Debt Hangover Forward to Longwaves

["Gary Santos" <evs@xxxxxxxxxxx>]

For the learning experience. . .


Stephen King: Debt levels could leave us with post-bubble hangover
When central banks have attempted to regulate the supply of money, they have
all too often failed
The Independent
03 February 2003

No central banker in his or her right mind would admit to impotence, at
least of the economic kind. Unsurprisingly, then, few within the central
banking fraternity have expressed any serious doubts about the efficacy of
monetary policy. Even when interest rates get close to zero without
generating a convincing recovery - a problem in many parts of the world
today - there appears to be no real concern. After all, central bankers have
other weapons up their sleeves. And the one that offers the most power,
apparently, is the printing press.

The zero rate bound on nominal interest rates is, in reality, only
infrequently encountered. In recent history, the only major country to have
experienced this unusual state of affairs is Japan. The problem with the
zero rate bound is straightforward: if expected returns on capital are very
low or, possibly, negative - more than likely in a deflationary
environment - interest rates may simply not be able to fall far enough to
ensure a recovery in economic activity. After all, why borrow at zero or 1
per cent if your prices, wages and profits are likely to fall by 2 or 3 per
cent over the coming year?

Under these circumstances, the printing press appears to be the obvious
remedy. Double the amount of money in the economy and its price should
halve. Put another way, double the amount of money in the economy and people
will simply have too much: they'll want to get rid of it and the only way to
do that is to buy something - an equity, a corporate bond, a work of art, a
house, a new kitchen or maybe a new factory.

The argument is simple, beautifully logical and probably wrong. It assumes
that central bankers are in complete control of the money supply and can
raise or lower the level of money flowing through the economy at will. The
evidence over the past 20 years, however, suggests rather the opposite. When
central banks have attempted to regulate the supply of money, they have all
too often failed. Two examples spring to mind. The first is the experiment
with monetary targeting that took place in many parts of the world in the
late 1970s and early 1980s. The second is the more recent Japanese
experience where, despite valiant efforts to the contrary by the Bank of
Japan, broad money supply growth has remained stubbornly depressed.

The common factor in these two episodes is debt. More specifically, in both
cases a gap opened up between actual debt levels and desired debt levels. In
the mid to late-1970s, when monetary targeting came into vogue, most credit
markets were tightly regulated. This basically meant that, at a given
interest rate, not all those who wanted to borrow were able to borrow. Back
then, getting a mortgage was a major headache and many applicants would be
rejected even if they appeared to be reasonably creditworthy. Actual levels
of debt were, as a result, lower than the debt levels that would have
"cleared" the market at prevailing interest rates.

With the advent of financial liberalisation in the 1980s, suddenly a whole
host of new competitors was able to enter the market. For a given interest
rate, many more people were able to borrow and many more suppliers of credit
were able to meet their needs. Suddenly, money supply started to grow rather
too quickly. Central banks and governments began to overshoot their money
supply targets for the simple reason that they had failed to detect the
hidden, or suppressed, demand for credit that suddenly began to reveal
itself in the 1980s. Policy makers may have thought that they were in
control of the printing press but, ultimately, it was the private sector
that determined its output. And the key determinant of money supply growth
became the speed with which actual debt levels were able to rise to desired
debt levels.

Now take a look at Japan. The collapse in Japanese asset prices through the
1990s, in effect, implied a collapse in expectations about future income
growth. This, in turn, created a problem for debtors. Those that had
borrowed in the heady days of the late-1980s, when asset prices roared ahead
and everyone thought that Japan was going to rule the world, began to regret
their decisions. Debts that, in a past life, would have easily been repaid
in just a few years became a lot more problematic. Put simply, with asset
prices having fallen and with income growth a lot weaker than expected, debt
repayment became sheer hard work. And with everyone hell-bent on debt
repayment, there was no money left for growth: the economy slumped,
deflation arrived and debt levels turned out to be persistently too high.

In other words, the Japanese situation is exactly the opposite of the 1970s
and 1980s experience. Then, debt levels were lower than people wanted them
to be. In Japan, debt levels were higher than people wanted them to be. So
what did this imply for the printing press? Well, for a few years, the Bank
of Japan wasn't terribly happy about the whole idea of printing money and
chose to keep the secret weapon hidden away. But over the past 18 months,
the Bank of Japan has been printing money with a vengeance. Growth in
so-called "narrow" money has been running at more than 20 per cent annually,
no mean achievement by anybody's standards.

There is, however, a catch. The printing press may be churning away but
there's no one around that wants to take the money away. The Japanese
banking system has a lot of problems in itself but the bigger problem
appears to be a lack of appetite from either companies or households to
borrow. Even if you can make the banking system itself awash with money, the
economy itself isn't going to benefit unless people actually have the
appetite to use the money. Of course, if the private sector doesn't want to,
you can get the public sector to do the job for you. But, even here, there
may be limits. Money will eventually end up in the pockets of companies and
households and they may again choose to repay debts than to spend. If debt
levels are too high, money may simply not be able to swish around the
economy. In Japan's case, broad money supply growth has remained remarkably
weak in recent years.

What relevance does all of this have for today? My charts show that debt
levels have risen in absolute terms very quickly in the US and the eurozone
over the past few years. They also show that, as a share of income,
household debt in the US has also risen dramatically. Is this a re-run of
the 1970s and 1980s - where actual debt levels rose to desired debt levels
as a result of financial liberalisation - or, instead, do these debt levels
raise the risk of Japan all over again where actual debt levels are too high
relative to desired debt levels?

Sadly, I suspect it's the latter. Debt levels that, a few years ago, were no
big deal, are increasingly becoming a constraint on growth, undermined at
first by falls in equity prices and, perhaps over coming months, by falls in
house prices. The printing press may give comfort to central bankers but
excessive debt levels in the private sector may leave us suffering from a
post-bubble hangover for a lot longer than policy makers would have us
believe.

Stephen King is managing director of economics at HSBC.