“You can’t cut debt by borrowing.” How often have you read or heard this comment from “austerians” (a nice variant on “Austrians”), who complain about the huge fiscal deficits that have followed the financial crisis?
The obvious response is: so what? Shifting debt from people who cannot support it to those who can – the population at large, both now and in future – seems to make a great deal of sense if the alternative is an economic collapse that leads to a loss of output and investment now and so of income in the long term. Indeed, under the latter alternative, even the fiscal deficits may end up little, if any, smaller if one tries to slash them, as the UK could be about to discover.
Before leaping to that conclusion, however, let us approach the issue of de-leveraging – or debt reduction – analytically. Between 1994 and 2007, total US non-financial private debt rose from 118 per cent of gross domestic product to 173 per cent, the highest level in US history. Over the same period, US financial sector debt rose from 54 per cent of GDP to 115 per cent. A great deal of this leveraging up of the economy (matched elsewhere, notably in the UK) was based on false premises: borrowers and lenders thought that the assets against which they had borrowed would be worth more than turned out to be the case.
How, then, can people reduce their indebtedness or restore their net worth, after an unforeseen fall in asset prices? There are three mechanisms: sale; bankruptcy; and frugality. Let us consider each of these, in turn. But remember that, at the global level, debt cancels out: net debt is zero. So, in paying down debt, one is also reducing credit by an equal amount.
People with assets that they no longer wish to hold and debts they no longer wish to bear, can sell the former to repay the latter. If this is to cancel debt, then the ultimate purchaser needs to be a creditor. Sale makes this a voluntary transaction.
This path to de-leveraging is going to be part of the story. But when the predominant asset is housing, as it is now, the willingness of creditors to purchase will be limited. By and large, people who wish to buy houses are young and have limited liquid assets. Most creditors already own houses. In theory, houses could be sold to cash-rich foreigners. But that, too, is going to be a limited avenue for economy-wide deleveraging in most countries. (In Spain, however, sale to cash-rich foreigners seems a more plausible solution, since much of the past construction was designed for their use.)
The second approach is mass bankruptcy. In this case, creditors are forced to write down their loans to the value of the asset. That is clearly an important part of any de-leveraging. But since highly leveraged financial intermediaries stand between the ultimate creditors (households) and the ultimate debtors (other households), mass bankruptcy is going to wipe out the capital of intermediaries. That is likely to trigger panic, as losses cascade across the financial system.
