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.
Mark Carney: Growth in the age of deleveraging
Today, American aggregate non-financial debt is at levels similar to those last seen in the midst of the Great Depression. At 250 per cent of GDP, that debt burden is equivalent to almost US$120,000 for every American (Chart 1).
…..backsliding on financial reform is not a solution to current problems. The challenge for the crisis economies is the paucity of credit demand rather than the scarcity of its supply. Relaxing prudential regulations would run the risk of maintaining dangerously high leverage – the situation that got us into this mess in the first place.
As a result of deleveraging, the global economy risks entering a prolonged period of deficient demand. If mishandled, it could lead to debt deflation and disorderly defaults, potentially triggering large transfers of wealth and social unrest.
Managing the deleveraging process
Austerity is a necessary condition for rebalancing, but it is seldom sufficient. There are really only three options to reduce debt: restructuring, inflation and growth. Whether we like it or not, debt restructuring may happen. If it is to be done, it is best done quickly. Policy-makers need to be careful about delaying the inevitable and merely funding the private exit.
……Some have suggested that higher inflation may be a way out from the burden of excessive debt. This is a siren call. Moving opportunistically to a higher inflation target would risk unmooring inflation expectations and destroying the hard-won gains of price stability.
…..With no easy way out, the basic challenge for central banks is to maintain price stability in order to help sustain nominal aggregate demand during the period of real adjustment. In the Bank’s view, that is best accomplished through a flexible inflation-targeting framework, applied symmetrically, to guard against both higher inflation and the possibility of deflation.
The most palatable strategy to reduce debt is to increase growth. In today’s reality, the hurdles are significant. Once leverage is high in one sector or region, it is very hard to reduce it without at least temporarily increasing it elsewhere.
In recent years, large fiscal expansions in the crisis economies have helped to sustain aggregate demand in the face of private deleveraging. However, the window for such Augustinian policy is rapidly closing. Few except the United States, by dint of its reserve currency status, can maintain it for much longer.
…..The route to restoring competitiveness [in the euro-zone] is through fiscal and structural reforms. These real adjustments are the responsibility of citizens, firms and governments within the affected countries, not central banks. A sustained process of relative wage adjustment will be necessary, implying large declines in living standards for a period in up to one-third of the euro area.
…..With deleveraging economies under pressure, global growth will require global rebalancing. Creditor nations, mainly emerging markets that have benefited from the debt-fuelled demand boom in advanced economies, must now pick up the baton. This will be hard to accomplish without co-operation. Major advanced economies with deficient demand cannot consolidate their fiscal positions and boost household savings without support from increased foreign demand. Meanwhile, emerging markets, seeing their growth decelerate because of sagging demand in advanced countries, are reluctant to abandon a strategy that has served them so well in the past, and are refusing to let their exchange rates materially adjust. Both sides are doubling down on losing strategies. As the Bank has outlined before, relative to a co-operative solution embodied in the G-20’s Action Plan, the foregone output could be enormous: lower world GDP by more than US$7 trillion within five years. Canada has a big stake in avoiding this outcome.
Mark Carney: Growth in the age of deleveraging.
Comment: ~ One of the most important papers I have read this year. Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board — established by the G-20 in 2009 to further global economic governance — maps out the hard road to recovery from the current financial crisis.
Bulk trouble – macrobusiness.com.au
These three commodities [thermal coal, coking coal and iron ore] make up half of Australia’s terms of trade. The first few months of next year are not going to be kind to the TOT. Not kind at all.
via Bulk trouble – macrobusiness.com.au | macrobusiness.com.au.
Thermal coal:
Coking coal:
Iron ore:
Private sector debt growth warns of anemic recovery
The cause of current anemic GDP growth is evident from the recently-released Z1 Flow of Funds report. GDP recovery from 2008/2009 is accompanied by only a modest rise in Domestic (Non-Financial) Debt — which is now constraining further growth.
Domestic (Non-Financial) Debt is made up of Government Debt and Private (Non-Financial) Debt — which can be further broken down into Household and Corporate debt. The Financial sector is excluded as it mainly acts as a conduit, channeling debt to other sectors of the economy. We can see below that Private (Non-Financial) Debt contraction was far greater than overall Domestic (Non-Financial) Debt. What saved the economy was a sharp spike in Government Debt in 2009, offsetting the fall. The massive fiscal deficit may have left a public debt hangover, but failure to offset the contraction in private borrowing would have had more serious consequences: a GDP collapse similar to the 1930s.
Resumption of corporate borrowing has dragged Private (Non-Financial) Debt growth into positive territory but growth remains anemic and households continue to de-leverage. Cessation of government borrowing would cause a fall in overall Domestic (Non-Financial) Debt growth to near zero and a sharp fall in GDP. The economy needs to be gradually weaned off stimulus spending in order to minimize disruption to growth. And not before Private sector borrowing recovers. We need a clear deficit-reduction plan, over 5 to 10 years, in order to restore corporate sector confidence and encourage new capital investment.
The only alternative is further quantitative easing (QE3), where continuous deficits are funded by borrowing from the Fed. But that poses a whole new set of problems — and could lead us back to square #1.
Asset prices, financial and monetary stability
If financial imbalances can build up in an environment of low inflation it stands to reason that a monetary policy reaction function that does not respond to these imbalances when they occur can unwittingly accommodate an unsustainable and disruptive boom in the real economy. The result need not take the form of inflation, although latent inflationary pressures would normally exist. Rather, it would be a contraction in economic activity, possibly accompanied by outright deflation, amplified by widespread financial strains. Accordingly, one could argue that the more serious “bubble” was in the real economy itself.
In this scenario, the consequences of failing to act early enough can be serious. If the contraction in economic activity is deep enough and prices actually decline, they can cripple the effectiveness of monetary policy tools and undermine the credibility of institutions. The Japanese experience is very instructive here. Moreover, reaction functions that are seen to imply asymmetric responses, lowering rates or providing ample liquidity when problems materialise but not raising rates as imbalances build up, can be rather insidious in the longer run. They promote a form of moral hazard that can sow the seeds of instability and of costly fluctuations in the real economy.
This paradigm sees the financial imbalances as contributing to, but, more importantly, as signaling distortions in the real economy that will at some point have to be unwound. In other words, the behaviour of prices of goods and services is not a sufficient statistic for those distortions. This runs contrary to the standard macroeconomic models used nowadays.
Asset prices, financial and monetary stability: exploring the nexus
by Claudio Borio and Philip Lowe
July 2002
Colin Twiggs: ~ Extract from BIS Working Paper No.114, co-authored in 2002 by Dr Philip Lowe, who has been appointed as the new RBA deputy governor. Looks like a good choice.
Deleveraging is over — it’s time to cut the deficit
US commercial bank loans and leases bottomed in April 2011, after shrinking more than $1 trillion in the previous two years. The annual rate-of-change has now recovered to positive territory, relieving downward pressure on asset prices, including stocks and real estate. Deleveraging has come to an end and is only likely to resume if the economy suffers further financial shocks.
You would expect the gap between savings and investment to close when net debt repayments cease, but a significant shortfall between Gross Private Savings and Domestic Investment warns of continued instability.
The Investment – Savings gap is reflected by strong, negative Net Private Investment on the chart below. If it were not for the fiscal deficit, the US would risk a significant contraction in national income.
For the benefit of those who may have missed my earlier coverage of this issue:
Debt repayment after a financial crisis/balance-sheet recession creates a gap between savings and investment that has serious implications for the economy. The resultant shortfall between spending and income risks a sharp contraction in national income. The gap may be relatively small but, like a puncture in a car tire, the impact can be huge. It only takes each of us to withhold 2% of what we earn (e.g. to repay debt) for a gap to appear between spending and income. A for example may earn $1.00 but now only pays 98 cents to B, who will pay 96.04 cents to C, who will pay 94.12 cents to D, and so on through the entire supply chain. By the time we get to L, they will only earn 80 cents where they previously earned $1.00.
The solution, as Keynes pointed out, is for government to offset the shortfall by running a fiscal deficit. The chart above shows that Treasury has been doing exactly that — spending more than they collect by way of taxes — in order to prevent a contraction. The problem is that continual deficits have two serious side-effects. The first is a loss of investor confidence as the ratio of public debt to GDP rises. The second is inflation — if private investment recovers and starts competing with government for ever-scarcer resources. By inflation I do not just mean an increase in the CPI, but also rising asset prices as experienced in the 2004 to 2008 housing bubble, when government ran a deficit while net private investment was positive.
As the chart shows, the fiscal deficit is being funded by net savings (plus a little help from China). So what would happen if we cut the deficit?
- An optimistic view would be that cutting the deficit would restore confidence and encourage more private investment, shrinking the savings – investment shortfall.
- Pessimists, however, would warn that private sector balance sheets have been impaired by falling asset prices and investors are reluctant to borrow even at current low interest rates. A shrinking deficit without a counter-balancing rise in investment would send the US back into recession.
The truth lies somewhere in between. Corporate balance sheets are generally in good shape while small-to-medium business and home-owners have suffered significant impairment. And one of the major factors inhibiting investment is the uncertain political/economic environment.
Deleveraging has ended and the time has come to start cutting back the government deficit — but cautiously. Cutting the entire deficit in one hit would be more of a shock than the economy could bear, but setting out a four-year plan to cut the deficit by say 2 percent a year would do a lot to restore confidence and set the economy on a path to recovery.
When debt levels turn cancerous – Telegraph Blogs
The professoriat has been a little too cavalier in arguing that debt does not really matter for the world as a whole because we all owe it to ourselves. Debtors are offset by creditors (not always from friendly countries). Common sense suggest that this academic solipsism is preposterous, and so it now proves to be.
“As modern macroeconomics developed over the last half-century, most people either ignored or finessed the issue of debt. Yet, as the mainstream was building and embracing the New Keynesian orthodoxy, there was a nagging concern that something had been missing…..There are intrinsic differences between borrowers and lenders; non-linearities, discontinuities… It is the asymmetry between those who are highly indebted and those who are not that leads to a decline in aggregate demand.”
Creditors do not step up spending to cover the shortfall when debtors are forced to retrench suddenly. So the economy tanks.
via Ambrose Evans-Pritchard|When debt levels turn cancerous – Telegraph Blogs.
The Botox economy
Fire the Fed …… and replace them with a Rating Agency
On 1 November 2010 the Fed commenced QE2, purchasing US Treasurys with the stated intention of reducing long term interest rates. Over the next 4 months, 10-Year Treasury yields rose by 120 basis points (1.20%).
Why do we need the Fed, who can’t punch their way out of a paper bag, when a rating agency (S&P) can send yields plunging 65 points in less than two weeks. 🙂
Did Standard and Poor’s Break SEC Regulations in Disclosing Its Downgrade to Select Parties? « naked capitalism
There is a much more straightforward basis for questioning S&P’s conduct, and it has nothing to do with how S&P arrived at its rating. There is compelling evidence that the ratings agency made selective disclosure of its downgrade decision before it made it public last Friday evening. A reader told us certain hedge funds were informed Tuesday and traded successfully on the information. A separate source had told me certain banks were briefed on Thursday and were told of the US downgrade but assured their ratings would be unaffected. On Friday morning, Twitter was alight with the news.
It appears that some market participants were aware of the coming downgrade even earlier — on Friday [?] the previous week.