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78 Deleveraging, What Deleveraging the reassurance that failure was not an option. The asset quality review currently under way in Europe provides an opportunity to live up to that standard. The issue of how to allocate the losses, which is the next stage in the process, is obviously complex. At the macroeconomic level, they have to be allocated so as to minimise a credit crunch. However, the pursuit of this objective may lead to controversial distributional consequences, such as penalising consumers/ taxpayers to the benefit of private creditors. The experience of some of the countries in the Eurozone periphery is an example of this problem. Any losses in asset values and in the net present value of future income, or less-thanpreviously-anticipated gains, have to be apportioned among the various sectors of the economy. The three candidates are the original holders of those claims in the private sector, the government (or, more aptly, the ultimate obligor – the taxpayer), or the central bank through loans or asset market purchases. The problem of the allocation of losses is particularly complex in the Eurozone since creditors and debtors have a clear geographical identity and mostly share a common currency. Once losses are realised and allocated, there is scope for other policies to offset the macroeconomic consequences, the third stage in the process. The options here include fiscal expansion, which might be problematic given the increase in debt associated with the rescue of financial entities, or monetary policy accommodation. The most straightforward way of thinking about the deleveraging policy problem is to consider the debt-to-income ratio, as in the next schematic. The essence of the recognition of a reduction in debt capacity is also the realisation that the ratio of debt-to-income cannot reach the level previously expected. A ratio can be adjusted either via the numerator or the denominator. Figure 5.2 Debt and growth nexus Repayment over time Structural reform Inflation D Y Writedowns Absorption by government or central bank Repressed interest cost
Policy issues 79 In terms of the numerator (the right side of Figure 5.2), four options are available. Debt can be paid down (if the problem is a lower level of debt capacity) or accumulated less rapidly (if the problem is a lower target debt capacity). Here, credit-income feedback dynamics intrude. If loans are expanding more slowly or being repaid on net, then headwinds created for aggregate demand that pulls GDP down relative to its prior trajectory. More directly, the value of debt could be written down in a credit event. But the debt of one entity is another’s asset, and the direct reduction in asset values and any indirect spillover to other markets represents an immediate impediment to economic expansion. Moreover, the credit event may have a long shadow to the extent that market participants demand higher risk premiums in the future. Either effort to trim back the path of debt tends to reduce nominal GDP relative to its prior path. As a consequence, it is not obvious that the ratio of debt to nominal GDP – the main metric of leverage adopted in this report – will decline. The most prominent case is fiscal austerity, which is the effort to reduce the public sector’s portion of debt in the numerator. Fiscal consolidation tends to be associated with short-run income contraction so the impact on the debt-toincome ratio is problematic. As shown repeatedly in this report, we observe a poisonous combination – globally and in almost any one geographic area – between high and higher debt/ GDP and slow and slowing (both nominal and real) GDP growth, which stems from a two-way causality between leverage and GDP: on the one hand, slowing potential growth and falling inflation make it harder for policies to engineer a fall in the debt-to-GDP ratio, and on the other hand attempts to delever both the private sector (especially banks) and the public sector (through austerity measures) encounter headwinds, as they slow, if not compress, the denominator of the ratio (GDP). The euro periphery is where this perverse loop of debt and growth is most severe. It could also soon become acute in China. An incorrect blend or sequence of anti-crisis policies (see below) would at the same time hurt the deleveraging effort and maximise output costs, worsening the ‘type’ of the crisis and thus the deviation from the pre-crisis output path (see Appendix 3.A in Chapter 3). The economic equivalent of write-downs could be accomplished if the government absorbed the losses directly – e.g. the US taking the mortgage-related government sponsored enterprises under conservatorship – or indirectly through central bank acquisition – e.g. the Federal Reserve’s purchase of mortgage-backed securities. The former represents a command on future tax revenue, in that the government debt has to be serviced. The latter represents a different kind of inter-temporal trade, since the central bank either has to pare back its balance sheet at some point in the future (presumably when the economy is better positioned to absorb the blow) or risk an increase in the price level in the long run. The lack of either form of support in the Eurozone, and especially of forms of quantitative easing – either bank loans or government bonds – has contributed to the development of a severe credit crunch and the establishment of a perverse loop with growth, at odds with the credit expansion which has resumed at a relatively early stage in the US (see Chapter 4).
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Geneva Reports on the World Economy
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International Center for Monetary a
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International Center for Monetary a
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Acknowledgements We thank Susan Lun
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List of Conference Participants Edm
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List of Conference Participants xii
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Foreword Since 1999 the Geneva Repo
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Global debt analysis: Deleveraging
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