[R-G] [BillTottenWeblog] US and UK on Brink of Debt Disaster

[Bill Totten]

by John Kemp

Reuters (January 20 2009)

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, 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
{1}. 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 sixty
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 {2}. 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 makes clear the rise in private sector debt had
become unsustainable {3}. 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 cash flow. 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 nationalization, 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.

Links:

{1} https://customers.reuters.com/d/graphics/USDEBT1.pdf

{2} https://customers.reuters.com/d/graphics/USDEBT2.pdf

{3} https://customers.reuters.com/d/graphics/USDEBT3.pdf

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http://www.globalpolicy.org/socecon/index.htm

More Information on US Trade and Budget Deficits, and the Fall of the Dollar
http://www.globalpolicy.org/socecon/crisis/tradedeficit/index.htm

More Information on Bubble Capitalism and the World Economic Crisis
http://www.globalpolicy.org/socecon/crisis/index.htm

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