Category: Essentials of Economics: Ch 15

‘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

  1. What would be the impact of several countries defaulting on debt?
  2. What factors determine the likelihood of sovereign defaults?
  3. What factors determine the likelihood of bank defaults?
  4. What is meant by ‘leverage’ in the context of (a) banks; (b) nations?
  5. What are the Basel III regulations? What impact will they have/are they having on bank leverage?
  6. Expand on the arguments supporting the doomsday scenario above.
  7. Expand on the arguments supporting the optimistic scenario above.
  8. What is the relationship between economic growth and debt?
  9. Explain how the explosion in global credit might merely be ‘the mirror image of rising output, asset prices and wealth’.
  10. 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?

Many important economic changes have occurred over the past two years and many have occurred in the past two months. Almost all economic events create winners and losers and that is no different for the Russian economy and the Russian population.

There is an interesting article plus videos on the BBC News website (see link below), which consider some of the economic events that, directly or indirectly, have had an impact on Russia: the fall in oil prices; the conflict between Russia and the Ukraine; the fall in the value of the rouble (see chart); the sanctions imposed by the West.

Clearly there are some very large links between events, but an interesting question concerns the impact they have had on the everyday Russian consumer and business. Economic growth in Russia has been adversely affected and estimates suggest that the economy will shrink further over the coming year. Oil and gas prices have declined significantly and while this is good news for many consumers across the world, it brings much sadder tidings for an economy, such as Russia, that is so dependent on oil exports.

However, is there a bright side to the sanctions or the falling currency? The BBC News article considers the winners and losers in Russia, including families struggling to feed their families following spending cuts and businesses benefiting from less competition.

Russia’s economic turmoil: nightmare or opportunity? BBC News, Olga Ivshina and Oleg Bodyrev (5/2/15)

Questions

  1. Why has the rouble fallen in value? Use a demand and supply diagram to illustrate this.
  2. What does a cheap rouble mean for exporters and importers within Russia and within countries such as the UK or US?
  3. One of the businesses described in the article explain how the sanctions have helped. What is the explanation and can the effects be seen as being in the consumer’s interest?
  4. Oil prices have fallen significantly over the past few months. Why is this so detrimental to Russia?
  5. What is the link between the exchange rate and inflation?

Yanis Varoufakis, the new Greek finance minister, is also an economist and an expert in game theory and co-author of Game Theory: a critical text. He is now putting theory into practice.

He wishes to renegotiate the terms of Greece’s debt repayments. He argues not that some of the debt should be written off, but that the terms of the repayment are far too tough.

Greece’s problem, he argues, was wrongly seen as one of a lack of liquidity and hence the Troika (of the EU, the ECB and the IMF) provided a large amount of loans to enable Greece to keep servicing its debts. These loans were conditional on Greece following austerity policies of higher taxes and reduced government expenditure. But this just compounded the problem as seen by Yanis Varoufakis. With a shrinking economy, it has been even more difficult to repay the loans granted by the Troika.

The problem, he argues, is essentially one of insolvency. The solution is to renegotiate the terms of the debt to make it possible to pay. This means reducing the size of the budget surplus that Greece is required to achieve. The Troika is currently demanding a surplus equal to 3% of GDP in 2015 and 4.5% of GDP in 2016.

The Syriza government is also seeking to link repayments to economic growth, by the issue of growth-linked bonds, whose interest rate depends on the rate of economic growth, with a zero rate if there is no growth in real GDP. He is also seeking emergency humanitarian aid

At the centre of the negotiations is a high stake game. On the one hand, Germany and other countries do not want to reduce Greece’s debts or soften their terms. The fear is that this could unleash demands from other highly indebted countries in the eurozone, such as Spain, Portugal and Ireland. Already, Podemos, Spain’s anti-austerity party is rapidly gaining support in Spain. On the other hand, the new Greek government cannot back down in its fundamental demands for easing the terms of its debt repayments.

And the threats on both sides are powerful. The Troika could demand that the original terms are met. If they are not, and Greece defaults, there could be capital flight from Greece (even more than now) and Greece could be forced from the euro. The Greeks would suffer from further falls in income, which would now be denominated in a weak drachma, high inflation and financial chaos. But that could unleash a wave of speculation against other weaker eurozone members and cause a break-up of the currency union. This could seriously harm all members and have large-scale repercussions for the global economy.

So neither side wants Greece to leave the euro. But is it a game of chicken, where if neither side backs down, ‘Grexit’ (Greek exit from the euro) will be the result? Yanis Varoufakis understands the dimensions of the ‘game’ very well. He is well aware of the quote from Keynes, ‘If you owe your bank a hundred pounds, you have a problem. But if you owe a million, it has.’ He will no doubt bring all his gaming skills to play in attempting to reach the best deal for Greece.

Greece’s last minute offer to Brussels changes absolutely nothing The Telegraph, Ambrose Evans-Pritchard (10/2/15)
The next card Yanis Varoufakis will play The Conversation, Partha Gangopadhyay (8/2/15)
Senior European official: ‘The Greeks are digging their own graves’ Business Insider, Mike Bird (10/2/15)
Greece: The Tie That Doesn’t Bind New York Times, Paul Krugman (9/2/15)
Greek finance minister says euro will collapse if Greece exits Reuters, Gavin Jones (8/2/15)
Greece is playing to lose the debt crisis poker game The Guardian, Project Syndicate and Anatole Kaletsky (9/2/15)
Greek markets find sliver of hope Financial Times, Elaine Moore, Kerin Hope and Daniel Dombey (10/2/15)
Greece: What are the options for its future? BBC News, Jamie Robertson (12/2/15)
‘If I weren’t scared, I’d be awfully dangerous’ The Guardian, Helena Smith (13/2/15)
Greek debt crisis: German MPs back bailout extension BBC News (27/2/15)

Questions

  1. Is a deal over the terms of repayment of Greek debt a zero sum game? Explain whether it is or not.
  2. What are Keynes Bisque bonds (or GDP-indexed bonds)? Do a Web search to find out whether they have been used and what their potential advantages and disadvantages are. Are they a good solution for both creditors and Greece in the current situation?
  3. What is meant by a ‘debt swap’? What forms can debt swaps take?
  4. Has Greece played its best cards too early?
  5. Should Greece insist on debt reduction and simply negotiate around the size and terms of that reduction?
  6. Are Greece’s new structural reform proposals likely to find favour with other EU countries and the Troika?

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

  1. Explain what is meant by ‘leverage’.
  2. Why does a low-leverage economy do better in a downturn than a high-leverage one?
  3. What is the relationship between deficits and the debt/GDP ratio?
  4. When might an increase in debt be good for an economy?
  5. Comment on the statement in The Telegraph article that ‘In theory, debt is fine if it is backed up by high-quality collateral’.
  6. Why does the rise is debt matter for the global economy?
  7. 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?
  8. What is the structure of China’s debt and what problems does this pose for the Chinese economy?