The world was awash in debt even before the coronavirus pandemic. The economic policy response will lead to another jump in debt — for governments and for the private sector actors they bail out. Last week, I noted that the pandemic intensified the need to fix underlying flaws in our labour market. The same is true for our debt-laden financial system.
My colleague Martin Wolf this week highlighted the link between inequality and indebtedness, which have grown in tandem across the western world in the past two decades (see his chart below). Greater inequality structurally raises savings, other things equal, since the rich save more than the poor. As Wolf’s article documents for the US, since the 1980s savings and indebtedness have moved in opposite directions both for the top 1 per cent and the bottom 90 per cent of earners. Wolf, like many others, worry that this fuels “secular stagnation” — a situation of perennially inadequate demand resulting in weak growth.
My concerns are somewhat different. The causal relationship also runs from debt to inequality. The rapid liberalisation of finance from the 1980s was a significant cause of credit and debt growth, which in turn fuelled both asset price inflation and a greater need for people to indebt themselves to own a house. Much of the increase in inequality came from higher rental or capital incomes. Increased financial intermediation also led gross debt to increase more than sectoral net indebtedness. These mechanisms explain why, for example, gross cross-border debt grew much faster than what the changes in macroeconomic savings rates can account for.
I also think the macroeconomic demand effects of high debt levels are unclear, since the burden of debt service has developed in a much more benign way than the amount of debt outstanding (because of falling interest rates). The chart below shows the evolution of US households’ debt service costs as a ratio to disposable income. On average, debt service takes up less of households’ incomes than at any time since 1980 (although admittedly this aggregate hides the sort of inequalities Wolf highlights).
That does not make high debt levels any less dangerous, far from it, but the dangers are more insidious than secular stagnation. Even if average debt service is low, large debt balances make for fragility. That is because when debts are large relative to economic activity, a smaller proportionate change in economic prospects suffices to cause cascading insolvencies, with all their legal and economic repercussions.
One of those repercussions is the debt deflation Wolf mentions, which shrinks demand and can cause recessions when everyone tries to reduce their debts at the same time. Another is that a debt overhang hinders investment in otherwise productive activities (a cause of slow supply growth rather than insufficient demand), because potential investors fear their money will just go to cover legacy debts. A third is that it hinders mobility of both workers and capital, geographically and to more profitable jobs and sectors (again a supply-side problem). The result is slower and more unstable growth, which hurt the poorest — who are rarely net creditors and who bear the brunt of downturns — the most.
As we think about how to rebuild our economies better, we must try to reinvent the financial system so that savings can finance investments without excessive debt accumulating. That requires tackling debts from the past (the legacy outlined by Wolf and others), the debts now being incurred at a dizzying pace in response to the Covid-19 lockdowns and the debt accumulation likely to continue in the future if we do not change our financial system.
The overarching principle in tackling all three must be to make financial relationships more equity-like. It is not the amount of financing in the economy that is the problem, but that so much of this financing is in the form of debt.
Debt finance, unlike equity finance, makes the promise of a regular pre-decided payment — this is what causes trouble when economic outcomes are not good enough to honour all these promises. That is the great paradox of debt finance: individuals choose it for its predictability, but collectively it makes for greater instability. Equity, on the other hand, has the built-in stabiliser that any disappointments (as well as windfalls) are straightforwardly and predictably absorbed at the hands of the investor.
For the legacy debts that already exist, giving them the characteristics of equity essentially means making it easier to restructure them. This will undoubtedly be necessary given the huge hit to national income from the lockdown. In the household and non-financial corporate sector, such restructuring takes place through bankruptcy processes. That means this is the time for countries to ensure that those processes are fit for purpose. In a recent paper for Brookings, David Skeel explains that even the comparatively smooth procedures of the US may not be ready for the onslaught of bankruptcy filings to come. He proposes a combination of legislative streamlining (including a “non-bankruptcy stay” on debt payments and simplified or pre-packaged bankruptcy procedures) and government financing in bankruptcy — all good ideas that other countries should also look into.
Beyond this, some types of debt may need special treatment. Governments should remember that the resolution regimes for banks brought in after the crisis, which require a restructuring of their debts before any recapitalisation with taxpayer money, are there to be used. Analogous “special resolution regimes” should be introduced to keep overindebted companies in systemically important sectors functioning (perhaps universities or airlines) while writing down their debts.
What to do with highly indebted governments is the biggest question of all — so big that we will pass on it for now and devote a future Free Lunch to it.
Next, the flood of new financing that governments are currently directing at companies should be designed, or redesigned, to be more equity-like. At the “soft” end, this could be done by making predictable the conditions under which the debt will be written off, so that current rescue loans do not become an obstacle to growth and investment down the line. At the harder end, support could be given equity-like characteristics up front.
This looks particularly attractive in the EU, where equity injections from an EU-level fund could overcome the dispute over whether crisis-hit countries should be helped with grants or with loans (equity is neither). A group of economists has developed a thoughtful proposal in this regard. For very small businesses — sole traders and family businesses — they suggest this can be done through grants combined with a profit surtax, to mimic the financial structure of equity investment.
In the EU financial system, which is overbanked and underserved with capital markets, such an equity fund could be a catalyst for the ambition of a “capital markets union” with more equity finance for smaller companies. But the same thinking makes a lot of sense elsewhere too. Giles Wilkes’s report for the Institute of Government is an extremely constructive contribution to how such schemes could be used in the UK.
Finally, after the crisis, the “new normal” ought to be one where most financing has equity characteristics. Making permanent the sort of bankruptcy and resolution regimes mentioned above will help. But much more can be done. As Wolf mentions, tax deductibility can be extended to equity financing and withdrawn from debt service. But that merely scratches the surface. Governments can also use financial regulation to make banks and other intermediaries favour equity-like forms of, for example, home finance. It can also give its own credit policies — such as student loan schemes and public business banks — more of the characteristics of equity. They can even begin to issue “sovereign equity” themselves — government securities that pay out depending on how fast the economy is growing.
Again, it is not financing that is the problem, but a financial system that relies too much on the false security of debt and fixed income. When the underlying instability materialises, it is those least able to bear it who suffer the most. We owe it to them to build a more robust financial system in the future — and that means one in which true risk is handled openly and no longer hidden under the cover of debt.
Coronanomics readables
A general-audience column version is now available of the excellent research paper modelling the “Keynesian supply shocks” that best capture what is happening in the Covid-19 economic lockdown.
A study of Italian death registry data confirms that the total death toll of the pandemic is higher than official numbers — but also highlights how well the Veneto region did compared to others, thanks to its aggressive testing, tracking and at-home care programme.
Other readables
The German constitutional court’s opinion that the European Central Bank has not justified its asset-purchase programme created waves across Europe this week. In my FT column, I explain why I think the German court got it so wrong.
Before that bombshell, the ECB had done a good job of explaining its (very bad) scenarios for the economy and how its monetary actions are intended to help.
Numbers news
The Bank of England expects the UK economy to contract by nearly 30 per cent in the first half of 2020 before a rebound in the second half.
The European Commission released its spring macroeconomic forecasts, which paint a grim picture: in 2020, the bloc’s national economies will shrink by between 4 per cent and 10 per cent from last year.
Source: Economy - ft.com
