Wednesday, July 7, 2010

Eroding a mountain range of debt

Eroding a mountain range of debt

The above data shows the debt outstanding of various sectors in the US economy.  It comes from the Federal Reserve Z1 release, and the data are annual except for the 2010 point, which is for Q1 (on the graph, the annual data are shown at the mid-point of the year, and the Q1 point is shown 1/8 of the way into the year, so slopes should still be accurate).

My operating assumption is that the main current problem with the US economy is Too Much Debt in the private sector, and that all will not be well until both the household and financial sectors have deleveraged back down at least to something like the levels of the 1990s (at a rough guess).  On the pace so far, it appears likely that that will take at least a decade.  I don't think any of us should be planning on living in a great economy any time soon.

At the moment, there is a great debate occurring between Keynesians such as Paul Krugman, who argue the government should run deficits to stimulate the economy, and the forces of fiscal austerity who argue the government needs to reduce its debt.

In thinking about this, it seems like the key fact is the accounting identity that

Private Sector Balance + Government Balance + Foreign Balance = 0

Now, there are deep structural reasons why the US is running a current account deficit that cannot be changed soon (dependence on foreign oil, offshoring of labor-intensive work).  Developments in Europe are making it even more difficult for the US to run a current account surplus.  So the third term in the accounting identity pretty much has to be positive (foreigners are net lenders to the US).  If we want the private sector to deleverage, then the private sector balance should be positive.  That means the government balance must be negative (the government should be a net borrower).  This is the argument against government fiscal austerity, and it's quite compelling.

At the same time, I think there's a serious magnitude problem with the idea that the US government should run big deficits until the private sector is sufficiently deleveraged.  The private sector is much larger than the government sector, and its debts are too big.  Here's a stacked graph of the private sector debts outstanding:

Eroding a mountain range of debt

If the government runs sufficiently large deficits for long enough for this to get back down to, let's say, the level of 1995, the government is going to end up with a debt to GDP ratio approaching that of Japan, and I would say it's politically inconceivable that the US government could sustain that level of debt.

My conclusion is that the private sector deleveraging process is not, and should not, be mainly a "pay down the debt" process.  That appears to me to be impossible.  It needs to be mainly a "write off the debt" process.  Households, businesses, and financial firms with weak balance sheets will need to go through the appropriate restructuring processes - whether it is short sales on houses, principal renegotiations on mortgates,  debt restructurings and bankruptcy of individuals and firms.  Obviously, there will be lots of nasty feedbacks as we go through this process: household debts being written down make the balance sheets of financial firms worse, financial firms shrinking and laying off workers reduce demand for the output of other businesses and worsen their cashflow, etc.

The main role of the government should thus not be "borrower of last resort", but rather "bankruptcy trustee of last resort".  Clearly, in this kind of environment, the largest financial firms could become at risk again.  In that scenario, it's critical that the government is in a credible position to take them over and conduct a restructuring, and that requires that the government's own balance sheet is in decent shape.  Therefore, I don't think the government should either try to massively increase its own debt, or massively reduce it.  I think it should aim for approximate balance, and in the meantime should place its focus on improving the speed, efficiency, and fairness of the various processes for resolving excessive private sector leverage.  I think given the scale of what needs to happen, we should try to find ways to make the processes more compassionate for the individuals involved.

Fundamentally, we've spent the last two decades borrowing and lending far too much, and there now isn't any painless path back to a healthy situation.  We need to get rid of a lot of this debt, and we need to get a lot less comfortable with borrowing as a solution to our problems.

As a side effect of this, it seems to me that many classes of assets are still very much over-priced.  Houses and stocks are likely to be in an overall bear market for as long as the deleveraging process is going on.

It's not going to be any fun.

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