Just as we dubbed the first years of the current millennium as the last phase of the credit boom, then we tend to view the current era as the age of deleveraging. The developed world took on too much debt during the good times and is now trying to shrink its balance sheet.
If you look at the data, however, very little of this deleveraging has actually taken place. Adding up the debts of all the various parts of the economy (governments, households, banks, companies), Jamil Baz of the hedge fund GLG calculates Spain’s debt-to-GDP ratio rose by 56 percentage points, between June 2007 and 2012, Italy’s ratio by 60 points, Japan’s by 64, Britain’s by 68, France’s by 85, Portugal’s by 92 and Ireland’s by a staggering 422 points. America’s ratio is slightly higher than it was back in 2007 but it has come down from its 2009 peak; the same is true of Germany.
Of course, the distribution of the debt has changed. The private sector has tried to reduce its debt and the government has stepped into the breach. In the US, for example, financial sector debt is down 20 points and household debt has fallen by 12. British households also have less debt than they did before the crash. To the extent that governments are better able to shoulder the burden, and have lower borrowing costs, this is a net gain.
Not all governments can bear the burden easily, of course. In the euro-zone, countries have given up the right to print their own currencies. The Europeans were determined not to have their economic plans disrupted by currency speculators as happened so often in the 1970s and 1980s. But the economic fundamentals that led to repeated currency realignments in those decades were not abolished by the advent of the euro. Eventually the pressures showed up in the bond markets instead.
Outside the euro zone, most countries have found their deficits relatively easy to finance; indeed, government bond yields have been at record lows. But it is hard to be sure why this is. Clearly anxious southern Europeans have moved their cash into the apparent safety of American and British, as well as German, government bonds. However, the use of quantitative easing means that government bond prices are no longer set in a free market; investors are well aware that central banks will step in to buy bonds and keep yields down. It is far from clear how these programmes will be unwound or indeed, when central banks will want to risk selling their holdings.
A related, and difficult, question is how long the age of deleveraging might last. Economists Carmen Reinhart and Kenneth Rogoff have suggested that previous financial crises have taken seven to 10 years to clear up. But we are far from sure what the “maximum” debt-to-GDP ratio might be, beyond realizing that the likes of Ireland and Iceland went too far.
The best way to get out of a debt crisis is to grow. But the US economy is hardly booming and Europe is struggling. Some put this down to austerity and the IMF recently suggested that fiscal tightening might have more of a contractionary effect than it previously thought. Given the political opposition, governments may well slow the pace of austerity until the private sector takes up the slack.
But that raises the question of what will make the private sector more confident. It is hardly surprising that workers are reluctant to borrow given the squeeze on their real income caused by higher energy prices and measly wage increases. Big businesses have cash but seem unwilling to invest because of the economic outlook; small businesses might be willing to invest but cannot get banks to lend to them.
The danger is that the economy gets stuck in a rut, rather as Japan has done in the last 20 years. But if we don’t grow our way out of the debt, what else can we do? Default is one option. Within the euro zone, Greece has already done so and other countries may yet reschedule their debt (borrowing for longer periods at a lower rate) as a way of easing the burden.
Countries which have borrowed in their own currencies can, in theory, inflate or devalue their way out of the problem. Many fear that QE is part of this process. But so far QE has yet to lead to any general inflation and many believe that each round is less effective than the last. There have been hints, however, that central banks might take things one step further; cancelling the debt the government owes them. That would be one way of bringing down the debt burden quickly. But would this result in rapid inflation or would it be deemed as a default by the rating agencies?
Such an option might seem a long shot at the moment. But if economies continue to stagnate, thoughts may yet turn to more unconventional options. After all, twenty years ago, who could have imagined we would have zero interest rates and vastly expanded central bank balance sheets?
Philip Coggan is Buttonwood columnist and capital markets editor for The Economist and author of Paper Promises.