Dec 21st 2013

Debt and Demand

by Adair Turner

 

Adair Turner, Chairman of the Institute for New Economic Thinking and former Chairman of the UK Financial Services Authority, is Chair of the Energy Transitions Commission. 

LONDON – Former US Treasury Secretary Larry Summers recently caused a stir with his warning of sustained economic stagnation in the advanced economies. But, while many reject his suggestion of a secular trend, the data support him. Yes, economic growth has picked up in the United States and the United Kingdom, while the eurozone economy is no longer contracting and Japan shows some signs of responding to “Abenomics.” But the global recovery remains extremely weak, with most advanced economies still performing at 10-15% below pre-crisis growth trends.

It is not difficult to see why the recovery has been anemic. Excessive private-debt creation before the crisis and subsequent attempts at deleveraging have weakened demand considerably.

While fiscal deficits can help to offset deficient demand, they also result in rising public debt. Leverage has not gone away; it has simply shifted to the public sector – creating a debt overhang that may last for many years, or even decades. Eliminating it will likely require significant debt write-offs or permanent monetization.

But, as Summers noted, the party that preceded this severe post-crisis hangover was not, in terms of actual growth, all that exuberant. Credit volumes and asset prices soared, but labor markets did not overheat, real earnings remained flat in many advanced economies, and inflation rates were remarkably stable. Nominal demand grew at roughly 5% annually, despite annual credit growth of 10% or more.

Today, the same pattern is unfolding in many emerging economies – most notably, China. With credit growth far outpacing nominal GDP growth, leverage is increasing. And it seems that the rising credit intensity of GDP growth (the amount of new credit required to generate a unit of output) is needed to ensure that economic performance remains in line with potential.

This implies a serious dilemma: while rising leverage is apparently essential, it inevitably leads to crisis and recession. Against this background, policymakers must consider whether rapid credit growth is really necessary, and whether there are any alternatives – a question that modern economics has so far largely ignored.

In fact, much credit growth is not critical to economic growth, because it does not play a direct role in financing consumption or investment. Economics textbooks often describe how households deposit money in banks, which lend to businesses to finance capital investment. But, in advanced economies – and increasingly in emerging economies – this story is largely fictional, because such lending accounts for only a small share of the total.

Instead, a large part of bank lending finances the purchase of existing assets, particularly commercial or residential real estate, the prices of which primarily reflect the value of the underlying land. Such existing-asset finance does not directly stimulate investment or consumption. But it does drive up asset prices, causing lenders and borrowers to believe that even more credit growth is both safe and desirable.

Lending to finance existing assets, primarily in real-estate markets, can thus play an asymmetric role in the real economy. While it has little impact on demand, output, and prices during the boom, it results in debt overhang, deleveraging, and depressed demand in the post-crisis period.

In this context, policymakers should distinguish between categories of debt. For example, they could impose higher capital requirements on real-estate lending or introduce direct borrower constraints like limits on loan-to-value or loan-to-income ratios. Such policies would help to reduce the credit intensity of growth, thereby curbing the threat to long-term economic stability.

Nonetheless, the problem of deficient demand might persist. Even though such lending does not stimulate demand for newly produced goods and services directly, it may do so   indirectly by generating unsustainable wealth effects (driving people to spend more because they feel richer). Constraining the lending that drives up real-estate prices could lead to lower nominal demand.

Curtailing demand for this category of credit would lower the real (inflation-adjusted) interest rate. But we cannot assume that this would offset the deflationary impact of reduced wealth effects. Even before the crisis, real long-term interest rates were on a clear downward trajectory, with 20-year index-linked yields falling from almost 4% in 1990 to below 2% by 2007. Whether even lower interest rates would have stimulated significant additional investment is unclear.

The fundamental question therefore remains: Is there something about modern economies that makes adequate demand growth impossible without damaging credit growth?

Rising inequality is one driver of this apparent “need for credit.” Wealthier people have a higher marginal propensity to save than poorer people. As the rich get richer, consumption growth may decline, unless the financial system uses their savings to lend to the relatively poor.

But much of this debt may prove unsustainable. As Raghuram Rajan pointed out in his book Fault Lines, the US subprime-mortgage boom and bust owed much to pitiably slow growth in lower-income Americans’ real earnings over the last three decades.

Global imbalances also contribute to rising debt risk. If current-account surpluses are not matched by rising equity claims against the rest of the world – whether through corporate foreign direct investment or household-equity investments in other countries – they inevitably result in debt claims, increasing public or private debt liabilities in deficit countries. Some of those debt claims will likely prove unsustainable, and all of them may contribute to post-crisis debt-overhang effects.

A more stable growth model requires less of the “wrong type of debt” – that is, debt that finances purchases of existing assets, supports consumption without addressing the drivers of inequality, or results from unsustainable global imbalances. Without targeted policies aimed at limiting such debt, the world economy risks secular stagnation or further cycles of instability and crisis.


Adair Turner, former Chairman of the United Kingdom’s Financial Services Authority, is a member of the UK’s Financial Policy Committee and the House of Lords.

Copyright: Project Syndicate, 2013.
www.project-syndicate.org

 


This article is brought to you by Project Syndicate that is a not for profit organization.

Project Syndicate brings original, engaging, and thought-provoking commentaries by esteemed leaders and thinkers from around the world to readers everywhere. By offering incisive perspectives on our changing world from those who are shaping its economics, politics, science, and culture, Project Syndicate has created an unrivalled venue for informed public debate. Please see: www.project-syndicate.org.

Should you want to support Project Syndicate you can do it by using the PayPal icon below. Your donation is paid to Project Syndicate in full after PayPal has deducted its transaction fee. Facts & Arts neither receives information about your donation nor a commission.

 

 

Browse articles by author

More Current Affairs

Feb 18th 2020
Extract: "In late 2019, Zogby Research Services (ZRS) once again had the opportunity to poll public opinion across the Middle East and North Africa about many of these issues that are of such critical concern to the region and its peoples..............One of the more intriguing results in our 2019 survey were the changes in Arab views toward the Israeli-Palestinian conflict. Most Arabs still blame the US and Israel for the absence of peace and have little confidence that the conflict can be resolved in the near future. Maybe as a result of this despair, this issue now ranks low as an Arab priority. Also noteworthy is the fact that majorities in most Arab countries now say that normalization with Israel, which they acknowledge is already happening, may be a good thing. This development shouldn’t be overstated, however, since there is still no love for Israel. It appears, from our survey, to be born of frustration, weariness with Palestinians being victims of war, and the possibility that normalization might bring some economic benefits and could give Arabs leverage to press Israel to make concessions to the Palestinians."
Feb 15th 2020
EXTRACT: "Global dissatisfaction with democracy has increased over the past 25 years, according to our recent report. Drawing upon the HUMAN Surveys project, the report covered 154 countries, with 77 countries covered continuously for the period from 1995 to 2020. These samples were possible thanks to the combination of data from over 25 sources, 3,500 national surveys, and 4 million respondents. Not surprisingly, the gloomy headline finding – rising democratic dissatisfaction – attracted the most attention. Less widely discussed, however, is the “good news” – that a small sample of countries has bucked the trend, and have record high levels of satisfaction with their democracies."
Feb 14th 2020
EXTRACT: "This is how dictatorships begin. As the US prepares for its next presidential election in November, it is every citizen’s responsibility rationally to examine Trump’s dictatorial impulses, which reelection would only reinforce. It is not safe to assume that he won’t go too far, or that he is too much of a “mediocrity” – as Leon Trotsky called Stalin (an assessment with which many Bolsheviks agreed) – to transform his country......Vladimir Lenin, himself a ruthless Bolshevik, wrote in 1922 that, “Stalin concentrated in his hands enormous power, which he won’t be able to use responsibly,” owing to traits like rudeness, intolerance, and capriciousness. Trump has all of them in spades. The more power he concentrates in his own hands, the dimmer the long-term outlook for American democracy becomes. His reelection could mean lights out."
Feb 9th 2020
EXTRACT: "Does this mean that the dream of European unity is over? Does the exodus of a member state obliterate the vision of Victor Hugo and Václav Havel? Does Europe now fit the description of what the great American president Abraham Lincoln called a house divided against itself? Not necessarily. History is more imaginative than we are. The EU still has the option of keeping Britain close in heart and mind. We can still benefit from our absent partner, by resurrecting the partnership through our actions."
Feb 7th 2020
EXTRACT: "There, no formal change from a republican system to an autocratic system ever occurred. Rather, there was an erosion of the republican institutions, a steady creep over decades of authoritarian decision-making, and the consolidation of power within one individual – all with the name “Republic” preserved.........Will the GOP-led Senate’s endorsement of this defense clear a path for more of the manifestations – and consequences – of authoritarianism? The case of the Roman Republic’s rapid slippage into an autocratic regime masquerading as a republic shows how easily that transformation can occur."
Feb 7th 2020
EXTRACT: "So all that is why Cramer is talking about the death knell of petroleum stocks. We probably agree on almost nothing else, but when people are right, you have to give them credit. He is right."
Feb 3rd 2020
EXTRACT: "........as the citizens of the remaining 27 states have observed the destabilising impact that the referendum decision has had on British politics, they have been inoculated against the desire to secede from the EU. Outside the UK, national-populist parties have moderated their anti-EU rhetoric and nowadays profess to want to change the EU from within instead of destroying it."
Feb 2nd 2020
EXTRACT: "Senators will soon decide whether to dismiss the articles of impeachment against President Donald Trump without hearing any witnesses. In making this decision, I believe they should consider words spoken at the Constitutional Convention, when the Founders decided that an impeachment process was needed to provide a “regular examination,” to quote Benjamin Franklin. A critical debate took place on July 20, 1787, which resulted in adding the impeachment clause to the U.S. Constitution. Franklin, the oldest and probably wisest delegate at the Constitutional Convention, said that when the president falls under suspicion, a “regular and peaceable inquiry” is needed."
Feb 1st 2020
EXTRACT: "Britain will be celebrating its glorious independence from the complications of international cooperation at a time when the intellectual, political, and economic hostility between China’s communist leadership and liberal democracies is becoming ever clearer. If liberal democracy is to survive, it must stand up for itself. And we should be under no illusion: open societies under the rule of law, from the Americas to Europe, Africa, and Asia, are in China’s hostile sights. The West should not aim to encircle or pen in China. But liberal democracies cannot allow it to distort international norms in its own favor."
Jan 29th 2020
EXTRACT: "Switzerland and Denmark have gone furthest into negative territory, both offering unprecedentedly low rates of -0.75%. The Swiss National Bank, which has kept its rate at this level since 2015, signalled recently that it intends to stick with this experiment and is not ruling out going even more negative. It has said that negative rates were boosting the economy and that the country’s fundamentals were not being significantly affected."
Jan 28th 2020
EXTRACT: "Electricity will dominate the future global energy system. Currently, it accounts for only 20% of final energy demand,......Without assuming any fundamental technological breakthroughs, we could certainly build by 2050 a global economy in which electricity met 65-70% of final energy demand,....."
Jan 27th 2020
EXTRACT: "With the world economy operating dangerously close to stall speed, the confluence of ever-present shocks and a sharply diminished trade cushion raises serious questions about financial markets’ increasingly optimistic view of global economic prospects."
Jan 26th 2020
EXTRACT: "Gibson’s diagnosis is supported by international attitude surveys. One found that most Americans rarely think about the future and only a few think about the distant future. When they are forced to think about it, they don’t like what they see. Another poll by the Pew Research Centre found that 44% of Americans were pessimistic about what lies ahead. But pessimism about the future isn’t just limited to the US. One international poll of over 400,000 people from 26 countries found that people in developed countries tended to think that the lives of today’s children will be worse than their own. And a 2015 international survey by YouGov found that people in developed countries were particularly pessimistic. For instance, only 4% of people in Britain thought things were improving. This contrasted with 41% of Chinese people who thought things were getting better."
Jan 24th 2020
EXTRACT: "........while over 80% of the ECB scheme buys government and other public sector bonds, a huge chunk still goes into corporate bonds and other assets. At the time of writing, the ECB holds €263 billion worth of corporate bonds – a very significant amount in relation to individual firms and the sectors in question. According to the ECB, 29% of these bonds were issued by French firms, 25% by German firms and 11% each by Spanish and Italian firms. As at September 2017, the sectors they came from included utilities (16%), infrastructure (12%), automotive (10%) and energy (7%)."
Jan 17th 2020
EXTRACT: "Thanks to cutting-edge digital technology, cars are increasingly like “smartphones on wheels”, so manufacturers need to have access to the latest patented 4G and 5G technologies essential to navigation and communications. But often the companies that hold the patents are reluctant to license them because manufacturers will not accept the high fees involved, which leads to patent disputes and licensing rows."
Jan 13th 2020
EXTRACT: "Recent polling from Pew Research demonstrates how the public’s attitudes toward the US and President Trump have witnessed sharp declines in many nations across the world. In Europe, the Americas, and the Middle East favorable attitudes toward the US went from lows during the years of George W. Bush’s presidency to highs in the early Obama years to lows, once again, in the Trump era. And in our Zogby Research Services (ZRS) polling we found, with a few exceptions, much the same trajectory across the Middle East."
Jan 13th 2020
EXTRACT: "In the absence of a declaration of war against Iran, the killing of a foreign official – by a drone strike on Iraqi territory – was possibly illegal. But such niceties do not perturb Trump. The evidence is that Trump’s decision was taken without consideration of the possible consequences. The national security system established under Dwight D. Eisenhower, designed to prevent such reckless measures, is broken to non-existent, with ever-greater power placed in the hands of the president. If that president is unstable, the entire world has a very serious problem."
Jan 9th 2020
EXTRACT: "It is possible that Trump’s reverential base won’t be sufficient to keep him in the White House past 2020. But such ardent faith is hard to oppose with rational plans to fix this or that problem. That is why it is so unsettling to hear people at the top of the US government speak about politics in terms that rightly belong in church. They are challenging the founding principles of the American Republic, and they might actually win as a result."
Jan 7th 2020
EXTRACT: "If anything has become clear in our recent Zogby Research Services (ZRS) polling in Iraq, is that most Iraqis are tired of their country being used as a playground for regional conflict, especially the conflict between the US and Iran. In fact, our polling has shown Iraqis increasingly upset with the role played by both the US and Iran in their country. Majorities see both of these countries as having been the major beneficiaries of the wars that have ravaged their nation since the US invaded in 2003. "