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Wednesday, March 24, 2010

Nouriel Roubini points at private debt as the millstone carrying the economy down

As clear as you can be, Nouriel Roubini begins, "The Great Recession of 2008-2009 was triggered by excessive debt accumulation and leverage on the part of households, financial institutions, and even the corporate sector in many advanced economies." He ends, "Unsustainable private-debt problems must be resolved by defaults, debt reductions, and conversion of debt into equity. If, instead, private debts are excessively socialized, the advanced economies will face a grim future: serious sustainability problems with their public, private, and foreign debt, together with crippled prospects for economic growth."

What are we doing? Excessively socializing the private debts of the big banks. Without a change in this policy, we will be going nowhere fast.


States of Risk

Nouriel Roubini
Project Syndicate
March 15, 2010

The Great Recession of 2008-2009 was triggered by excessive debt accumulation and leverage on the part of households, financial institutions, and even the corporate sector in many advanced economies. While there is much talk about de-leveraging as the crisis wanes, the reality is that private-sector debt ratios have stabilized at very high levels.

By contrast, as a consequence of fiscal stimulus and socialization of part of the private sector’s losses, there is now a massive re-leveraging of the public sector. Deficits in excess of 10% of GDP can be found in many advanced economies, and debt-to-GDP ratios are expected to rise sharply – in some cases doubling in the next few years.

As Carmen Reinhart and Ken Rogoff’s new book This Time is Different demonstrates, such balance-sheet crises have historically led to economic recoveries that are slow, anemic, and below-trend for many years. Sovereign-debt problems are another strong possibility, given the massive re-leveraging of the public sector.

In countries that cannot issue debt in their own currency (traditionally emerging-market economies), or that issue debt in their own currency but cannot independently print money (as in the euro zone), unsustainable fiscal deficits often lead to a credit crisis, a sovereign default, or other coercive form of public-debt restructuring.

In countries that borrow in their own currency and can monetize the public debt, a sovereign debt crisis is unlikely, but monetization of fiscal deficits can eventually lead to high inflation. And inflation is – like default – a capital levy on holders of public debt, as it reduces the real value of nominal liabilities at fixed interest rates.

Thus, the recent problems faced by Greece are only the tip of a sovereign-debt iceberg in many advanced economies (and a smaller number of emerging markets). Bond-market vigilantes already have taken aim at Greece, Spain, Portugal, the United Kingdom, Ireland, and Iceland, pushing government bond yields higher. Eventually they may take aim at other countries – even Japan and the United States – where fiscal policy is on an unsustainable path.

In most advanced economies, aging populations – a serious problem in Europe and Japan –exacerbate the problem of fiscal sustainability, as falling population levels increase the burden of unfunded public-sector liabilities, particularly social-security and health-care systems. Low or negative population growth also implies lower potential economic growth and therefore worse debt-to-GDP dynamics and increasingly grave doubts about the sustainability of public-sector debt.

The dilemma is that, whereas fiscal consolidation is necessary to prevent an unsustainable increase in the spread on sovereign bonds, the short-run effects of raising taxes and cutting government spending tend to be contractionary. This, too, complicates the public-debt dynamics and impedes the restoration of public-debt sustainability. Indeed, this was the trap faced by Argentina in 1998-2001, when needed fiscal contraction exacerbated recession and eventually led to default.

In countries like the euro-zone members, a loss of external competitiveness, caused by tight monetary policy and a strong currency, erosion of long-term comparative advantage relative to emerging markets, and wage growth in excess of productivity growth, impose further constraints on the resumption of growth. If growth does not recover, the fiscal problems will worsen while making it more politically difficult to enact the painful reforms needed to restore competitiveness.

A vicious circle of public-finance deficits, current-account gaps, worsening external-debt dynamics, and stagnating growth can then set in. Eventually, this can lead to default on euro-zone members’ public and foreign debt, as well as exit from the monetary union by fragile economies unable to adjust and reform fast enough.

Provision of liquidity by an international lender of last resort – the European Central Bank, the International Monetary Fund, or even a new European Monetary Fund – could prevent an illiquidity problem from turning into an insolvency problem. But if a country is effectively insolvent rather than just illiquid, such “bailouts” cannot prevent eventual default and devaluation (or exit from a monetary union) because the international lender of last resort eventually will stop financing an unsustainable debt dynamic, as occurred Argentina (and in Russia in 1998).

Cleaning up high private-sector debt and lowering public-debt ratios by growth alone is particularly hard if a balance-sheet crisis leads to an anemic recovery. And reducing debt ratios by saving more leads to the paradox of thrift: too fast an increase in savings deepens the recession and makes debt ratios even worse.

At the end of the day, resolving private-sector leverage problems by fully socializing private losses and re-leveraging the public sector is risky. At best, taxes will eventually be raised and spending cut, with a negative effect on growth; at worst, the outcome may be direct capital levies (default) or indirect ones (inflation).

Unsustainable private-debt problems must be resolved by defaults, debt reductions, and conversion of debt into equity. If, instead, private debts are excessively socialized, the advanced economies will face a grim future: serious sustainability problems with their public, private, and foreign debt, together with crippled prospects for economic growth.

Copyright: Project Syndicate, 2010.

6 comments:

  1. Nouriel Roubini is right that as individuals try to clear their debts they exacerbate the paradox of thrift. It still has to happen. This is when stimulus should be applied to offset the savings, and to maintain stability. As for some claiming that it is crowding out private borrowing. That is clearly not happening. They would not be borrowing anyway. They are already in too much debt, and with uncertain times why borrow? The automatic stabilisers of unemployment benefit would help the country get to the new norm as quickly as possible. Then when asset prices have reached a new stable level then stimulus to get people back to work may have been better.

    Though some western governments only have themselves to blame for poor policy in the past for not encouraging savings, or mis-calculating actual savings rates, or even at least attempting to maintain savings levels. Add in a reliance on bubbles to create the illusion of growth and prosperity, and you have a perfect storm for governments to deal with. I still see a number of crises that will further destabilise money markets, and may cripple governments.

    I am coming to the conclusion that the stimulus came too soon. It only supported the asset values till banks could claim to be solvent again. It just delayed the price adjustment till a later date. US property is now looking 10% overvalued still. With the UK more than 30% overvalued these look vulnerable, and could damage banks further. Falling real estate values take time to find a floor. The intervention has slowed this process, and only creates a false floor for markets to build on. As this floor crumbles it will deter any further investment until a more secure floor to asset prices is found.

    Now the deficit hawks are now circling around governments. The price support for many assets will whither as governments come under assault from those wishing to cut deficits. This could still crush the banks who were apparently saved. Though now with government guarantees this will destroy government finances as the credit default markets siphon off trillions of dollars.

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  2. Any news on the podcast?

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  3. If the banks had their extended credit fully backed no one would be tempted to "run" - this always happens precisely because people KNOW they can't pay. But with a "lender of the last resort" in place equally there should be no run as people KNOW there's no reason to run. So something's amiss here and that is because the whole "last lender" idea is totally discredited, and now that the "lender" has overdone it, he needs to actually turn into "borrower of the last resort".

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  4. The first and last paragraphs of Roubini's post are right on. In the middle there is a lot of concern about financial casinos and too little concern about investment.

    We will open the podcast on April 4 with commentary on this

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  5. Great! looking forward to hearing from you on the 4th!

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