Debt of Nations

Mr. Micawber’s* Vindication: Causes & Consequences of Excessive Debt

After the leverage binge in advanced economies (AEs) over the three decades preceding 2008, debt growth is generally likely to be low in the years ahead. Deleveraging is likely to continue to weigh heavily on growth in highly indebted economies, and the deleveraging process will be costlier and take longer unless adequate policies are implemented to support it.

Debt in the non-financial sector of AEs has almost doubled as a share of GDP between 1980 and 2008 – a period during which GDP grew rather briskly. It initially grew more strongly in the private sector, but only for public debt shot up sharply after the 2007-09 North-Atlantic financial crisis.

Since 2008, debt growth has slowed by a third in real, and by half in nominal, terms. It would have fallen even more sharply if public debt growth had not more than doubled. The speed of deleveraging varies widely in different countries and sectors. On average, household and non-financial corporate debt has fallen, while public debt is still rising. Private (and sometimes public) deleveraging has generally been faster where GDP and income growth have held up, and is impeded by weak income growth in countries where deleveraging pressures are intense, such as in Greece, Ireland, Portugal or Spain. Safe debt is rapidly becoming an oxymoron.

Hangovers from credit booms are serious. Increases in debt can cause systemic crises which generally tend to be both long-lived and costly. Large increases in debt also make such crises more painful – we find that the ‘GDP loss’ relative to trend in the aftermath of financial crises is almost twice as large in countries which had a large pre-crisis increase in debt than in countries that did not. Today, growth is weakest, on average, in countries with the largest pre-crisis debt increases. But even when debt does not cause a major crisis, debt reduction through higher saving rates tends to be contractionary because the poor coordination of deleveraging, saving and investment decisions give rise to Keynes’s ‘paradox of thrift’.

Deleveraging – shrinking balance sheets – occurs when households, businesses or the public sector either desire to save more or are forced to do so. Economic actors may want to save more, or may be forced to save more by restricted access to external funding or because their net worth is perceived to be inadequate. Both net worth and gross debt therefore matter for saving and deleveraging behavior.

Some of the costs of deleveraging are likely unavoidable, but policies can help to reduce the avoidable costs of deleveraging. First among those is access to liquidity. A well-capitalized banking system would be a good start, but the private provision of liquidity – a public good – in crises is usually highly inefficient, so central banks will likely retain a key role in liquidity provision for the coming years. Mechanisms to allow the gross deleveraging, i.e. the ‘netting’ of assets, especially among banks and other financial intermediaries, should be encouraged. Where higher financial surpluses are required, policies should encourage higher saving rather than lower investment. Extensive debt restructuring for governments, banks, and in some countries also households, using yet-to-be-created orderly debt restructuring mechanisms, is both desirable and likely. In the medium-term, the lessons should be clear. First, to better coordinate saving and investment decisions, while supporting financial markets with more effective and sustainable fiscal and monetary policies. Second, on the liability side of any balance sheet: more equity, less debt.

* In Charles Dickens’ David Copperfield, Mr Micawber offers this financial advice: “Annual income twenty pounds, annual expenditure nineteen ninety six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.”