The debt trap
ALMOST eight years have elapsed since the financial crisis took hold in August 2007 and still the same issues are being fought over. Who should suffer the most pain—creditors or debtors? Is the best way to achieve growth short-term fiscal stimulus or long-term structural reform? And, in Europe in particular, how does one reconcile local democracy with international obligations?
Debt is a claim on future wealth: lenders expect to be paid back. The stock of debt accordingly tends to expand at moments of economic optimism. Borrowers hope that their incomes are set to rise, or that the assets they are buying with borrowed money will increase in price; lenders share that enthusiasm.
But if wealth does not rise sufficiently to justify the optimism, lenders will be disappointed. Debtors will default. This causes creditors to cut back on further lending, creating a liquidity problem even for solvent borrowers. Governments then step in, as they did in 2008 and 2009.
The best way of coping with too much debt is to spur growth. But developed countries, even America, have struggled to reproduce their pre-crisis growth rates. So the choice has come down to three options: inflate, default or stagnate.
The inflation option means that nominal GDP rises rapidly, reducing the ratio of debt to GDP. The main constraint on this strategy is the speed with which creditors react by forcing up interest rates on newly-issued debt. The longer the maturity of their existing debt, the easier it is for governments to use this option.
In practice, there has been very little inflation in the developed world. (Countries in the euro zone do not control their own currencies so have no power to inflate the debt away in any case.) The debt burden has been controlled by “financial repression”: holding real rates at very low, or negative, levels. By making it easier for borrowers to service their debts, this has staved off a repayment crisis in many countries, but it has not made much of a dent in the overall debt burden.
The Greeks did manage to default on private-sector debt in 2012, but this wasn’t enough help given the collapse in their GDP in recent years. And the problem with default, when debt is so widespread, is that it simply shifts the liability somewhere else. If a country’s banks hold a large amount of government debt, and the government defaults, then the banks will need to be rescued by the government, making the problem circular (with bailIN not anymore…). Countries have been defaulting to foreign creditors for centuries, of course, and they tend to be forgiven by investors after a few years. But economic conditions get pretty scary in the interim, as the Greeks may find out.
So if inflation has been hard to achieve and default looks like a risky option, then stagnation (or near-stagnation) ends up being the outcome. That has been the case in Japan, where sluggish economic growth has been the norm since its asset bubble burst in the early 1990s. But stagnation only postpones the problem. Japan has faced less pressure than most, since it owes money mainly to its own citizens—it does not have to worry about foreign creditors. Yet even Japan has tired of the situation: Abenomics was designed to get the country out of the trap by generating more growth and inflation.
The EU has been heading down the Japanese route. Both places face demographic problems that will sap their growth indefinitely. That increases the need for offsetting improvements in productivity, but reforms to that end face fierce political resistance.
Like Japan, the euro zone has an internal, not an external, debt problem. However, the current crisis has shown that there is not enough political solidarity to support outright burden-sharing. Intra-European transfers are seen as a zero-sum game, in which any aid to Greece is a loss to other nations in the bloc.
This has been a flaw in the euro project from the start. The only answer is political union with a central fiscal authority. But that would require voters in the 19 euro-zone member states to give up sovereignty—something the Greeks are not alone in resisting. And the EU’s sluggish growth is adding to the disillusionment with Brussels among European electorates.
So what does all this mean?At the very least, an endless series of crises and European summits. It also means that Syriza will not be the last insurgent party to gain power, that central banks will have to keep interest rates low in order to keep the system going and that, given current high valuations, portfolio returns for investors are going to be mediocre for the foreseeable future.