Estratto dell'intervento di Trichet dello scorso venerdì.....
Options for reducing the debt overhang
Several ways of dealing with the legacy of excesses and imbalances accumulated over previous decades have been tried in the past. Let me discuss them in turn to assess whether they are viable options now.
You will not be surprised to know that I exclude any kind of debt repudiation in the industrialized countries from these options.
1. Inflation?
A recurrent suggestion for solving a debt overhang is the creation of surprise inflation. Again, let me clearly dismiss this type of action. The history of the debasement of money through hyperinflation has been disastrous everywhere. Even before reaching extremely high levels,
surprise inflation produces an arbitrary redistribution of wealth and creates a burden for the unprepared, especially the weakest.
In addition,
surprise inflation would destroy the hard-won credibility of central banks worldwide. After a short period, the loss of credibility, and increased inflation uncertainty would lead to a world with higher volatility, higher risk premia and higher nominal and real interest rates. We would be left with no alleviation of outstanding debt, and ultimately with lower growth as we witnessed during the Great Inflation of the 1970s. The now classic work on time inconsistency clearly points to the permanent and substantial costs of the loss of credibility once inflation and inflation expectations cease to be anchored.
2. Living with the debt?
What about the option of “living with the debt”?
Some have suggested to ignore existing financial imbalances “for the time being” and focus only on the short term. Rather than pressing on with the deleveraging process, more spending could be encouraged to sustain growth in the short term.
I believe that adopting this view would be very dangerous for our economies. There is a very clear example of the consequences of choosing to live with the debt: Japan in the 1990s. The “lost decade” in that country was the result of allowing the banking system to remain fragile over many years.
Banks appear to have contributed to economic weakness by rolling over the bad debts of inefficient firms. [
5] Banks’ inadequate capitalisation implied that they were unwilling to take losses. Low productivity growth in those inefficient firms and the locking in of capital and labour put a drag on potential output. [
6] Only a healthy financial system is able to provide funding for good projects that spur productivity and innovation. [
7]
The lesson from past history is that dealing with the legacy of accumulated imbalances is not simply a duty to be fulfilled after the economic recovery, but rather an important precondition for sustaining a durable recovery. The primary macroeconomic challenge for the next 10 years is to ensure that they do not turn into another “lost decade”.
This lesson is consistent with economic theory and evidence. Since the time of Irving Fisher, economists have explored the impact of a legacy of indebtedness for growth. In various ways, these analyses suggest that an excessive debt burden – whether emanating from the corporate, household or public sector – constitute a drag on spending, thereby dampening growth.
For firms, for example, high indebtedness reduces their net worth and the ability to borrow for new projects. Consequently, firms will postpone investments until they are able to restore sound balance sheets. Similarly, households’ precautionary saving could remain high until their wealth-to-income ratios return to more normal levels, following the collapse in asset values at the peak of the crisis. [
8]
Economic growth can also be threatened by high public indebtedness, which, without a credible fiscal retrenchment plan, can generate substantial uncertainty. Firms and households know that ultimately they will have to bear the consequences of the painful measures needed to reduce debt. As long as it is unclear when the adjustment will occur and who will bear what fraction of the costs of adjustment, firms and households may delay their investment and consumption decisions, slowing down the economic recovery. In the data, evidence points to the existence of a negative association between the level of public debt and subsequent GDP growth, which is particularly marked at high debt levels. [
9]
Finally, the debt overhang can make it attractive for governments to adopt regulatory measures that compel the financial and/or household sectors to hold government debt at low or even negative real interest rates – measures referred to as “financial repression”. Forced investment in government bonds distorts the role of the financial system in channelling resources to the most efficient firms and slows down economic growth. While the effects of financial repression on growth are particularly severe, these effects may also occur through excessive financial regulation. [
10]
So the option of
‘living with the debt’ indefinitely is not a solution to the challenges currently facing policy-makers, nor is it a means to ensure sustainable economic recovery. We must focus on policies to address the debt overhang.
3. Growing out of the debt
The most appealing solution to the debt overhang is clearly to achieve strong economic growth.
Strong growth produces higher income and wealth, thus increasing the net worth of households and firms and reducing their leverage. Robust economic growth also boosts government revenues and reduces expenditure, especially when large automatic stabilizers are in place, thus leading to a rapid reduction of the government debt-to-GDP ratio.
A spectacular example of the effect of growth on public finances is provided by the UK, which managed to reduce the government’s debt-to-GDP ratio from close to 240% at the end of the Second World War to 60% in the early 1970s. How did this turnaround come about?
- First, real interest rates on government debt were kept relatively low. This reflected an environment of “financial repression” – including severe restrictions on the activities of financial institutions combined with controls on international capital movements.
- Second, economic growth was relatively strong during this period (averaging 2.4% a year), reflecting both increased productivity and labour force growth.
- Third, fiscal policy was overall disciplined and, indeed, in a number of years, fiscal surpluses were recorded. [11]
Of course, such processes may well be linked and reinforce one another. For example, fiscal discipline may yield additional benefits due to favourable confidence effects on interest rates and growth.
Although the UK’s post-war experience is encouraging, it should not lead us to be too sanguine about future prospects for the advanced economies. First, a return to an environment of financial repression is neither desirable nor feasible. It would represent a reversal of the trend in policy over the last 40 years towards freer capital markets.
Second, we should probably not expect the real growth rates in the developed world to go back to the levels of the 1950s or 1960s, an era now characterised by economic historians as a “Golden Age”. [
12] That being said, one should never underestimate the room for higher growth potential through resolute structural reforms, particularly in Europe, which is still marked by numerous rigidities. And given that population growth rates will differ significantly among economies in the decade ahead, we have to focus more on per-capita growth rates in our international comparisons.
ECB: Central banking in uncertain times: conviction and responsibility
