Sunday, April 20, 2014
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Debt and Demand

LONDON – Former US Treasury Secretary Larry Summers recently caused a stir with his warning of sustained economic stagnation in the advanced economies. But, while many reject his suggestion of a secular trend, the data support him. Yes, economic growth has picked up in the United States and the United Kingdom, while the eurozone economy is no longer contracting and Japan shows some signs of responding to “Abenomics.” But the global recovery remains extremely weak, with most advanced economies still performing at 10-15% below pre-crisis growth trends.

It is not difficult to see why the recovery has been anemic. Excessive private-debt creation before the crisis and subsequent attempts at deleveraging have weakened demand considerably.

While fiscal deficits can help to offset deficient demand, they also result in rising public debt. Leverage has not gone away; it has simply shifted to the public sector – creating a debt overhang that may last for many years, or even decades. Eliminating it will likely require significant debt write-offs or permanent monetization.

But, as Summers noted, the party that preceded this severe post-crisis hangover was not, in terms of actual growth, all that exuberant. Credit volumes and asset prices soared, but labor markets did not overheat, real earnings remained flat in many advanced economies, and inflation rates were remarkably stable. Nominal demand grew at roughly 5% annually, despite annual credit growth of 10% or more.

Today, the same pattern is unfolding in many emerging economies – most notably, China. With credit growth far outpacing nominal GDP growth, leverage is increasing. And it seems that the rising credit intensity of GDP growth (the amount of new credit required to generate a unit of output) is needed to ensure that economic performance remains in line with potential.

This implies a serious dilemma: while rising leverage is apparently essential, it inevitably leads to crisis and recession. Against this background, policymakers must consider whether rapid credit growth is really necessary, and whether there are any alternatives – a question that modern economics has so far largely ignored.

In fact, much credit growth is not critical to economic growth, because it does not play a direct role in financing consumption or investment. Economics textbooks often describe how households deposit money in banks, which lend to businesses to finance capital investment. But, in advanced economies – and increasingly in emerging economies – this story is largely fictional, because such lending accounts for only a small share of the total.

Instead, a large part of bank lending finances the purchase of existing assets, particularly commercial or residential real estate, the prices of which primarily reflect the value of the underlying land. Such existing-asset finance does not directly stimulate investment or consumption. But it does drive up asset prices, causing lenders and borrowers to believe that even more credit growth is both safe and desirable.

Lending to finance existing assets, primarily in real-estate markets, can thus play an asymmetric role in the real economy. While it has little impact on demand, output, and prices during the boom, it results in debt overhang, deleveraging, and depressed demand in the post-crisis period.

In this context, policymakers should distinguish between categories of debt. For example, they could impose higher capital requirements on real-estate lending or introduce direct borrower constraints like limits on loan-to-value or loan-to-income ratios. Such policies would help to reduce the credit intensity of growth, thereby curbing the threat to long-term economic stability.

Nonetheless, the problem of deficient demand might persist. Even though such lending does not stimulate demand for newly produced goods and services directly, it may do so indirectly by generating unsustainable wealth effects (driving people to spend more because they feel richer). Constraining the lending that drives up real-estate prices could lead to lower nominal demand.

Curtailing demand for this category of credit would lower the real (inflation-adjusted) interest rate. But we cannot assume that this would offset the deflationary impact of reduced wealth effects. Even before the crisis, real long-term interest rates were on a clear downward trajectory, with 20-year index-linked yields falling from almost 4% in 1990 to below 2% by 2007. Whether even lower interest rates would have stimulated significant additional investment is unclear.

The fundamental question therefore remains: Is there something about modern economies that makes adequate demand growth impossible without damaging credit growth?

Rising inequality is one driver of this apparent “need for credit.” Wealthier people have a higher marginal propensity to save than poorer people. As the rich get richer, consumption growth may decline, unless the financial system uses their savings to lend to the relatively poor.

But much of this debt may prove unsustainable. As Raghuram Rajan pointed out in his book Fault Lines, the US subprime-mortgage boom and bust owed much to pitiably slow growth in lower-income Americans’ real earnings over the last three decades.

Global imbalances also contribute to rising debt risk. If current-account surpluses are not matched by rising equity claims against the rest of the world – whether through corporate foreign direct investment or household-equity investments in other countries – they inevitably result in debt claims, increasing public or private debt liabilities in deficit countries. Some of those debt claims will likely prove unsustainable, and all of them may contribute to post-crisis debt-overhang effects.

A more stable growth model requires less of the “wrong type of debt” – that is, debt that finances purchases of existing assets, supports consumption without addressing the drivers of inequality, or results from unsustainable global imbalances. Without targeted policies aimed at limiting such debt, the world economy risks secular stagnation or further cycles of instability and crisis.

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  1. CommentedJoshua Ioji Konov

    If taken from real estate equity could be considered in an open market the overall business activity, if such, could deleverage the high leverage, therefore the transmission ability of the market i.e. economy should be considered when evaluating and estimating the tipping off point when indebtedness moves into the red. In China, as an example, as long as the real estate's overcapitalization does not exceed the real of the market's opportunities such may have a positive effect on the overall economy, however, if the leverage go so high to exceed than the possibilities for bubbles becomes very real.

  2. CommentedStamatis Kavvadias

    Several questions and disagreements to points of this article.

    1) "it seems that the rising credit intensity of GDP growth [...] is needed to ensure that economic performance remains in line with potential."

    What is this "potential"? It does not refer to 5% nominal demand growth, because in the next sentence the author writes "This implies a serious dilemma: while rising leverage is apparently essential, it inevitably leads to crisis and recession." So, it cannot justify the word potential. Maybe the word "expectation" was meant.
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    2) "[...] the problem of deficient demand might persist. Even though such lending does not stimulate demand for newly produced goods and services directly, it may do so indirectly by generating unsustainable wealth effects (driving people to spend more because they feel richer). Constraining the lending that drives up real-estate prices could lead to lower nominal demand."

    This does not make sense, because these people have assets that have ...unsustainable prices, which they should be led to shell, which in turn could lead to lower prices and a more meaningful real-estate market. If these people will have losses, such losses are very likely to reflect draining of previous savings, which are thus mobilized (brought back in the economy, instead of being trapped in real-estate). Liquidation of the asset will, of course, reduce the leverage in the system.
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    3) "Is there something about modern economies that makes adequate demand growth impossible without damaging credit growth?"

    What is it about economists that does not allow them to think "out of the box"? How is it possible that they expect the only thing needed, to match growth with growing social needs, is tuning of financial capitalism? Is it not obvious that social capacity for progress and innovation is, to some extend, independent of financing and, thus, an "externality" to the global economy?

    What is it that convinces them otherwise? Is it their models and theories, proven so wrong by this crisis??? I do not believe it. It seems more like a mix of biased judgment toward favoring financialization and financiers; fictionalization bias caused by ideology and benefits if credit for economies of the past; financier bias caused by self-interest and direct or indirect profits, resulting from the difficulty to change the status quo and oppose vested interests. To the extend I am right, economics is becoming increasingly a failed science (which would be a historical first) and financial capitalism is dragging the planet over the cliff (of which there are other signs also).
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    In my eyes, since both government and private money creation have failures in the course of history, a hybrid model is imperative and not only one with limited sovereign government capacity to issue debt-free money, but one that liberates such capacity to backstop unemployment, social security and environmental problems. What would be the limit to such sovereign government capacity? Ideally, I would say, the capacity of the private sector to provide these things. How can this be implemented? Well, that is what economists should tell us. The more global/federal the level of application, the more neutral it would be.

  3. CommentedRalph Musgrave

    Good article by Adair Turner. The dilemma to which he refers at the end of his article has been solved by Laurence Kotlikoff (and Positive Money who advocate a banking system similar to the Kotlikoff model). That system involves depositors who want interest on their money footing the entire bill if the underlying loans go bad. That would put a constraint on lending of the sort that Turner wants. At the same time, the deflationary effect of that is counterbalanced by having the government / central bank machine print and spend base money into the economy.

    The net effect is that everyone would have more money, and thus would not need to borrow so much, all else equal. Plus bank failures become near impossible, plus bank subsidies like the TBTF subsidy disappear.

    For Kotlikoff and Positive Money see respectively:

    http://www.bloomberg.com/news/2013-03-27/the-best-way-to-save-banking-is-to-kill-it.html

    http://www.positivemoney.org/our-proposals/sovereign-money-creation/

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