‘The world is sinking under a sea of debt, private as well as public, and it is increasingly hard to see how this might end, except in some form of mass default.’ So claims the article below by Jeremy Warner. But just how much has debt grown, both public and private? And is it of concern?
The doomsday scenario is that we are heading for another financial crisis as over leveraged banks and governments could not cope with a collapse in confidence. Bank and bond interest rates would soar and debts would be hard to finance. The world could head back into recession as credit became harder and more expensive to obtain. Perhaps, in such a scenario, there would be mass default, by banks and governments alike. This could result in a plunge back into recession.
The more optimistic scenario is that private-sector debt is under control and in many countries is falling (see, for example, chart 1 in the blog Looking once again through Minsky eyes at UK credit numbers for the case of the UK). Even though private-sector debt could rise again as the world economy grows, it would be affordable provided that interest rates remain low and banks continue to build the requisite capital buffers under the Basel III banking regulations.
As far as public-sector debt is concerned, as a percentage of GDP its growth has begun to decline in advanced countries as a whole and, although gently rising in developing and emerging economies as a whole, is relatively low compared with advanced countries (see chart). Of course, there are some countries that still face much larger debts, but in most cases they are manageable and governments have plans to curb them, or at least their growth.
But there have been several warnings from various economists and institutes, as we saw in the blog post, Has the problem of excess global debt been tackled? Not according to latest figures. The question is whether countries can grow their way out of the problem, with a rapidly rising denominator in the debt/GDP ratios.
Only mass default will end the world’s addiction to debt The Telegraph, Jeremy Warner (3/3/15)
Questions
- What would be the impact of several countries defaulting on debt?
- What factors determine the likelihood of sovereign defaults?
- What factors determine the likelihood of bank defaults?
- What is meant by ‘leverage’ in the context of (a) banks; (b) nations?
- What are the Basel III regulations? What impact will they have/are they having on bank leverage?
- Expand on the arguments supporting the doomsday scenario above.
- Expand on the arguments supporting the optimistic scenario above.
- What is the relationship between economic growth and debt?
- Explain how the explosion in global credit might merely be ‘the mirror image of rising output, asset prices and wealth’.
- Is domestic inflation a good answer for a country to the problems of rising debt denominated (a) in the domestic currency; (b) in foreign currencies?
In recent times the notion that the financial sytem can be destabilising seems blindingly obvious. And, yet, for some time macroeconomic models of the economy tended to regard the financial system as benevolent. It served our interests. We were the masters; it was our servant. Now of course we accept that credit cycles can be destabilising. Policymakers, especially central banks, follow keenly the latest private-sector credit data. Here we look back at previous patterns in private-sector debt and crucially at what patterns are currently emerging.
First a bit of theory. The idea of credit cycles is not new. But the financial crisis of the late 2000s has helped to reignite analysis and interest. Economists are trying to gain a better understanding of the relationship between flows of credit and the state of the economy and, in particular, why might flows increase as the level of real GDP rises – why might they be endogenous variables in models of the determination of GDP. One possibility is the financial accelerator. This is the idea that as real GDP rises banks perceive lending to be less risky. After all, real incomes will tend to rise and collateral values (against which borrowing can be secured) are likely to be rising too.
Another possibility is growing exuberance as the economy grows. This has gained in popularity as an idea, with economists revisiting the work of Hyman Minsky (1919–96), an American economist. Here success breeds failure as the balance sheets of people and businesses deteriorate as they become increasingly burdened with debt. The balance sheets are said to be congested leading to a point when a deleveraging starts. A balance sheet recession then follows.
Now for the data. Consider first the stocks of debt acquired by households and private non-financial corporations from MFIs (Monetary Financial Institutions). The first chart shows debt stocks as a percentage of GDP. It illustrates nicely the phenomenon of financialisation. In essence, this is the increasing importance of MFIs to the economy. At the end of 2014, these two sectors had debt stocks outstanding equivalent to 90 per cent of GDP. In fact, this is down from a peak of 129 per cent in September 2009. (Click here for a PowerPoint of the chart.)
The growth in debt, especially in the 1990s and for much of the 2000s, was through financial innovation. In particular, the bundling of assets, such as mortgages, to form financial instruments which could then be purchased by investors helped to provide financial institutions with further funds for lending. This is the process of securitisation. Some argue that this was part of a super-cycle which works alongside the normal credit cycle, albeit over a much lengthier period. It can be argued that these cycles coincided during the 1990s and for much of the 2000s until financial distress hit. The distress was hastened by central banks raising interest rates to dampen the rising rate of inflation, partly attributable to rising global commodity prices, including oil.
Some refer to 2008 as a Minsky moment. Overstretched balance sheets needed repairing. But, the collective act of repair actually caused financial well-being to worsen as asset prices and aggregate demand fell.
The global response to the events of the financial crisis has been for policy-makers to pay more attention to the aggregate level of credit provision. The Bank of England’s Financial Policy Committee (FPC) has responsibility for monitoring and helping to ensure the soundness of the UK financial system.
Undoubtedly, the FPC will have constructed a chart similar to our second chart. (Click here for a PowerPoint of the chart). This chart suggests some caution: the need for casting a ‘Minsky eye’ on lending patterns. Over 2014, the UK household sector undertook net lending (i.e. after deducting repayments) of £30 billion. While nothing like the £100 billion or so in 2007, this does mark something of a step up. Indeed it is almost exactly double the flow in 2013. In the months ahead we will continue to monitor the credit data. You can bet that the FPC will do too!
Articles
Comment: Household debt threatens return to spending Herald Scotland, Bill Jamieson (2/3/15)
Household debt rising at fastest rate for 10yrs moneyfacts.co.uk (10/2/15)
Housing starting to rally after home loan approvals rise in January London Evening Standard, Ben Chu (2/3/15)
Data
Bankstats (Monetary and Financial Statistics) – Latest Tables Bank of England
Statistical Interactive Database Bank of England
Questions
- What is meant by the term the business cycle?
- What does it mean for the determinants of the business cycle to be endogenous? What about if they are exogenous?
- Outline the ways in which the financial system can impact on the spending behaviour of households. Repeat the exercise for businesses.
- How might uncertainty affect spending and saving by households and businesses?
- What does it mean if bank lending is pro-cyclical?
- Why might lending be pro-cyclical?
- How might the differential between borrowing and saving interest rates vary over the business cycle?
- Explain what you understand by net lending to households or firms. How does net lending affect their stock of debt?
According to a report by the McKinsey Global Institute, global debt is now higher than before the financial crisis. And that crisis was largely caused by excessive lending. As The Telegraph article linked below states:
The figures are as remarkable as they are terrifying. Global debt – defined as the liabilities of governments, firms and households – has jumped by $57 trillion, or 17% of global GDP, since the fourth quarter of 2007, which was supposed to be the peak of the bad old credit-fuelled days. In 2000, total debt was worth 246% of global GDP; by 2007, this had risen to 269% of GDP and today we are at 286% of GDP.
This is not how policy since the financial crisis was supposed to have worked out. Central banks and governments have been trying to encourage greater saving and reduced credit as a percentage of GDP, a greater capital base for banks, and reduced government deficits as a means of reducing government debt. But of 47 large economies in the McKinsey study, only five have succeeded in reducing their debt/GDP ratios since 2007 and in many the ratio has got a lot higher. China, for example, has seen its debt to GDP ratio almost double – from 158% to 282%, although its government debt remains low relative to other major economies.
Part of the problem is that the lack of growth in many countries has made it hard for countries to reduce their public-sector deficits to levels that will allow the public-sector debt/GDP ratio to fall.
In terms of the UK, private-sector debt has been falling as a percentage of GDP. But this has been more than offset by a rise in the public-sector debt/GDP ratio. As Robert Peston says:
[UK indebtedness] increased by 30 percentage points, to 252% of GDP (excluding financial sector or City debts) – as government debts have jumped by 50 percentage points of GDP, while corporate and household debts have decreased by 12 and 8 percentage points of GDP respectively.
So what are the likely consequences of this growth in debt and what can be done about it? The articles and report consider these questions.
Articles
Instead of paying down its debts, the world’s gone on another credit binge The Telegraph, Allister Heath (5/2/15)
Global debts rise $57tn since crash BBC News, Robert Peston (5/2/15)
China’s Total Debt Load Equals 282% of GDP, Raising Economic Risks The Wall Street Journal, Pedro Nicolaci da Costa (4/2/15)
Report
Debt and (not much) deleveraging McKinsey Global Institute, Richard Dobbs, Susan Lund, Jonathan Woetzel, and Mina Mutafchieva (February 2015)
Questions
- Explain what is meant by ‘leverage’.
- Why does a low-leverage economy do better in a downturn than a high-leverage one?
- What is the relationship between deficits and the debt/GDP ratio?
- When might an increase in debt be good for an economy?
- Comment on the statement in The Telegraph article that ‘In theory, debt is fine if it is backed up by high-quality collateral’.
- Why does the rise is debt matter for the global economy?
- Is it possible for (a) individual countries; (b) all countries collectively to ‘live beyond their means’ by consuming more than they are producing through borrowing?
- What is the structure of China’s debt and what problems does this pose for the Chinese economy?
After promises made back in July 2012 that the ECB will ‘do whatever it takes’ to protect the eurozone economy, the ECB has at last done just that. It has launched a large-scale quantitative easing programme. It will create new money to buy €60 billion of assets every month in the secondary market.
Around €10 billion will be private-sector securities that are currently being purchased under the asset-backed securities purchase programme (ABSPP) and the covered bond purchase programme (CBPP3), which were both launched late last year. The remaining €50 billion will be public-sector assets, mainly bonds of governments in the eurozone. This extended programme of asset purchases will begin in March this year and continue until at least September 2016, bringing the total of asset purchased by that time to over €1.1 trillion.
The ECB has taken several steps towards full QE over the past few months, including €400 billion of targeted long-term lending to banks, cutting interest rates to virtually zero (and below zero for the deposit rate) and the outright purchase of private-sector assets. But all these previous moves failed to convince markets that they would be enough to stimulate recovery and stave off deflation. Hence the calls for full quantitative easing became louder and it was widely anticipated that the ECB would finally embark on the purchase of government bonds – in other words, would finally adopt a programme of QE similar to those adopted in the USA (from 2008), the UK (from 2009) and Japan (from 2010).
Rather than the ECB buying the government bonds centrally, each of the 19 national central banks (NCBs), which together with the ECB constitute the Eurosystem, will buy their own nation’s bonds. 
The amount they will buy will depend on their capital subscriptions the eurozone. For example, the German central bank will buy German bonds amounting to 25.6% of the total bonds purchased by national central banks. France’s share will be 20.1% (i.e. French bonds constituting 20.1% of the total), Spain’s share will be 12.6% and Malta’s just 0.09%.
Central banks of countries that are still in bail-out programmes will not be eligible to purchase their countries’ assets while their compliance with the terms of the bailout is under review (as is the case currently with Greece).
The risk of government default on their bonds will be largely (80%) covered by the individual countries’ central banks, not by the central banks collectively. Only 20% of bond purchases will be subject to risk sharing between member states according to their capital subscription percentages: the ECB will directly purchase 8% of government bonds and 12% will be bonds issued by European institutions rather than countries. As the ECB explains it:
With regard to the sharing of hypothetical losses, the Governing Council decided that purchases of securities of European institutions (which will be 12% of the additional asset purchases, and which will be purchased by NCBs) will be subject to loss sharing. The rest of the NCBs’ additional asset purchases will not be subject to loss sharing. The ECB will hold 8% of the additional asset purchases. This implies that 20% of the additional asset purchases will be subject to a regime of risk sharing.
As with the QE programmes in the USA, the UK and Japan, the transmission mechanism is indirect. The assets purchased will be from financial institutions, who will thus receive the new money. The bond purchases and the purchases of assets by financial institutions with the acquired new money will drive up asset prices and hence drive down long-term interest rates. This, hopefully, will stimulate borrowing and increase aggregate demand and hence output, employment and prices.
The ECB will buy bonds issued by euro area central governments, agencies and European institutions in the secondary market against central bank money, which the institutions that sold the securities can use to buy other assets and extend credit to the real economy. In both cases, this contributes to an easing of financial conditions.
In addition, there is an exchange rate transmission mechanism. To the extent that the extra money is used to purchase non-eurozone assets, so this will drive down the euro exchange rate. This, in turn, will boost the demand for eurozone exports and reduce the demand for imports to the eurozone. This, again, represents an increase in aggregate demand.
The extent to which people will borrow more depends, of course, on confidence that the eurozone economy will expand. So far, the response of markets suggests that such confidence will be there. But we shall have to wait to see if the confidence is sustained.
But even if QE does succeed in stimulating aggregate demand, there remains the question of the competitiveness of eurozone economies. Some people are worried, especially in Germany, that the boost given by QE will reduce the pressure on countries to engage in structural reforms – reforms that some people feel are vital for long-term growth in the eurozone
The articles consider the responses to QE and assess its likely impact.
Articles
ECB publications
Previous blog posts
Data
Questions
- Why has the ECB been reluctant to engage in full QE before now?
- How has the ECB answered the objections of strong eurozone countries, such as Germany, to taking on the risks associated with weaker countries?
- What determines the amount by which aggregate demand will rise following a programme of asset purchases?
- In what ways and to what extent will non-eurozone countries benefit or lose from the ECB’s decision?
- Are there any long-term dangers to the eurozone economy of the ECB’s QE programme? If so, how might they be tackled?
- Why did the euro plummet on the ECB’s announcement? Why had it not plummeted before the announcement, given that the introduction of full QE was widely expected?
The eurozone is certainly in trouble and, despite the efforts of world leaders to create confidence, it appears that most announcements are having the opposite effect. The risk of deflation has now emerged to be very true; the powerhouse of Europe ‘needs to do more’ and the euro has fallen following Mario Draghi’s recent comments. So, just how bad are things in the eurozone?
Mario Draghi suggested that as a means of stimulating the eurozone economies, a process of quantitative easing may soon need to begin. However, rather than reassuring investors that action was being taken to improve the economic performance in the region, it appears to have had the opposite effect. Following his comments, the euro fell to its lowest level since the middle of 2010.
Quantitative easing has seen much use in the aftermath of the financial crisis and the aim in the eurozone would be to put a stop to the continuing price decreases. The eurozone has now entered deflation and, while the aim of this economic area has always been low prices, deflation is not good news. The downward pressure on prices has been largely driven by oil prices falling and prices in other areas remaining relatively stable.
Quantitative easing would inject money into the eurozone, thus creating growth (or at least that’s the idea) and pushing up prices. One of Mario Draghi’s comments was:
‘We are making technical preparations to alter the size, pace and composition of our measures in early 2015.’
So, while it’s not certain that the QE policy will be used, it seems pretty likely, especially as this policy has been floating around for almost a year.
A key question is, will it work? The quantity theory of money does suggest that an increase in the money supply will lead to inflationary pressures, unless its velocity of circulation falls. But will it actually stimulate aggregate demand and economic growth? If there is more money in the banking system and hence more money available for lending then it may well stimulate investment and consumption. However, if consumers and firms are not confident about the effectiveness of the policy or about the future of the economy, then will the fact that more money is available for lending actually encourage them to borrow? In this case will there merely be a fall in the velocity of circulation?
The comments by Mario Draghi have also caused the euro to fall to its lowest level since 2010. The graph included in the CNBC article provides an interesting view of the path of the euro. Marc Chandler, from Brown Brothers Harriman said:
‘I’d say there’s a good chance it [the euro] gets there [parity with the dollar] before the election next November (2016) … We know the Fed’s going to be raising rates sooner or later, and the ECB is going to be easing sooner or later. I just see a steady grind lower.’
The outlook of the euro therefore doesn’t look too good by all accounts. It is now a waiting game to see if the policy of quantitative easing is implemented and whether or not it has the desired effect. The following articles consider this topic.
Eurozone economy slows further BBC News (6/1/15)
Eurozone falls into deflation for first time since October 2009 Financial Times, Claire Jones (7/1/15)
Eurozone officially falls into deflation, piling pressure on ECB The Telegraph, Marion Dakers (7/1/15)
Eurozone consumer prices fall for first time in five years Nasdaq, Brian Blackstone and Paul Hannon (7/1/15)
Draghi comments send euro to lowest level since 2010 BBC News (2/1/15)
Oil slump drags Eurozone into deflation The Guardian, Graeme Wearden (7/1/15)
Eurozone prices fall more than expected in December Reuters (7/1/15)
Eurozone lurches into deflation after oil price crashes Independent, Russell Lynch (7/1/15)
German inflation hits five-year low as Eurozone prepares for QE The Telegraph, Mehreen Khan (5/1/15)
Euro slide could take it to parity with dollar CNBC, Patti Domm (7/1/15)
Questions
- Why is deflation a cause for concern when normally the main problem is inflation that is too high?
- What is the quantity theory of money and how does it suggest an increase in the money supply will affect prices?
- If quantitative easing is implemented, is it likely to have the desired effect? Explain why or why not.
- Why has the euro been affected by Mario Draghi’s comments? Use a diagram to help your explanation.
- How will quantitative easing help to stimulate economic growth across the Eurozone? Are there any other policies that would be effective?
- Oil prices have had a big influence on the deflationary pressures in the Eurozone. If oil prices increased again, would this be sufficient to create inflation?
‘The world is sinking under a sea of debt, private as well as public, and it is increasingly hard to see how this might end, except in some form of mass default.’ So claims the article below by Jeremy Warner. But just how much has debt grown, both public and private? And is it of concern?
