Economics
Debt

Michael Spence on Managing Debt in an Overleveraged World

Burgess COMMENTARY

Peter Burgess

Managing Debt in an Overleveraged World

MILAN – What ever happened to deleveraging? In the years since the 2008 global financial crisis, austerity and balance-sheet repair have been the watchwords of the global economy. And yet today, more than ever, debt is fueling concern about growth prospects worldwide.

The McKinsey Global Institute, in a study of post-crisis debt trends, notes that gross debt has increased about $60 trillion – or 75% of global GDP – since 2008. China’s debt, for example, has increased fourfold since 2007, and its debt-to-GDP ratio is some 282% – higher than in many other major economies, including the United States.

A global economy that is levering up, while unable to generate enough aggregate demand to achieve potential growth, is on a risky path. But to assess how risky, several factors must be considered.

First, one must consider the composition of the debt across sectors (household, government, non-financial corporate, and the financial sector). After all, distress in these sectors has very different effects on the broader economy.

As it turns out, economies with similar and relatively high levels of gross debt relative to GDP exhibit sharp differences when it comes to the composition of the debt. Excessive household debt is particularly risky, because a shock in the price of assets (especially real estate) translates quickly into reduced consumption, as it weakens growth, employment, and investment. Recovery from such a shock is a long process.

The second factor to consider is nominal growth – that is, real growth plus inflation. Today, real growth is subdued and may even be slowing, while inflation is below target in most places, with some economies even facing the risk of deflation. Because debt is a liability for borrowers and an asset for creditors, these trends have divergent effects, increasing value for the asset holder, while increasing the liability of the debtor. The problem is that, in a low-growth environment, the probability of some form of default rises considerably. In that case, nobody wins.

The third key factor for assessing the risk of growing debt is monetary policy and interest rates. Though no one knows exactly what a “normal” interest-rate environment might look like in the post-crisis world, it is reasonable to assume that it will not look like it does today, when many economies are keeping rates near zero and some have even moved into negative territory.

Sovereigns with high and/or rising debt levels may find them sustainable now, given aggressively accommodative monetary policy. Unfortunately, though such accommodation cannot be sustained forever, today’s conditions are often viewed as semi-permanent, creating the illusion of stability and reducing the incentive to undertake difficult reforms that promote future growth.

The final, and arguably most important, factor shaping debt risk relates to investment. Increasing debt to sustain current consumption, whether in the household or government sector, is rightly viewed as an unsustainable element of a growth pattern. Here, China’s case is instructive.

In a sense, the frequent refrain that China’s debt is on an unsustainable path is true. After all, high levels of debt increase vulnerability to negative shocks. But, in another sense, this misses the point.

Many governments nowadays are accumulating debt in order to buttress public or private consumption. This approach, if overused, can amount to borrowing future demand; in that case, it is clearly unsustainable. But, if used as a transitional measure to help jump-start an economy or to provide a buffer from negative demand shocks, such efforts can be highly beneficial.

Moreover, in a relatively high-growth economy, ostensibly high debt levels are not necessarily a problem, as long as that debt is being used to fund investments that either yield high returns or create assets worth more than the debt. In the case of sovereign debt, the return on investment can be viewed as the increment to future growth.

The good news is that, in China, much of the accumulated leverage has indeed been used to fund investment, which in principle creates assets that will augment future growth. (Whether the results of the government’s recent decision to increase the fiscal deficit to stimulate the economy follow this long-term growth-enhancing pattern remains to be seen.)

The bad news is that directed lending and the relaxation of credit standards in China, particularly after the crisis, have led to investment in assets in real estate and heavy industry with a value well below the cost of creating them. The return on them is negative.

China’s so-called debt problem is thus not really a debt problem, but an investment problem. To address it, China must reform its investment and financial systems, so that low- or negative-return investments are screened out more reliably. That means tackling the mispricing of risk that results from the government’s backing of the country’s state-owned banks (which surely could not be allowed to fail).

Many developed countries are also failing to invest in high-return assets, but for a different reason: Their tight budgets and rising debts are preventing them from investing much at all. As this weakens growth and reduces inflation, the speed at which their sovereign-debt ratios can be reduced declines considerably.

In order to spur growth and employment, these economies must start paying closer attention to the kind of debt they accumulate. If the debt is financing growth-promoting investment, it may be a very good idea. If, however, it is financing “current operations” and raising short-term aggregate demand, it is highly risky.

Of course, the situation is not cut and dried. The return to public investment is affected by the presence or absence of complementary reforms, which vary from country to country. And there is some potential for abuse, with expenditures being misclassified as investments.

Yet, in an environment of low long-term interest rates and deficient short-term aggregate demand (which means there is little risk of crowding out the private sector), it is a mistake not to relax fiscal constraints for investment. In fact, the right kind of public investment would probably spur more private-sector investment. Identifying such investment is where today’s debt debate should be.

Michael Spence Michael Spence, a Nobel laureate in economics, is Professor of Economics at NYU’s Stern School of Business, Distinguished Visiting Fellow at the Council on Foreign Relations, Senior Fellow at the Hoover Institution at Stanford University, Academic Board Chairman of the Asia Global Institute in Hong Kong, and Chair of the World Economic Forum Global Agenda Council on New Growth Models. He was the chairman of the independent Commission on Growth and Development, an international body that from 2006-2010 analyzed opportunities for global economic growth, and is the author of The Next Convergence – The Future of Economic Growth in a Multispeed World.

Comment

eusebio manuel MAY 1, 2016 Do not get we wrong global economic labor market is still far to adapt to reality and time will tell who is right Reply Comment

Frans Verhagen MAY 1, 2016 Why not start a major national and international discussion of money creation and the feasibility of credit-based rather than the present debt-based system. Prompted by www.positivemoney.org and www.onsgeld.nu the UK and Dutch governments have started to consider the issue of money creation. A next step is to graduate to an expanded SDR replacing the U.S. dollar as the world’s transactional currency which is to be followed by carbon-based international monetary systems as proposed by www.global4c.org and www.timun.net. The latter system is based upon the monetary standard of a specific tonnage of CO2e per person and a balance of payments system that includes both financial and ecological (climate) accounts. Its conceptual, institutional, ethical and strategic dimensions are presented in Verhagen 2012 'The Tierra Solution: Resolving the climate crisis through monetary transformation'. READ LESS Reply Comment

Per Kurowski MAY 1, 2016

Spencer writes about mispricing of risk:

Perceived credit risk is perceived credit risk. So when bank regulators introduced risk weighted capital requirements, assigning risk weights of 0% for sovereigns, 20% for AAArisktocracy, 35% for residential housing finance, 100% for citizens, SMEs and entrepreneurs; and 150% for those rated below BB-, those that clearly pose the least danger to the banks since banks won’t touch them… then they imposed on our financial markets the mother of all mispricing of risks, which distorted the allocation of credit to the real economy.

And the world kept mum on it! http://bit.ly/1TgB6EJ READ LESS Reply Comment

Jose araujo APR 29, 2016 @Steve

I'm not discussing the effect, 2 % has an impact on deand for sure, what I'm discussing is THE CAUSE, the genesys of the problem, wich many (the austrians and others) attribute to the debt levels.

Now IMHO debt levels were not the problem, market manuipulation and Fraud (the sub-prime crisis) were the trigger, after that all things came tumbling down, expectations, risk aversion, demand contraction and income contraction and then finnaly the defaults.

I don't believe there was a market bubble in real estate, sub-prime was a low market scheme. I also don't believe real estate gains are transmitted to consumption of tradable goods. When house prices go-up we don’t sell our houses and consume. We probably are worst off, since moving up to a better house is going to cost us more.

I believe there is a large insentive for bank management to miss behave, namelly on the Investment Banking part, not the comercial part. READ LESS Reply Comment

Jose araujo APR 28, 2016

My point of view is very simple. Did we stopped consuming and investing because our income levels diminished and companies stopped selling or did we stopped consuming and investing because we had too much debt?

Paid interests accounts for less the 2% of the GDP, interest rates are at an historical low, so no the problem isn’t debt; the problem is the reduction of available income. The % of the population with maxed out cards and unsustainable debt is very low, it has always been. The problem is that we stopped making money and were not capable of meeting our loans. Do you think our problems started because people were consuming too much, or because a limited set of people were uncontrollable on their greed? The financial crisis was triggered by the Maddoffs, Lehmans and all this Fraud and Mismanagement on the part of a selected few. We are not at crisis because of the collapse of our institutions, the institutions collapsed because they were attacked. READ LESS Comment

D. V. Gendre MAY 2, 2016

Dear Jose

If we all repay our loans, banks would not be filled with money. Debt and credit are two sides of the same coin. Banks just woundn't have any liabilities anymore! Comment

Steve Hurst APR 28, 2016 @Jose

Most markets move dramatically in the face of a 2% shift in demand

Oil and Housing to name two

It follows that you do not need much to collapse a market

The institutions where not attacked, they selfharmed thru market manipulation. In a consumer society the biggest individual debt is housing which is why the market was pumped up, it gives immediate returns on commission. Now first time buyers are priced out, buy-to-let is being reined in for fear of vulnerbility if interest rates inch up

As for all this global overall balance stuff. Darwin looked at individual effects to define what was going on. We live in a consumer society and what the consumer does dictates outcomes. Very simply we are running out of consumers. That is why China looked to develope its domestic consumer base. They in turn will run out of consumers

In terms of global debt the question remains - what quotient is orientated to propping up lifestyle. The answer has to be a function of every developed economy running a deficit

The West buys from China et al, China buys from Emerging Economies et al. The West runs out of cash, China runs to a walk, Emerging Econs go from a walk to a crawl. The Emerging Economies cannot invest in infrastructure because they are crawling. The money pump is consumers in the West and they are cashed out

Its not rocket science

All efforts are focused on trying to build banks bottom lines and capital ratios. They need ZIRP for that but ZIRP damages retail banking profit so they are contracting. When the banks have made the transition then ZIRP will lifted and inflation return and interest rates track it and so called growth will return READ LESS Comment

Jose araujo APR 28, 2016

Just think what would happen if we all by miracle started repaying our loans. Banks would be filled with money that would add to the mountains of unused money they already have…

Talking about leverage problems on a low interest rate, no investment opportunity environment makes no sense. If there are no opportunities for investment bad loans are not crowding out good loans, there is no alternative use for the money. READ LESS Reply Comment

John Brian Shannon APR 27, 2016

Hi Jose,

'we haven’t seen any major correction in the prices...'

Yes, that's exactly what many said just before the 2007/08 subprime mortgage collapse.

And what many said just before every other economic disaster.

And what many said just before the Titanic sank.

Something to think about.

Cheers, JBS READ LESS Comment

Jose araujo APR 28, 2016 @John

I'm convinced that the theory of the real estate bubble is a convenient explanation derived from the Austrian school of thought, more than reality. This narrative is demagogic at its core and appeals at our Christian Jewish sin/punishment morals and grounding, problem is that although appealing it is not verifiable by evidence.

First evidence points to the fact that defaults on private/individual debt comes more from the loss of income and not because of bad loans in the first place. Second, the level of private/individual debt in default is still low and a small part of the equation. So the narrative that tries to explain the financial crisis because of the excesses and orgies we made due to cheap credit, isn’t verifiable by evidence, first because there wasn’t such an orgy, second because during the period before the crisis, credit wasn’t cheap.

Yes something didn’t work during the financial crisis period, but IMHO it wasn’t your regular lending mechanism. We just have to check what is happening on the banking bankruptcies, the problem isn’t the commercial portfolio, most of the problems lie on the IB portfolio and the excesses made by management.

Off course redoing the narrative would take a lot of work, so instead of placing the focus on miss-management and fraud committed at the higher levels of organizations, we put the blame on the real-estate markets and the asset bubbles.

By the way, I feel that the same thing is being done regarding the emergent economies. Instead of addressing the problem of the loans made to the Russians, Emirates, Brazilians, Chinese that were most of the times a piece on the money laundry scheme where deposits were made in the offshores in the name of the oligarchs and credit was conceded to the companies on the country of origin, we are now blaming the commodity bust for the non-performing loans… READ LESS Reply Comment

Jose araujo APR 27, 2016

Is there any economic model that accounts for debt, or are we all just shooting from the hip?

I don't think any model that tries to explain flows (GDP) accounts for stock (Debt), also in a macro level Debt is irrelevant, since someone's debt is another person’s credit (deposit), so the way you finance your assets is irrelevant.

Nowadays we have both an increase in debt and an increase in liquid assets, adds that being the interest rate at 0% it appears there is no shortage of available funds, so in the end Debts is irrelevant.

Just to conclude and say that this whole real estate bubble explanation is very faulty, we haven’t seen any major correction in the prices, default levels are stable and low, and IMHO most of them come from the loss of income and not the misprice of assets, adds that I don’t understand how leverage has the impact they say on an environment of low interest rates….

It just doesn’t add up READ LESS Comment

Jose araujo APR 29, 2016 @steve

I agree with you, but at this moment debt is increasing and consumption is stable. So Debt is not fueling consumption, its just increasing assets and liabilities. Comment

Steve Hurst APR 28, 2016 @Jose

Inequality means cash concentrates with those who do not spend

Alongside that - Poor returns slow investment Comment

Jose araujo APR 28, 2016 @Steve

You continue to make a basic mistake, which is not to consider all the economy but only a part of the economy. You see if some people are leveraged and stop consuming, the others which have loaned will start consuming/investing.

The problem isn't leverage, Mogdiliani and Miller stated that on the micro level. And in the macro sense, this concept is not appliable because if you see the economy has a whole, debt and equity are the same.

That is the beauty of the financial system, the ones that save don't have to be the ones that invest, but in the end savings=investments, so debt and equity are all the same. READ LESS Comment

Jose araujo APR 28, 2016 @dan

Please explain why an accounting equality is non-sense?

Even if you don't believe in the liquidity trap, please explain where is all this debt going into, because consumption isn't picking up and investment is low.

In your dreams probably the debt is being used to buy up stocks, but guess what most of the money is tied up in sovereign debt (that's why interest rates are low and yelds are flat) and liquid assets/money/reserves. READ LESS Comment

Steve Hurst APR 28, 2016 @Jose

The banks fold if too many mortgages move to the at risk ledger. That is why you have ZIRP. It is as simple as that. Why do you keep going on about one mans debt is another mans asset. The value of th asset is dicated by the market and the housing market price is dicated by servicing affordability. A 2% shift in housing demand one way or the other takes you from a freeze to a boom. Move interest rates 2% and 3% or 4% of mortgages are struggling, move more and its geometric. One mans debt is not another mans asset. It doesnt matter if the mortgage is in default or not, just tha fact it is moved to the at risk ledger READ LESS Comment

dan baur APR 27, 2016 'Debt is irrelevant, since someone's debt is another person’s credit' - Stop perpetuating this nonsense Comment

dan baur APR 27, 2016 @Jose araujo You should go live in the socialist tree top (Cuba, Venezuela, etc.) because that's your dream come true. Reply Comment

dan baur APR 27, 2016 Chasing 'aggregate demand' is a fool's game. If I pay you $1 for a handshake and you pay me $1 for the same, are we better off? Hey economic embalmers, GDP was supposed to be an indicator of the economy, and a lousy one too, not the whole purpose of the economy itself. There is no such thing as 'the right kind of public investment' except once in a million by pure dumb luck. Never by design. READ LESS Comment

Jose araujo APR 27, 2016 So you llok into the hospitals, roads, schools and you think its was just dumb luck or a bad investment.. Glad we are not all like you, if not we would still be living on the top of trees Reply Comment

Godfree Roberts APR 27, 2016 The World Bank gives the following ratios for Debt to GDP: Japan: 390% at 0% growth USA: 290% at 2% growth China: 209% at 6.9% growth China's debt fragilities are overstated. They don't threaten the model. In real life, Chinese corporate net debt is near zero, private savings are $3 trillion, foreign reserves $4 trillion. The proof is in the numbers. Not just headline growth, but stable and low inflation, strong wage growth and rising tax revenue.

Debt to GDP Chart http://www.inpraiseofchina.com/2015/09/chinas-debt-is-exaggerated.html .

External Debt List: https://en.wikipedia.org/wiki/List_of_countries_by_external_debt . READ LESS Reply Comment

edward maran APR 27, 2016

Everything in the article seems correct, but mostly unfocused. An entire paper is surely merited on how China should go about reforming its banking system. A brief analysis on how China's liquid assets affect, or don't affect, the level of risk would be welcome. I would love to see a paper on how China could productively use its liquid financial assets to help it manage the transitions from export / investment oriented to a more domestic / consumption oriented economy as well as a roadmap for banking reform in China. p.s. if I had the knowledge I would write these papers myself. READ LESS Reply Comment

Paul Daley APR 27, 2016

Spence's points -- that there's lots of debt out there, but debt can be a good thing -- is pretty well acknowledged by all. The big question is how do you ensure that debt is a good thing when central banks are busy undermining capital markets through QE initiatives that pump up asset prices and reduce even long term interest rates to near zero. That's simply a recipe for bad investment on a colossal scale.

Central banks should start by bypassing capital markets; if you need to fund government expenditure, then do it directly from within the bank by creating new deposit accounts for the government (ala Bernanke's suggestion) and placing conditions on the use of those funds to ensure they're used for public investment purposes. Put even more simply, central banks in developed countries need to take stock of what they're doing for good and for ill, and cut out the nonsense, even if that nonsense is what they've always done. READ LESS Comment

Paul Daley APR 28, 2016

Come now. You have participants in capital markets that have no budget constraint at all, who can conjure money out of thin air. What do you think they will do (in fact, have done) to those markets? The operations of central banks have reached a scale where they have to be separated from capital markets, and run through government channels, if capital markets are going to function efficiently in allocating capital Comment

edward maran APR 27, 2016

Rather than have the central bank direct investments, it would be preferable to have the private sector act more energetically. Taking actions to encourage the banking sector to make more loans would probably allocate capital more efficiently. Quantitative easing has caused a shift in private sector assets from treasury securities to bank deposits. If the increased level of bank deposits is not accompanied by increased loan activity then the impact on the real economy of QE will be minimal. Capital markets have to be better at allocating capital than central banks. READ LESS Reply Comment

Steve Hurst APR 27, 2016

Western debt looks to be dominated by lifestyle support (private and public) and overblown housing markets so is high risk as per your para5. Emerging economies have trouble funding the neccessary infrastructure development. Global debt continues to grow so the question is - what quotient of that debt is investment giving a healthy result, bearing in mind assessment has a subjective element to it. ZIRP is in place to buy time so is a transition, but a transition to what? Comment

Jose araujo APR 28, 2016 @Steve

Hoover must have had a time machine, because how are the future unborn generations going to pay to our generation for the loans?

You can see how stupid is this argument. Future generations are going to pay the debt to future generations, not to our generation. READ LESS Comment

Steve Hurst APR 28, 2016 @Jose

Debt can have a life of its own. The UK has only just cleared some debt from the Napoleonic War, as it had been rolled over repeatedly. How many meetings have there been in that process when somebody has decided the best ridiculous thing to do is to defer closing an early 19th century loan. In a somewhat shorter timeframe the UK has just cleared the US loan taken shortly after WW2 which prevented the UK going bust. So how much of this global debt will have decades of life. Certainly in Greece they currently are borrowing to pay for the servicing of existing borrowing

'Blessed are the young for they shall inherit the national debt'. Herbert Hoover, US Pres

Except he got it wrong, it should be '... the future unborn generations..' READ LESS Comment

Jose araujo APR 27, 2016

Amazing also how most of these guys although keep shouting about the debt problems, don't even acknowledge that there is a redistribution issue, after all excess debt should be symptom money is flowing to the wrong people, and that both consumers/workers and entrepreneurs are not getting their fair share.

GDP is growing (at a slow pace) and the share of interest on GDP is declining (1,2%), which is a sign that we are facing a new paradigm: Capital is not scarce anymore, so you can’t extract a rent from it, and the concept of misallocation of capital and resources is mute, because you can replace it at no cost. READ LESS