The prudent will have to pay for the profligate

By Martin Wolf

You have enjoyed a debt-financed spending spree. But times are now harder: you find it impossible to roll over your debt; you have to pay much higher interest rates than before; or you find that the value of the assets you pledged as collateral is now less than your loan. What can you do? Provided enough of you are in trouble, you call for help from the fairy government-mother.

Thus, George Magnus of UBS, among the wisest analysts of this crisis, has already observed, with some approval, that the crisis “is spawning an array of well scripted but highly unconventional public policy responses” – that is to say, rescues of various kinds.*

Over-indebted individuals have just three choices: reduce spending below income, sell assets they own to somebody else or, if the worst comes to the worst, default. But one person’s debt is another person’s asset, one person’s expenditure is another person’s income; one person’s sale is another person’s purchase and one person’s default is another person’s loss.

If very many individuals reduce their spending, in order to pay down their debt, the economy slumps. If many try to sell assets they own, their prices crash. If many default on their debts, financial intermediaries implode. The economics of an entire economy are not the same as the economics of a single household. That was perhaps the most important point John Maynard Keynes made.

Thus, argues Mr Magnus, “there is a quite serious risk that the de-leveraging downturn could run amok: credit contraction causes economic contraction, which causes further write-downs and capital destruction, which leads to more credit contraction and so on”. On the upside, the fairy government-mother stood on the sidelines, applauding the enthusiasm of her charges. On the downside, she is dragged in, as risk-addiction turns into risk-aversion.

Between its low in the first quarter of 1982 and its high in the second quarter of 2007, the share of the financial sector’s profits in US gross domestic product rose more than six-fold. Behind this boom was an economy-wide rise in leverage (see chart). Leverage was the philosopher’s stone that turned economic lead into financial gold. Attempts to reduce it now risk turning the gold back into lead again.

Hélène Rey of the London Business School has demonstrated this process for the financial sector.** She describes three ways in which markets have malfunctioned: via the originate-to-distribute model, with its weak incentives to assess loan quality and wide diffusion of assets of unknown quality; via the vicious spiral in credit default swaps, with rising prices forcing a higher cost of funds on banks, so worse credit standing and so forth; and, finally, via tumbling market valuation of assets, with distressed sales in thin markets lowering solvency and forcing further sales.

Each drowning institution drags others down with it. The solution they all desire is for the government to act as lender of last resort against illiquid instruments and buyer of last resort of impaired ones. While the former activity has been known since the days of Walter Bagehot’s Lombard Street, the latter is an overt bail-out. But for the sector as a whole, any other way of reducing excessive liabilities is far too slow, collectively ruinous, or both.

Now consider a second crucial sector: US households. They have been spending more than their income for a decade. Indeed, this spending has been the single most important counterpart of the persistent US surplus on the capital account (or deficit on the current account). In the process, households have accumulated ever more debt.

How might households seek to reduce their indebtedness, collectively? They can try to sell assets. But they can sell houses only to one another, which would not, in aggregate, help. They can sell equities to the rest of the world, but their prices might crash first. They can default. Indeed, many seem likely to do so. But that would damage the financial sector’s solvency and, through that, either the government’s balance sheet, via bail-outs, or the balance sheet of other households, via losses on financial assets.

Finally, they can cut back on spending. But that would guarantee a recession, if not a slump. In the fourth quarter of 2007, household savings were still as low as ever, at 2 per cent of GDP. Imagine that they rose swiftly back to where they were in the early 1990s. That would be an increase of 4 percentage points of GDP. The result would be a deep recession. It is no surprise, therefore, that politicians are trying to rescue the housing market, while the Federal Reserve has been slashing interest rates with vigour.

In such predicaments, the government always emerges as the lender, borrower and spender of last resort. It will act by bailing out insolvent people and institutions, by either replacing or guaranteeing the lending activities of the private financial sector and, not least, by running larger fiscal deficits, as private-sector financial deficits shrink.

It should be no surprise, therefore, that the principal balance-sheet effect of Japan’s long crisis was a rise in the government’s gross debt from 70 per cent of GDP in 1990 to 180 per cent at the end of last year. Leverage did not so much disappear as become socialised.

Similarly, a rise in the indebtedness of the US government is an almost inevitable consequence of any prolonged financial crisis. A jump in public debt is an invisible increase in long-term private obligations. But this is socialised private debt: the prudent pay for the profligate.

An escape from the public sector’s debt trap exists: the mass default known as inflation. By destroying the purchasing power of money, the government can engineer a speedy reduction in indebtedness across the economy, at the expense of creditors, principally the elderly and foreigners. Inflation is a magic tax on creditors whose proceeds are directly transferred to debtors.

The bottom line is simple. Neither households nor the financial sector, as a whole, can de-leverage swiftly, other than via a calamitous mass default or by shifting their debt elsewhere, usually on to the government. For an entire economy, particularly a huge one, to recover from debt-addiction is hard. However much one may loathe the idea, a private-sector financial mania will finish up as public-sector pain.