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Debt reduction
Handle with care
“Deleveraging” will dominate the rich world’s economies for years. Done badly, it could wreck them
Jul 7th 2011
DEBT reduction, or deleveraging as it is known in the inelegant argot of economists, is a painful process. Growth suffers as consumers and firms, let alone governments, try to reduce their debts. Countries which experienced the biggest asset busts, such as America, Britain and Spain, have had the most disappointing recoveries. And the pain will continue: a careful look at the numbers suggests that the process of deleveraging has barely begun.
A new analysis by the McKinsey Global Institute suggests that over the past year or so total debt levels, measured relative to GDP, have stabilised and, in some rich countries, started to inch down. But if history is a guide, there is still a long way to go. The ratio of total debt to GDP in both America and Britain has fallen by just over ten percentage points from its peak—a fraction of the scale of debt reduction in a typical deleveraging period (see article). Worse, the McKinsey analysis suggests that economies usually stagnate, or even shrink, early in the overall debt-reduction process.
To minimise that risk, the pace of deleveraging needs to be carefully calibrated. The experience so far of the most indebted economies offers useful pointers on what to do, and what not to do.
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Debt can be reduced in several ways. It can be paid off with the help of higher thrift (though not everyone can spend less than they earn at the same time). Its burden can be reduced through higher inflation or faster growth. Or it can be defaulted on. In practice, rich countries seem to be using different combinations of these approaches.
In America, where overall debt levels have fallen fastest, a lot of the reduction in household debt has been thanks to mortgage defaults and write-downs. In Britain, where there have been virtually no mortgage write-downs, relatively high inflation has pushed down the overall debt burden. Spain, in contrast, has seen virtually no reduction in its debt load, despite fiscal austerity, partly because that very austerity has contributed to weak growth and low inflation which have kept down nominal GDP. Tough rules on mortgages have made it hard to reduce unpayable household debt.
Write down and get real
What can be learnt from these various approaches? It is still early days, but four lessons stand out. The first is that in some extreme cases, when a large debt reduction is needed, orderly write-downs are necessary. The foreclosures on American mortgages have been severe, but they mean that household debt is likely to shrink to manageable levels faster than in, say, Britain, where low interest rates on variable mortgages and a lot of “forbearance” by banks have kept defaults artificially low. At the sovereign level the same logic should apply to hopelessly bankrupt Greece: it needs a debt write-down.
Second, nominal growth is essential to bring down the weight of debt. It is hard to ease the debt burden in a stagnant economy with low inflation. That suggests the pace of public-sector austerity, where possible, needs to be calibrated to the scale of private deleveraging. America’s government, for instance, needs a medium-term plan for deficit reduction, but cutting back spending viciously in the short term at a time of private-sector retrenchment would be a mistake.
Third, the best way to ease the pain of deleveraging is with an export-led boom. Here, progress has been painfully slow. The external deficits of ex-bubble economies have shrunk since 2007, but not by enough—and some now seem to be rising again. There has been too little rebalancing of global demand towards big emerging economies. That will require stronger currencies in emerging Asia and weaker ones in the rich world.
Deeper shifts will also be necessary: a strengthening of consumer society in China, for example, and a reallocation of resources towards tradable goods and services in Britain and America. Unfortunately, the sensible goal of rebalancing towards net exports can lead to dubious policy prescriptions. Britain, for instance, would be mad to turn its back on financial services (see article). No rich country needs a smorgasbord of subsidies for manufacturing. Far better to get rid of distortions and improve the economy’s flexibility.
All this will take time. So the fourth, most important and most depressing lesson for the great deleveraging is that of realism. Even if handled well, the difficult business of debt reduction will hold back the rich world’s economies for several more years. Get used to it.