Martin Wolf's Exchange

In the previous three posts in this series, I have argued that large fiscal deficits are a more or less inevitable concomitant of post-financial crisis deleveraging by the private sector. Moreover, I have argued, substituting a solvent debtor (the government or taxpayers, in general) for insolvent (or illiquid) private ones is feasible and desirable in an economy going through a balance-sheet recession. It is therefore quite possible to get out of debt by going into it, because they are not the same debtors. And the distribution of the debt, not its level, is what matters.

Needless to say, arguments can be made against this point of view and alternative policies considered.  But, before considering those arguments and alternatives, it is crucial to stress one point: no pain-free escapes from the consequences of a huge credit boom and consequent private sector debt overhang exist. We are trading off bad alternatives.

The simple argument for taking the fiscal deficit route is that in countries in balance-sheet recessions that are lucky enough to have their own currency, rates of interest on long-term debt can be very low.  This is because the depression condition is, rightly, expected to be long-lasting. An economy in such a liquidity trap has excess ex ante savings and so ought to have very low interest rates as Paul Krugman has argued in the New York Times.

If interest rates are very low, the cost of running fiscal deficits is also very low. Indeed, with real rates of interest in the US and UK close to zero, government borrowing is now free, in real terms. (See the extraordinary charts below, in which bond yields collapse as the fiscal deficits soar.) So why not borrow?

So what is the objection to running such deficits? The most potent comes from Carmen Reinhart, Vincent Reinhart and Kenneth Rogoff, in “Debt Overhangs: Past and Present”, April 2012. This is from the abstract of their paper:

 “We find that public debt overhang episodes [when ratios of public debt to gross domestic product exceed 90 per cent] are associated with growth over one per cent lower than during other periods.  Perhaps the most striking new finding here is the duration of the average debt overhang episode.  Among the 26 episodes we identify, 20 lasted more than a decade. Five of the six shorter episodes were immediately after World Wars I and II.  Across all 26 cases, the average duration in years is about 23 years.  The long duration belies the view that the correlation is caused mainly by debt build-ups during business cycle recessions.  The long duration also implies that cumulative shortfall in output from debt overhang is potentially massive.  We find that growth effects are significant even in the many episodes where debtor countries were able to secure continual access to capital markets at relatively low real interest rates.  That is, growth reducing effects of high public debt are apparently not transmitted exclusively through high real interest rates.”

I have great respect for these authors who have made enormous contributions to our understanding of debt crises. But what conclusion should one draw from their analysis?

The conclusion one cannot draw is that public debt must be kept below 90 per cent of GDP, whatever the cost. Struggling to keep debt below 90 per cent of GDP might be far more costly than letting debt rise above that threshold. As in almost everything in economics, it is all about choosing the best (or, in this case, least unpleasant) alternative.

Whether the least costly option is accelerated fiscal austerity depends on the following points.

First, it depends on why the public debt is accumulated. In many cases, the reason for the debt was the need to fight wars. The authors probably do not wish to argue that the UK should not have fought World War II because it led to excessive public debt (peaking at close to 250 per cent of GDP). Again, if the government’s borrowing was aimed at reducing the economic impact of private sector deleveraging, the economic costs of keeping debt below 90 per cent, instead, could well exceed the costs of allowing debt to rise above it. The authors do not analyse such counterfactuals.

Second, it depends on the direction of the causality: does high debt lower growth or low growth raise debt? The authors themselves note that:

“Another line of reasoning for dismissing concerns about public debt and growth is the view the causality mostly runs from growth to debt.  The multi-decade long duration of past public debt overhang episodes suggests that at very least, the association is not due to recessions at business cycle frequencies.”

That may well be true. But huge debt crises that follow credit booms are not normal business cycle events: in advanced countries, they are once- or twice-in-a-century events.

Again, we need to analyse what is going on in particular contexts. In the case of Japan, for example, it seems quite plausible that a collapse in growth opportunities after 1990 also lowered investment opportunities. This then generated long-lasting financial surpluses in the corporate sector, whose counterparts were high fiscal deficits. The causality would then indeed go from poor growth opportunities to high public debt, rather than the other way around.

Third, as the authors again note:

“[S]ome dismiss concerns about high debt, citing the immediate period after World War II for the United States and United Kingdom, and pointing to the fact that the United Kingdom had extremely high debt after the Napoleonic Wars.  Our analysis, based on these cases and the twenty three others we identify, suggests that the long term risks of high debt are real.”

Among those “some”, are, I suspect, me. Again, let us accept that very high public debt ratios may create problems. None the less, the period after the Napoleonic War was when the UK began its industrial revolution and the post-war period was one of good economic performance, in both the US and UK. The conclusion is that high debt can be perfectly manageable in countries that know how to manage it.

Finally, as the authors also note:

 “this paper should not be interpreted as a manifesto for rapid public debt deleveraging in an environment of extremely weak growth and high unemployment. “

In other words, they agree that the context does matter. Yes, very high public debt may cause problems. But it may still be the least bad alternative: it may make no sense to suffer a huge slump now in order to avoid a putative slowdown in growth later on.

It is all about timing. While the private sector is deleveraging and so running large financial surpluses, large fiscal deficits are necessary, provided they can be sustained, as they certainly can be in the US. Once the deleveraging is finished and the economy recovers, the fiscal deficit will need to be closed. The key is to introduce policy commitments on taxes and spending that make a closure of the deficits credible.

Nevertheless, it must also make sense to consider alternatives to large  and continuous fiscal deficits as ways of managing the macroeconomic impact of post-crisis deleveraging. I do that in the next and final post in this series.

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. Continue reading »

Economic crises bring forth a great deal of nonsense. One of the most frequent bits of such nonsense is the idea that the countries in crisis in the eurozone are full of idle people, while the countries that are not in crisis are full of hard-working ones.

This, it so happens, is the reverse of the truth. Indeed, if one went by the hours worked on average by each worker, one would conclude that the fewer hours  people work, the less crisis-prone will be the country.

Here is a relevant chart for the eurozone, which comes from the Conference Board database I have frequently used. The reader will note that the crisis-hit countries are in the middle or right of the chart. (I have excluded former communist countries, which have somewhat different characteristics: most are much poorer than those listed below. But, again, the people in crisis-hit ex-communist countries, such as Estonia and Latvia, tended to work long hours.) Continue reading »

Last week (in Debt, deleveraging and crisis in the US), I discussed what happened to US debt and borrowing, prior to and since the crisis. In this post, I look at the associated pattern of income and expenditure. It looks at the macroeconomics of deleveraging or what Richard Koo of Nomura Research calls “balance sheet recessions”.

I look at this through the lens of “sectoral financial balances”, an analytical framework learned from the work of the late Wynne Godley. The essential idea is that since income has to equal expenditure for the economy, as a whole, (which is the same things as saying that saving equals investment) so the sums of the difference between income and expenditures of each of the sectors of the economy must also be zero. These differences can also be described as “financial balances”. Thus, if a sector is spending less than its income it must be accumulating (net) claims on other sectors.

The crucial point is that, since sectoral balances must sum to zero, a rise in the deficit of one sector must be matched by an offsetting change in the others. It follows that if the fiscal deficit is increasing, the sum of the surpluses of the other sectors of the economy must be increasing in a precisely offsetting manner.

These are tautologies. But the virtue of this framework is that it forces us to ask what drives what: are, for example, fiscal deficits in the US (or UK) driving the surpluses in other sectors or are the surpluses in the other sectors driving the fiscal deficit? We can obtain answers by examining what behaviour is changing. I will argue that during a big financial boom and subsequent crisis, it is the private sector’s behaviour that changes. The government responds in a largely passive way. That has certainly been the case in the US. It is not government decisions that explain the huge shift into fiscal deficit, but private sector decisions.

Analytically, it is useful to divide the economy into four sectors: foreigners; households; incorporated businesses; and government. The second and third of these make up the domestic private sector. What this looks like for the US economy since 1990 is shown below. (All data come from the US National Income and Product Accounts.

What does this picture tell us? First, the US has been a consistent net importer of capital, via its current account deficit. The foreign financial surplus has fallen since the crisis, but not that much. It looks baked into the structure of the US economy. Meanwhile, by definition, the private and government sectors have, in aggregate, been running a financial deficit. But the components of this aggregate domestic financial deficit have oscillated with the state of the economy.

In the recession of the early 1990s, the mild recession of the early 2000s and the “great recession” since 2007, the private sector has run either small or (in the last case) very large financial surpluses. The government’s position has been the mirror image: when the private sector has boomed, the government has been in financial surplus (as in the later 1990s). When the private sector spends more, relative to its income, the economy booms, the government’s revenue surges and its counter-cyclical spending shrinks; when the private sector spends less, the government’s revenue shrinks and its counter-cyclical spending rises. This happens without any deliberate government decisions. It is essentially automatic.

The best example of this is what happened when the crisis hit after the second quarter of 2007. The financial balance of the private sector shifted towards surplus by the almost unbelievable cumulative total of 11.2 per cent of gross domestic product between the third quarter of 2007 and the second quarter of 2009, which was when the financial deficit of US government (federal and state) reached its peak, driving the economy into a deep recession.

The government’s deficit then exploded, almost without any decisions being taken (this being well before the impact of the Obama administration’s negligible stimulus package, of about 6 per cent of GDP over three years). The idea that the huge fiscal deficits of recent years have been the result of decisions taken by the current administration is nonsense. No fiscal policy changes explain the collapse into massive fiscal deficit between 2007 and 2009, because there was none of any importance. The collapse is explained by the massive shift of the private sector from financial deficit into surplus or, in other words, from boom to bust.

The chart below, which breaks the private sector balance into that of households and corporations, reveals what happened more clearly.

The financial balance of the corporate sector (the difference between retained earnings and investment) has had a fascinating course over the past two decades: a swing into deficit during the stock market bubble of the late 1990s; then a sharp cut-back in the recession of the early 2000s; then a weak move into deficit in the 2000s; and, finally, a massive cut-back during the crisis – a swing of 6.2 per cent of GDP between the fourth quarter of 2008 and the third quarter of 2009. The latter shift was, of course, the trigger for a potential depression.

The balance of the household sector is, however, even more interesting. From the early 1990s to the end of 2005, the US household sector moved into unprecedented (and ultimately unsustainable) financial deficit. This shift into deficit did, of course, coincide with the house-price bubble: as house-prices rose, households both borrowed and spent more. Then, of course, house prices started to fall and credit to dry up. This started the household sector back towards balance and then, once the crisis hit, into a substantial surplus.

Note that the cut-back by the household sector started before the crisis, while the cut-back by the corporate sector followed it. This fits well with our understanding of the crisis: first, house prices peaked; then borrowing was cut back, while the quality of outstanding credit deteriorated and financial intermediaries started to lose money; then, from the summer of 2007, financial intermediaries started to collapse; in the autumn of 2008, in the aftermath of Lehman’s failure, a massive crisis occurred, in which the financial sector froze; and, finally, during and after the crisis, household spending collapsed and the corporate sector retrenched on an extraordinary scale.

Let us now look at two further figures, which reveal what happened in these two sectors, in greater detail.

In the case of households, the shift into pre-criss deficit was explained by both a decline in savings and a rise in investment in construction of dwellings. The subsequent shift into surplus, during the crisis, was again explained by a rise in savings and a collapse in investment in dwellings. The latter shift was particularly big.

In the case of the business sector, the big shift since the crisis has been the rise in profits, though investment has also fallen as a share of GDP. As a result of both of these shifts, the business sector is now running a large surplus: it is accumulating net claims on other sectors.

The overall story, then, is of an economy driven not by fiscal policy decisions, but by private sector decisions taken for reasons that have nothing to do with the long-run fiscal prospects of the economy. Meanwhile, the government, as a whole, was driven into huge deficit by these private sector decisions. That is exactly what one expects to happen in a huge balance-sheet recession, such as this one.

The question is, of course, how the government should respond to its sudden shift into massive deficits. That depends on how the economy best adjusts to balance-sheet adjustments in the private sector. If the government is to move back into balance, by cutting spending and raising taxes, how would the private sector respond to being forced back into balance? Would it spend more, because of a sudden surge in confidence about fiscal prospects? Or would it cut back more, so driving the economy into depression, thereby at least partially defeating the effort to improve the fiscal position? Or might the foreign balance adjust instead?

These are the questions to which I will turn in the final post in this series.

My column this week We still have that sinking feeling examined the progress of post-crisis deleveraging, focusing on the US. I would like to elaborate on this issue.

 The chart attached to the column showed the cumulative total of gross private sector debt, relative to gross domestic product. In the chart below, I show total debt, including government debt, relative to GDP. The reader will notice that the economy as a whole has deleveraged, despite the rising debt of the government. Continue reading »