecedented level, and taking down the real economy. This will be the hardest task ever for whoever is going to be managing the economy in the next couple of years. The solutions are not easy, most are not doable. It requires a lot of luck, and needs someone who understands the markets,a real trader like George Soros,not an academician (i.e. Greenspan, Bernanke) or investment banker (Paulson) or an opportunist (Rubin). We all got into this because some bankers thought they can generate great revenues without taking market risk with government bond like instruments, because geeks told them they are AAA. Now we know extra return does not exist without taking risk. Same philosophy applies here; we have to take some risks to get out of this mess we get into because we thought we were not taking risk. And for that, we need very good risk takers at the top to get it done.
I agree, the only way to resolve this is mass defaults.
SO…..The debts are unrecoverable, take your losses, and if u still have the resources to continue than fill the void left by those that dont.
Go to Zimbabwe! Mugabe would LOVE you. They are now printing their first hundred trillion dollar note for people to use..”for convenience”. Of course the news article reporting this neglected to say that Zim banks would never issue such a note to customers as they are limited to ten thousand zeedollars a day to bank customers by law, an amount that is not worth the paper it is printed on, and is likely rare; most having been used as fire fuel long ago. You should go to Zimbabwe. And stay there!
Good question Mr Kemp, but answer not so simplistic.
Credit default swaps (CDS), collateralized debt obligations (CDO) and the like –synthetic instruments or derivatives that can increase leverage without any relation to textbook theories tied to savings rates, etc.
The notional amount of CDS last year was in the tens of trillions of dollars, mulitples of the actual amount of underlying debt. CDS are useful as hedges, but left unregulated they are also susceptible to naked or leveraged speculation. By putting up margin, a small percentage of the notional, counterparties could take and trade positions (gamble, speculate) on certain assets like bonds or mortgages. Similar to call options or buying stock on margin for small investment you buy the right to participate in the upside without burden of putting up whole purchase price.
These are near perfect instruments for speculation.
In 1954, J.K. Galbraith, writing in “The Great Crash 1929″ (reprinted in 1979) wrote:
” The machinery by which Wall Street separates the opportunity to speculate from the unwanted …burdens of ownership is ingenious, precise and almost beautiful. Banks supply funds to brokers, brokers to customers, and the collateral goes back to banks in a smooth and all but automatic flow. Margins –the cash which the speculator must supply …are effortlessly calculated and watched. … Wall Street, however, has never been able to express its pride in these arrangements. They are admirable and even wonderful only in relation to the purpose they serve. The purpose is to accommodate the speculator and facilitate speculation. But the purposes cannot be admitted. If Wall Street confessed this purpose, many thousands of moral men and women would have no choice but to condemn it for nurturing an evil thing and call for reform. Margin trading must be defended not on the grounds that it efficiently and ingeniously assists the speculator, but that it encourages the extra trading which changes a thin and anemic market into a thick and healthy one. … Wall Street in these matters, is like a lovely and accomplished woman who must wear black cotton stockings, heavy woolen underwear, and parade her knowledge as a cook because, unhappily, her supreme accomplishment is as a harlot.” p.20
I dont know I exactly agree with all Galbraith says, but in the 1990s, CDS took the place of margin trading in the debt markets and allowed participants to create a huge market that fostered the creation of unrestricted and unprecedented amounts of leverage — I believe Warren Buffett once remarked something to the effect that he couldn’t quite understand all the possible implications of the CDS market, and that fact alone made him suspicious.
American stock mkts. are phoney as hell.contrived and controlled by hedge funds,and a conglomerate of corporations buying & selling their own shares in unison at given intervals. At this point in time i’m convinced the stock mkts. are grossly over bought. A real crash my be just around the corner.
So how exactly does the author see the government will inflate the debt away? As soon as money printing induced CPI increases, so do the interest payments on the huge national debt and we are back in deflation.
Ladies & Gentlemen,
I can’t tell you how depressed I was lately regarding this economic situation. Then I read the posts following this article. The majority of the posters get it. Hyper-inflation will benefit the government and hurt the people.
Our “leaders” remember OF the people and BY the people . . . they just forget the FOR the people.
If you want to really understand what the US would be like in a hyper-infaltionary enviroment, just google: “weimar republic” or “zimbawe”. We don’t want to go there … I don’t care who’s company it saves.
Sadly, this IS where we are going unless the people wake up.
Great analysis - and if the subprime crisis hadn’t been the trigger, the studen loan & credit card debt would have been the trigger - we’d be asking “why did they make all those loans to students who didn’t have a job future in the U.S. thanks to outsourcing to low-wage countries?”.
The outsourcing of manufacturing has been a major factor - manufactured goods represent Real wealth, not Leveraged wealth - and the entire country forgot that without real wealth, no amount of leverage does you much good. This is also a side effect of NAFTA and similar trade deals, which increased the financial wealth of the United States while at the same time reducing real wealth.
Similarly, infrastructure - roads, electric grids, bridges - are real wealth because they allow the rest of the economy to function. Corrupt manipulation of energy prices increases financial wealth (i.e. the manufactured California energy crisis, 2000-2001) but destroys real wealth (businesses had to stop manufacturing, etc.) - but Wall Street doesn’t understand the difference between the two:
Real wealth is not subject to inflation - a lobster or a car is still a lobster or a car at the end of trading. Financial wealth is subject to inflation, and typically a decrease in real wealth will lead to inflation - the lobsters are rarer and so cost more; the cars are fewer and so cost more, etc. Argentina, here we come.
[...] 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. http://blogs.reuters.com/great-debat…deb t-disaster/ [...]
let’s just keep it simple: save more, spend less
for the government, firms, and individuals. There will be some pain to be endured for sure but there’s simply fast and painless way out of it. How did you think countries like China and Singapore become such mighty economic super power so fast?
The perspective of the current economic quagmire by one of Thatcher’s children Louis Szikora..not quite sure how I stumbled on your website and comments but certainly am enjoying the read!
Mrs Thatcher had probably about right in her housewifely handbagging ways. She was a tough cookie who didn’t use government money to bail out weak companies…she always looked to reduce government borrowing and in my time made me proud to be British for the first time in my life. Her sometimes brutal honesty and disciplined ways spawned a whole new vitality in the UK as well as inspiring nations around the world to follow suit. She certainly had a finger on the pulse of the monetary supply and it would be hard to envisage the same sweetly named’credit crunch’ occuring under her watchful eye.
Am sure Maggie would in no way be bailing out greedy banks etc…nor would the UK be in a situation with a chronically overfed public sector and bloated unproductive welfare state and its millions of dependents. Nor would Mrs Thatcher have permitted an open door immigration policy to all-and-sundry whilst allowing our own burgeoning underclass to fester and rot on growing state dependency and criminally high rates of disability benefits to those able to work but not sufficiently motivated to do so. Anyone left wondering where the money’s gone?
Woe betide the US if Obama’s fine rhetoric and intentions bring the US to an unmanageable mixed economy such has become the UK…the UK in a debt crisis….oh did you see how Tony Blair nipped off just a few weeks before the first bad news hit our screens??? Good timing Tony…..
Am often inspired by US wealth creators though today shocked to learn about inadequate health care for those who cannot afford health insurance in the US. watch this quickly while it’s on BBC ’s video on demand iplayer http://www.bbc.co.uk/iplayer/episode/b00 gvflg/Panorama_What_Now_Mr_President/
Obama’s got some work to do there and I hope the US can indeed become fairer in its treatment of the genuinely poor and weakest of society without being over liberal and squandering zillions of taxpayers’ money as happens in the UK. The point is zillions of taxpayers’ money to prop up what is effectively a bankrupt system is just weakening the West and rendering us less able to compete economically with the East.
I guess some of you in the US cannot imagine the extreme state generosity to the undeserving here in the UK.
That said…you need to fine tune your economy so that it benefits the truly needy without crippling the creativity of the people. It doesn’t inspire confidence to see a young US mother of 4 dying for lack of health insurance for a liver transplant whilst US can finance schools, roads and all sorts for Afghanistan etc.
As for the debt burden of today’s society…well I only have to look into my own excesses to understand what the rest of us have been up to. Am not proud..i have lived on borrowed time and equity in absence of real economic activity for many years. That said I will manage it or suffer the consequences if I do not…we all must suffer for our actions. I don’t expect any government bailout for sure!
On a positive note: health is the most important thing. Wealth creation is a great thing but we should not lose sight of basic human needs.I watched a programme about US people applying for food aid today…good Lord… they certainly looked like they needed a diet before state food handouts. End of the era of excess?
You know…it’s time we in the West focused less on material consumption as what defines us and our status in the world. We’ve imported just about all we can from Asia on tick…the last and most important thing I now recommend we import is a good dose of Buddhism and acceptance of the here and now. From this point on we should be able to see ourselves and our personal needs more humbly and realistically.
I do believe it’s the dawning of new political and economic order with a swing to Asia that will be unstoppable in our lifetime. Boohoo to those who internationally financed our Last Supper! They were just as guilty of greed as the rest of us
Now… keep calm..learn yoga…meditate…whatever it takes for lift your stress of the here and now..learn to breathe and hear your own heart beat. Prepare to lose your homes, plasma tvs or whatever..but take a good look at those around you whom you love and care about…and check your pulse and look forward to sharing the next sunny day with them. Just look at how Thailand handled the tsunami….pretty cool people and known as the Land of Smiles. There’s more than just gadgets on the cheap we can obtain from Asia. We need to take on board some of their thinking too - big time from now on!
It’s the kinda thing many do in parts of Asia when disaster strikes. Live for the moment….yeah!
Am giving up the UK…there’s nothing left for entrepreneurs…am off to live in Asia soon. If ya can’t beat ‘em….join ‘em :))))
Thanks for listening…back to my imported Austrailian Chenin Chardonnay as long as the £ Pound permits