The (Debt) Hangover – Part II
The summer of 2011 has taken developed and overdeveloped economies on a rough ride – and it has taken its toll on consumers, investors, and politicians. With talk of a double dip recession in the United States and a break-up of the eurozone, it seems like a second—possibly larger—financial and economic storm is brewing. US (and German) consumer confidence deteriorated sharply in August and are approaching the lows of 2008, and stock markets are (almost) as volatile as ever (see figures below).
Thus the debt hangover – Part I, which resulted from an excess of private debt and unleashed a global recession in 2008, has metastasized into its second phase. The debt hangover – Part II is being caused by the combination of private debt overhang and increased public debt resulting from the economic contraction in advanced economies, and poses significant threats to both advanced economies and the global economy.
This article looks at three aspects of this second wave of the crisis. It first examines the nature of the current crisis; second, it looks at the reasons why the second wave of the crisis has been allowed to build up; finally, it discusses some of the policy options that could help stem the crisis, and some of the political reasons why these measures are not being taken.
Volatility in US stock markets
Source: Federal Reserve Bank; Bloom (2011)
While the summer has been filled with bad news, the current economic slowdown, financial stress and political tensions in Europe and the US are in fact the logical extension of the first leg of the crisis that hit in 2008-2009. There is one major difference, though: the policy tool box to deal with financial and economic shocks is now significantly smaller than it was in 2008. Interest rates are at 1.5% in Europe, 0.5% in the UK, and 0.25% in the US. In Europe, banks own large amounts of sovereign debt, which creates the possibility of a self-fulfilling crisis of bank runs and bankruptcies if fears of default on sovereign debt leads the interest rate on this debt to increase, causing a default and bank runs.
Beware the ides of September
How did we get here? And, more importantly, how can we get out of the current crisis? Among the troubles that ruined policy makers’ summer and that have darkened the global economic and financial outlook for the next two year (if not more), three developments stand out.
First, the eurozone sovereign debt and banking crisis worsened—which was predictable. Since May 2010, the eurozone crisis has been treated by European authorities like a periphery-country government liquidity crisis rather than a periphery-country sovereign and core-country bank solvency crisis. As a result, the underlying problem (government and bank insolvency) was not addressed, and the crisis has become intractable and threatens the viability of the euro system.
Indeed, the European Central Bank’s balance sheet is ballooning—possibly at an unsustainable rate— due to the need to support banks and sovereigns, notably via purchases of Italian and Spanish government bonds (see figure below). With Greece failing to meet its fiscal targets last week, the country is in full social turmoil and on the verge of defaulting on its debt. The coming days will be crucial for the survival of the euro: a disorderly default by Greece could cause a full-fledged systemic crisis as spreads on other European countries’ government bonds and insurance (CDS spreads) explode, precipitating a wave of sovereign defaults and a collapse in bank funding.
The second negative development: markets came to the realization that the US has not even begun to recover from the economic unbalancing caused by the massive drop in output that took place in 2008-2009, and is facing a decade-long slump. This realization poses large downside risks for asset prices. With the debt debacle of July-August confirming that the US political system is too inept and captive to special interests to pull the country out of a decade-long slump, investors fled to financial safety. This flight into relatively “safe” assets caused financial mini-crashes—it also caused the US government bond yields to plunge to historic lows and financial markets to suffer near-record levels of volatility (see figures below).
Interest rate on 10-year US Treasury bonds
US stock market decline
The third woe of the summer: the continuing eurozone debt crisis is causing the US and European banking systems (both of which remain fragile given that neither have been adequately strengthened following the systemic crisis of 2008) to experience levels of stress that are, in some respects, close to those that prevailed prior to the failure of Lehman Brothers in September 2008.
The figure below shows an indicator of the current level of stress in European banks’ funding: the 10-year euro swap spread (the difference between the cost of a 10-year fixed/floating rate swap between banks and the benchmark German Bund 10-year rate). Currently, the average in Europe is about three times larger than for the US, as it was in September 2008 at the time of the failure of Lehman Brothers.
10-year euro swap spread (indicator of stress in European bank funding)
Source: Bloomberg
What can be done? A large part of the West’s current woes are due to the nature of its political system and the powerful vested interests created by the financial globalization that has been occurring since the 1970s. I explore some aspects of these political economy dynamics below.
A lost decade?
The global financial crisis caused a balance sheet contraction, which is fundamentally different from an ordinary recession. Instead of returning to the pre-recession trend within one or two years, as happens with “normal” recessions that are not due to excessive leverage, in balance sheet contractions (such as the Great Depression and our current Lesser Depression) output remains depressed for several years. This is exactly what is happening now across the developed world: the figures below show the level of US, German, French and UK GDP indexed to 4 quarters preceding the onset of the 1991, 2001 and 2007 recessions in the US. Only in the current contraction has output not recovered its pre-recession level two years after the crisis.
Source: Federal Reserve Bank of Saint Louis; Eurostat; Author’s calculations
The global financial crisis was caused by a confluence of factors: an imbalance between desired consumption and real wages; the overindebtedness of US households caused by the sharp increase in the supply of subprime mortgages (see figures below); the resulting US housing bubble; low interest rates; global imbalances; perverse incentives in US banks and financial markets; and the large, interconnected nature of US financial institutions, to name a few.
US household debt and credit availability
Household leverage and the subprime bubble: Mortgage and house price growth in “prime” and “subprime” US counties
Source: Mian and Sufi (2010)
What happened after the credit crunch of late 2008 was a “balance sheet” recession. This is not an ordinary recession caused by tight monetary policy and which can be alleviated through easier monetary policy, but rather a much deeper slump caused by massive overleverage (that is, an unsustainably high ratio of debt to disposable income). In a balance sheet contraction, excessive accumulation of debt leads to the formation of asset bubbles, which when they inevitably burst lead to massive wealth destruction. This in turn causes a drop in net wealth and a badly overleveraged private sector, combined with a fall in output which worsens households’ ability to pay down debt as unemployment increases. As the figure below shows, US house prices continue to fall, worsening US households’ net worth and ability to pay down debt—and household leverage imposes a heavy drag on growth and employment.
US house price index
It’s the debt, stupid: Employment growth (indexed to 2005 Q4)
US household net worth and personal saving rate
Source: Federal Reserve Bank of St. Louis; Federal Reserve Bank of San Francisco
There are three basic ways for an economy to deleverage: austerity, economic growth, and transfer of wealth from creditors to debtors, either via inflation or via default. Moreover, leverage can exist in both the private and the public sector. In the US, households are still badly overleveraged, which puts extraordinary weight on the economy and will prevent a sustained recovery, no matter how many tax cuts are voted by Congress. The solution in the US therefore involves a substantial debt writedown for households under water with mortgage debt.
In Europe, the problem is public debt. The solution similarly involves debt restructuring of sovereign debt. But given banks’ significant holdings of sovereign debt, measures must be taken to strengthen banks’ balance sheets and ensure they can take the hit.
In both the US and Europe, the initial private-sector leverage caused by the crisis led to public-sector leverage in the aftermath of the crisis. As automatic stabilizers kicked in and growth plummeted, the US and many European countries saw their public deficits surge (see figures below). European countries, however, don’t benefit from that the US advantage of having their own central bank capable of printing currency, and do not face the threat of a run by its creditors.
Thus in Europe, deleveraging is most urgent in Southern countries—those most exposed to creditor runs. As discussed above, the reason for the urgency is that these countries’ debt servicing costs have become unsustainable and threaten the entire eurozone and European banking system.
Though Spain has lower deficits and public debt than the UK, the specter of a self-fulfilling crisis of spiraling debt costs and ultimately sovereign default has led to a surge in the Spain’s debt-servicing costs. This means that the only options—beyond transferring the debt burden to a pan-European monetary fund—are to boost growth or reduce the sovereign debt burden by restructuring the Spanish public debt held by European banks.
Relying on growth is not an option: it will take years for Spain to improve its labor unit costs and make its exports more competitive, all the more so given that it cannot affect its currency’s exchange rate. The problem is essentially the same for Greece, Ireland, Portugal, Italy, Belgium France – the major eurozone economies in need to reduce the leverage of their public sector.
Therefore southern European economies have so far been trudging down a dead-end street: austerity. The problem is that successful austerity-led debt reductions have in the past worked only in the context of strong global growth (which is not the case now) and in conjunction with depreciation of the exchange rate (to which European countries do not have access)
In sum, austerity is self-defeating and economic growth is unrealistic. This leaves the third option: inflating away public or private debt and/or wealth transfer from creditors to debtors.
Caveat creditor?
This is where the politics kick in. The political economy of wealth in the US and Europe is such that wealth transfers from creditors to debtors, although they would go a long way in solving the current crisis, are extremely difficult to implement. There are two main barriers to wealth transfers: the distribution of wealth and the disproportionate political power held by the top creditors and wealth holders in both the US and Europe.
First, the distribution of wealth in society is extremely unequal. As shown in the table below, Edward Wolff of the Levy Institute estimates that the top 1% of US households (classified by net worth—the top 1% here represents households with a net worth of $8.2 million or more) own fully 60% of all households’ security holdings. This is a remarkable number.
Distribution of US wealth by wealth class
Source: Wolff (2010)
Second, this unequal distribution of wealth gives rise to unequal political power in society. Citizens may have one vote each, but they certainly do not each contribute one dollar/euro, or one phone call, to top policy makers. In reality, the distribution of political power is closely aligned with the distribution of economic power.
Given the strong correlation between policy makers’ voting patterns and the policy preferences of their wealthy constituents (documented for the case of the US by Larry Bartels) for both financing and ideological suasion reasons, it is easy to understand why there would be immense pressure on any central banker who would try to deliberately increase inflation to help debtors pay down their debt, at a substantial cost for creditors/wealth owners. This is all the more true given the recent evidence of populist threats against Ben Bernanke in the face of his attempts to move the US economy not with a higher inflation target, but with asset purchases by the Federal Reserve
Perhaps more importantly, research by Thomas Ferguson on the “investment theory of politics” suggests that the financial sector plays a pivotal role in funding America’s ever more expensive legislative and electoral process.
In the eurozone, the transfer of wealth that could help reduce stress in the financial system would be of a different nature, but there too it is banks that mostly oppose such a solution. In Europe, public debt reduction would entail a government-induced sell-off by banks of their non-strategic assets (so as to reduce banks’ current swollen balance sheets) and a restructuring of their holdings of sovereign debt. It would also potentially include amendments to national legislations to ensure that appropriate special resolution regimes are put in place to deal with banks that are deemed insolvent. Bank equity in exchange for taxpayer money used to recapitalize banks, as suggested by Harald Hau, would be only fair game. Needless to say, none of these solutions chime well with bankers.
The asset-selloff by European banks would strengthen their balance sheets and ensure that the restructuring of their holdings of government bonds does not cause a systemic banking crisis. The net result would be a net transfer of wealth from creditors (i.e., banks that own government debt) to taxpayers (i.e., troubled European countries’ citizens, whose taxes would otherwise serve to pay banks 100 cents on the euro as interest on government bonds). This would restore the balance between the cost of government insolvency that falls on taxpayers versus banks.
What has been happening, meanwhile, is precisely the opposite. The July agreement by European governments to add €109 billion to the €110 Greek rescue plan amounted to a transfer of European taxpayer money to Europe’s (and to a much smaller extent, foreign) investors. As Harald Hau explains, “The new plan foresees so-called credit enhancement for the new debt, which means that the new Greek debt is mostly guaranteed by the European Financial Stability Facility (EFSF) – and thus by the taxpayers. Now, in the financial world, a guarantee is worth hard cash – it’s like getting automobile insurance for free. This is no small concession given that a successful turnaround for Greece is highly uncertain. … Most creditors can foresee this and are happy to accept the public guarantees for their debt before the next and much bigger haircut comes.”
Eurobonds are unlikely to materialize, given the amount of political will they require. Even if they were to be created, however, in the same vein as the Greek rescue plan they essentially entail a huge and unjust transfer of wealth.
Why are taxpayers getting such a bad deal? And why are the necessary restructuring and special resolution of insolvent European banks not taking place? The problem probably has a lot to do with asymmetric information, the symbiosis between financial and technocratic elites, and ideology. Hau argues that rampant conflicts of interest constitute a major obstacle:
“The better prepared we are for such [bank recapitalization] the smaller will be the impact on the economy. Europe’s governments have had plenty of time to prepare over the last year, so why was such a solution not even considered? The reasons are political. Such a solution would have upset powerful vested banker interests, even though it would have imposed the costs on those most responsible for the massive credit misallocation. A strong negotiating position of politicians confronts two important obstacles: First, the finance ministry and banking authority typically lack competence and information in order to prepare contingency plans for bank recapitalization … Secondly, the strong lobbying power of the banking sector deters politicians from preparing in advance and taking risks in favour of the taxpayer. Conflicts of interest between the politicians and the bankers are rampant.”
Ultimately, however, powerful financial elites have a lot to lose from a full-fledged financial crisis. Thus the following paradox arises: if they want to preserve the wealth they have accumulated so far, those at the top would be well advised to ensure they let go of some of it now. But given the stakes, things may yet have to get worse for bankers before they get better for the rest. Let us hope we do not reach an economic, financial and/or social-political tipping point of no return.
This post originally appeared at Global Policy.
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