Years of expansionary fiscal and monetary policies have left the world economy overburdened with debt. In the next downturn, much of that debt will become unserviceable. This should be dealt with now.
For many years, the macroeconomic policies of the major, advanced countries have been forcing their economies down a dangerous path. Economic downturns were met with fiscal expansion. Similarly, monetary policies were eased to induce more private sector borrowing and more spending. From the perspective of each moment, these policies seemed eminently sensible. However, in the recoveries that followed, fiscal and monetary policies were never tightened in an equally vigorous way.
As a result, both public and private debt ratios ratcheted up over time, increasingly acting as «headwinds» that reduced the effectiveness of the easier policies required in the next downturn.
The official response has been to use the policy instruments ever more aggressively. However, this has resulted, almost arithmetically, in the room for still further easing shrinking progressively even as the «headwinds» have continued to grow progressively. In economist’s terms, our policy framework suffers from a fundamental intertemporal inconsistency.
More simply, the path that we have been on has led us to a dead end.
Looking at the global economy today, there are ample grounds for concern. Growth has been slowing in most of the major regions, and profit expectations are declining. Corporate leverage has been rising, as have worries about the quality of corporate liabilities. In many markets, equity prices and the prices of high-risk liabilities seem elevated. In some areas, the price of houses and commercial properties are at record levels, as indeed are associated debt levels.
These indicators point to the possibilities of future stress in the financial sector, in spite of post-crisis changes made to financial regulation. The policies of the Trump administration, not least with respect to trade, are the icing on an otherwise unpalatable cake.
Suppose these concerns were to materialize, what might policy do? Crucially, some policy reactions will be significantly constrained compared to 2008. Policy rates are still unusually low in many jurisdictions and even negative in others. While unconventional monetary policies are uncertain to stimulate demand, they are certain to leave the «headwinds» of debt still higher if they should work.
Other policy measures to manage a downturn will also be constrained. There will almost certainly be popular resistance to measures appearing to «bail out the banks» once again. In the United States, the Dodd Frank Act purposefully constrains the crisis management capacities of the Fed.
Finally, in 2008 the Fed provided around one trillion of US dollar loans to foreign banks that were short of dollars. A similar exposure exists today, but would the Fed react similarly? Would Congress permit it?
To say a path leads to a dead end is not to say we have come to the end of that path. In the next downturn, given the constraints just noted, more reliance will have to be placed on fiscal expansion than previously. Fortunately, most large countries are in little danger of losing market access, even if their longer run fiscal prospects need very serious attention.
It would be naïve, however, to believe that fiscal expansion alone could generate a strong enough recovery, and then self-sustaining growth, to reduce both public and private sector debts to manageable levels over time.
History clearly indicates that there will be some limit to the market’s willingness to tolerate increased deficits and rising public sector debt ratios, particularly when the latter (even excluding off-balance-sheet items) are already at unprecedented levels.
Given that it would be dangerously inflationary to test that limit, the issue of unserviceable debts must be addressed directly. Action needs to be taken, now, to reduce these debt «headwinds» which suppress future growth.
A crucial point is that it would be counterproductive for creditors to demand that debtors service debt when they can only do so by significantly cutting other expenditures. Such cuts could undermine the whole economy, the so-called «paradox of thrift», eventually leaving both creditors and debtors worse off than if the debts had been restructured. This is another path leading to a dead end.
Instead, our economies would benefit greatly from more voluntary debt restructuring by creditors, and the sooner the better. Orderly solutions are better than disorderly solutions, and half a loaf is better than no loaf. Moreover, there is a political advantage in forcing those who have made imprudent loans to pay a price for it. It would take the sting out of the populist cry that the elite always get off, while ordinary citizens suffer.
While this is a better path, it would also be naïve to say that it is a path without obstacles. Some of these obstacles can and should be removed. Others, however, will be more difficult to deal with.
Recently, the OECD, the IMF and the Group of Thirty have drawn attention to serious inadequacies in the legal framework for restructuring private sector debt in many countries. Laws are poorly drafted and the judicial framework is inadequate. There are not enough «out of court» deals, nor specialized judges, nor adequate flows of information, nor adequate enforcement. All of this could and should be dealt with.
Various problems also impede voluntary loan restructuring by creditors, particularly banks. Rather, they often «extend and pretend», fearing a negative market reaction to capital shortfalls. Moreover, in most advanced countries, governments are senior creditors, implying that banks face larger losses once restructuring is initiated. Many banks also have an inadequate capacity to manage bad loans internally and, in most countries, no external markets exist for distressed loans.
These shortcomings could and should be addressed. Further, it has been suggested that banking supervisors have also been complicit in this, not least because they fear having to confront the «too big to fail» problem. Supervisors also worry that tough action might impede new lending and slow economic recovery. These obstacles to recognizing losses, though inherently deep seated, must also be addressed more vigorously.
Unfortunately, the sovereign debts of some countries also need to be restructured. Again, there are significant impediments to this happening. For a starter, domestic politicians will prefer to forbear until their term of office is over. Further, in some countries the banking sector holds enough of its own sovereign’s debt that a government default would bankrupt the financial system as well.
There are also no internationally agreed criteria for the need to restructure sovereigns, even if the United Nations recently made a tentative step in that direction. Finally, there exist no legal ways to enforce a sovereign restructuring or even to prevent the provision of new loans from international sources.
Measures to facilitate voluntary debt restructuring, mostly at the expense of private sector creditors, would help to reduce the severity of the next economic downturn. Yet, history teaches us that a significant part of the losses recognized by financial institutions will find their way on to the balance sheet of the public sector.
Since, as just noted, some sovereigns will not be able to bear this burden, the question of international support will immediately arise. Further, even in countries where the access of the sovereign to financial markets is not currently in question, contingent domestic liabilities will strain the government’s fiscal resources and its capacity to stimulate demand.
Another crisis is not inevitable. But it is highly likely. Moreover, our capacity to manage it has been much reduced. Given such a hostile environment, it is inevitable that many bad debts will have to be recognized.
It would seem only prudent to take steps now to ensure that this happens in as orderly a way as possible. Hoping for the best is not a viable strategy. Preparing for the worst is.