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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).