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28 Deleveraging, What Deleveraging
1960s to 1980s and the accession of important economies to the WTO, notably
shaping the Chinese experience of the past decade.
These innovations directly spur aggregate supply, certainly its level and often
its rate of growth. Thus, as in the transition to the next box, innovation is
followed by optimism over economic prospects. When households, firms and
the government collectively embrace taking on more debt because they think
they can, they do. Indeed, many economic models explain the rationality of
borrowing in anticipation of future increases in income. After all, people can pull
future income forward through borrowing to consume today, confident that they
have the wherewithal to service that debt out of higher future incomes. Thus,
optimism over economic growth feeds directly into credit expansion, as in the
transition of the boxes. Essentially, the expectation of a higher track of potential
output leads people to mark up their expected capacity to take on debt.
Often, in the last half-century or so, the world ‘miracle’ has been used to
highlight periods of high growth initially spurred by genuine innovations and
then sustained by increased borrowing: from the ‘Italian miracle’ to the ‘Latin
America miracle’, the ‘Japanese miracle’, the ‘South-East Asia miracle’, the ‘US
miracle’, the ‘Irish miracle’, the ‘Spanish miracle’ and last, but not least, the
‘Chinese miracle’. By now we know how these ‘miracles’ have ended: in various
forms of financial crisis when the ‘irrational exuberance’ of leverage went beyond
repayment capacity after the positive supply-side shocks spurred by innovation
faded. (Our judgment on China is still suspended, although the risks are rising as
we show in Section 4.3).
The problem is that curbing newfound enthusiasm about future prospects for
income may prove disruptive for overall macroeconomic performance. Leverage
can be used to prolong the dreams spurred by the ‘miracle’, with the idea that
the debt capacity is still there. In Italy, when the raw materials shocks of 1971
and 1973 halted the post-war miracle, leveraging of the public sector rather than
supply-side reforms was used as a weapon to fight the trend. The resulting higher
debt stock did not precipitate an explicit default crisis, but at times it was a closerun
thing. Instead, there was a slow and silent crisis in which the incentives
to inflate away the problem rose and policymakers embarked on a series of
deleveraging attempts. As a consequence of sluggish growth for more than two
decades, the ratio of public debt to GDP persistently remained above 100%.
In the late 1970s, recycling ‘petro dollars’ fuelled Latin American economies.
Cash-flush oil producers put their wealth to work by lending to Latin American
sovereigns through the intermediation of US money centre banks, providing a
higher return than elsewhere and sparking a leap forward in development on the
back of massive capital investment. What ensued was the debt crisis of 1981-82
and a decade of sluggish expansion in the region.
In the mid-1990s, authorities in the ‘miracle-growth’ countries of East Asia
explained that their success owed to ‘Asian values’ and argued that financial crises
were a purely Latin American phenomenon. The crisis of 1997-1998 changed
that tune.
Soothing words were similarly spoken by senior US officials in 2006 as they
basked in the glow of the Great Moderation, as economists called the damping