Don’t fear the death of excess debt
James Saft is a Reuters columnist. The opinions expressed are his own.
How do you save an economy during a debt bust without mass defaults or a lost decade?
From the evidence thus far the answer is: you don’t.
Both Europe and the U.S. have bent over backwards in trying to deal with excess private and public debts without default, hoping to keep the circus floating along for long enough so that they can be rescued by growth and inflation.
In the U.S. that has meant rescuing the banks while using various types of new leverage to try to keep housing and securities prices above the level where banks carry them. In Europe, quixotically, this has included both cutting back on public expenditure while at the same time refusing to recognize a 50 percent writedown on Greek debt. It has also meant keeping banks and countries on life support via loans or debt purchases from the European Central Bank.
If you want to know how well temporizing works while dealing with a mass repayment of debt, you only need to look at Japan, the original victim of a self-inflicted lost decade of scant growth. There, too, bad companies and banks were kept alive, and calls for fiscal sobriety without debt restructuring produced lousy results. The hallmarks were very little growth and a tendency to lurch back into recession.
So why this fear of extinguishing debt? In part it is because a default or jubilee makes plain who is getting gored, unlike a soft default through inflation. It is not easy, politically or practically, to press reset on an over-leveraged financial system. And in Europe the losers in a mass default would be concentrated in the north, whose banks and countries would be hit, while the private and public borrowers of the south would tend to benefit.
It is also made worse by the fact that the dominant strain of conventional economics fails to take account of the key role that both debt and instability play in capitalist economies. In this view because one man’s debt is another woman’s wealth, the debt itself is held not to matter. This is based on a naive model under which debt is created by savers lending their money to borrowers.
That’s not how it works in the real world, where banks in essence create money when they choose to make loans, only later looking for the reserves to backstop the deal. Nor does it reflect the way in which the shadow banking world of securitization and investment leverage creates money and drives prices and economic growth.
WRONG SIDE OF THE SLOPE
With private creditors having reached saturation and now seeking to repay debts, we now find ourselves on the downside of a slope where simply supplying easy terms to banks fails to stimulate borrowing or growth. Add to this the folly of the European bank recapitalization programme, and very possibly a similar one to come in the U.S. This will only force many banks to all sell loans and other assets at the same time, depressing prices and making credit for those who can’t tap a friendly central bank much harder to get.
“The way you get out of a debt-induced crisis is by abolishing debt that never should have been extended in the first place,” Steve Keen, an iconoclastic Australian economist said in a talk with the Institute for New Economic Thinking.
“You can do it in the slow grinding way of bankruptcy, or you can do it rapidly with a debt moratorium. The financial sector fundamentally has the responsibility for creating that debt — it should never have been extended in the first place. If we continue honoring that debt which was dishonorably extended, we face an incredibly long period of slowly reducing that debt in the grinding ways we allow.”
Keen is in favor of a kind of a modified debt jubilee, under which all individuals are given money and those with debt are forced to use it to pay it down. This type of debt monetization could also theoretically be applied to sovereign debt, though this is not part of Keen’s plan.
Of course just printing money by itself does nothing to prevent another bubble forming, in fact it could create an incentive for people to take on too much debt in hopes of being bailed out by the next jubilee.
For that, you’d need strong controls on the financial system to prevent it from supplying excess leverage. That actually might help to control excess borrowing by states, as the risk-blind way in which the banking system treats sovereign debt is a prime cause of our current state.
A controlled debt jubilee beats the other two likely alternatives; a market-imposed borrowing freeze with a currency crisis or years of Japanese-style misery.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)