The role of fiscal deficits in deleveraging
“You can’t get out of debt by adding more debt.” How often have you read this sentence? It is a cliché. I am going to argue that, to a first approximation, this obvious, even banal, statement is the reverse of the truth, which is that the only way to get out of debt is to add more debt. What matters is who adds the debt and in what form. To put it more bluntly, it depends on who these“you” are.
As I have done in two previous posts on the theme of “balance-sheet recessions”, I am going to focus on the US, because it is the most important country now going through the post-crisis deleveraging process.
Let us start with an obvious and crucial fact: at the world level, net debt is zero. For an individual country, net debt is how much foreigners have lent to residents less how much residents have lent to foreigners. In the case of the US, net debt at the end of 2011 was 44 per cent of GDP, roughly an eighth of gross debt.
Suppose that all the people who lent and borrowed knew what they were doing: thus they had an unbiased and reasonably accurate appreciation of the future course of incomes and asset prices. Then, barring some huge and unexpected external shock –a world war, for example – the debt some have contracted would create no problem. It would simply reflect improved opportunities for inter-temporal trade in savings.
This is, however, not the world we live in. Indeed, if we did live in such a world, huge financial crises would be impossible. If you disagree on that point, I recommend that you read something else.
If the people who have borrowed, the people who have lent and the intermediaries that went between them have made large errors about future prospects, then gross debt can become a serious problem, indeed. It can cause huge crises and subsequent depressions.
Unfortunately, people are regularly fooled by rising asset prices, particularly rising house prices, into borrowing more than they should. In making such mistakes, they will always be encouraged by the foolish, the ill-informed and, above all, the self-interested. Maybe, people think, “this time is different”, to quote the title of the seminal book by Carmen Reinhart and Kenneth Rogoff.
Financial intermediaries play a crucial role in such a “bubble economy”. The managers and other employees of intermediaries can become extraordinarily wealthy by leveraging up the balance sheets of their institutions and those of their customers. Indeed, they are able to create leverage and so money (the other side of the banking sector’s balance sheet), at will. The result is more debt and a more fragile economy.
Now consider what happens when the asset prices start to fall. Debtors will be unambiguously poorer. Creditors will also feel poorer, since their assets will have deteriorated in quality. Financial intermediaries will become both insolvent and illiquid. There is likely to be a systemic financial crisis.
The supply of credit to the private sector will halt. Borrowing will shrink. Investment, particularly in new housing, will collapse. The desired savings of the heavily indebted will rise, as they seek to pay down excessive debt. Creditors, too, will become far more cautious, as they recognise how vulnerable they have become to a wave of bankruptcy among their debtors. The overall effect will be big cutbacks in spending and a deep recession, if not worse. A big financial crisis will accelerate the cuts and turn the recession into a potential depression. That is, of course, what happened in 2008.
The effects of the emergence of balance-sheet constraints on spending and borrowing will, in brief, be revealed in the huge financial surpluses in the private sectors of crisis-hit economies.
These forces for shifting the private sector into surplus are very strong, as the previous post showed. But, as I also noted, the sum of all sector financial balances must be zero. This is basic accounting. As the Oxford University macroeconomist, Simon Wren Lewis notes, sectoral financial balances provide a fundamental check of the feasibility of envisaged adjustments.
There are only two other sectors: the government and the rest of the world. So, if the household and corporate sectors are to go into surplus, as the over-indebted seek, or are forced, to pay down their debt, the other two must go into deficit. That is exactly what has happened: the government has gone massively into deficit, not because of active policy decisions, but as a result of declines in revenue and rising government spending triggered by the post-crisis recession.
The alternative would have been a shift into an external surplus. Suppose, for simplicity’s sake that the US government had been determined to run a balanced budget throughout. Suppose, too, that the private sector had continued to run roughly the same financial surplus as it did after the crisis.
Then the surplus in the current account would now need to be 6 per cent of GDP – a shift of about 11 per cent of GDP over five years. For small, open economies, like Ireland or Estonia, such a shift is just about conceivable. For the US it is impossible, without a collapse in imports, which would follow a deep depression. The productive capacity to produce such a surplus and the willingness of the rest of the world to accept it simply do not exist, at least in the short to medium run.
It follows as a matter of logic that the only way of accommodating the private sector’s need to run aggregate financial surpluses is for the government to run large fiscal deficits. It is, therefore, not only untrue that one cannot get out of debt by adding to debt, it is in fact the obvious way of doing so.
This leaves two further points.
The first concerns the role of monetary policy. The answer is that by pursuing an aggressive monetary policy, the central bank can hold up the prices of assets and facilitate debt service. These effects should lower the desired financial surplus of the private sector, by encouraging spending and reducing the pressure to pay down debt. But, despite the most aggressive monetary policy in US history, the private sector is still running a huge financial surplus. It follows that this sort of monetary policy has not been enough to prevent the emergence of the extraordinary financial surpluses I noted in my previous post.
The second concerns the feasibility of offsetting private sector deleveraging with public sector leveraging. The point I am making here is that it is possible to get out of debt by going into it because the burden of the gross debt shifts from some people to other people: more precisely, it shifts from the people who borrowed too much in the run up to the crisis to future taxpayers.
Is that feasible? Certainly, it is feasible if taxpayers can bear that burden. Is it moral? Yes, it is, if it prevents the economy from collapsing into depression. Contrary to what is often said, the present is not simply bequeathing larger debts to the future. It is bequeathing both larger debts and larger financial claims in order to sustain a larger economy, now and in future.
It is doing this by shifting the debt from the shoulders of those who cannot bear it today to those – taxpayers at large – who can. The crisis is because the wrong people (and institutions) are indebted. The obvious way to change this is for the debt to be paid down. But the impact of that is to depress the economy. Some other entity must start to borrow, instead. In a post-crisis recession, the only credible borrower is the government.
Now, suppose that instead of letting that happen, it followed advice to eliminate the fiscal deficit promptly. What would happen? If the government is to eliminate its deficit, the rest of the economy must also go into balance. If we assume a modest adjustment in the external balance, that must mean an elimination of the private surplus.
That has two implications. The first is that, with the ability of monetary policy to stimulate private spending quite possibly exhausted, the adjustment will occur via a collapse in private incomes: in other words, the private sector will cease to run a surplus because the economy falls into a depression. The second implication is that deleveraging is then going to occur via the mass bankruptcy triggered by such a depression.
Thus the deleveraging brought about by the offsetting of a large private surplus with a large government deficit is the least disruptive way of securing the post-crisis adjustment. This policy will not work , however, if one (or both) of two things are the case: first, the government risks becoming excessively indebted; or, second, the private sector will save more, precisely because the government is becoming excessively indebted.
The evidence for the latter – “Ricardian equivalence”, as it is called – is weak. The assumptions that underlie it – perfect capital markets, for example – are particularly inapposite in a financial crisis.
The former is a far more serious objection, however. I will examine it in two more posts on this topic, which will examine what the alternatives might then be to private sector adjustment via large financial surpluses offset by huge government deficits.
