Saturday, January 24, 2009

America's Problem Isn't Liquidity - It's Insolvency

America's problem isn't finding a way to free up credit. It isn't the federal government's debt. The problem is that the country, and especially the private sector, is hopelessly debt-bound. The country is insolvent, it's broke, it's bankrupt.

Ed Kemp writing in Reuters makes a compelling argument that America's efforts to rescue the country through trillions of dollars of bailouts and stimulus spending can't work because those measures don't shrink what's squeezing the life out of America, the mountain of debt weighing down on its chest.

The United States and the United Kingdom stand on the brink of the largest debt crisis in history.

While both governments experiment with quantitative easing, bad banks to absorb non-performing loans, and state guarantees to restart bank lending, the only real way out is some combination of widespread corporate default, debt write-downs and inflation to reduce the burden of debt to more manageable levels. Everything else is window-dressing.

Kemp notes that America's fiscal house began falling apart around 1970. From 1975 to 2997, total US output, gross domestic product or GDP, has increased just under eight fold. In that same interval, however, rose 20 fold, two and a half times faster than the growth in GDP. In the result, total debt, public and private sector, soared from 155% of GDP to the astonishing 355% where it stands today.

...the real debt explosion has come from the private sector. Private debt outstanding has risen an enormous 22 times, three times faster than the economy as a whole, and fast enough to take the ratio of private debt to GDP from 117 percent to 303 percent in a little over thirty years.

For the most part, policymakers have been comfortable with rising private debt levels. Officials have cited a wide range of reasons why the economy can safely operate with much higher levels of debt than before, including improvements in macroeconomic management that have muted the business cycle and led to lower inflation and interest rates. But there is a suspicion that tolerance for private rather than public sector debt simply reflected an ideological preference.

...By 2000-2007, total debt was rising almost twice as fast as output, with the rapid issuance all coming from the private sector, as well as state and local governments.

This created a dangerous interdependence between GDP growth (which could only be sustained by massive borrowing and rapid increases in the volume of debt) and the debt stock (which could only be serviced if the economy continued its swift and uninterrupted expansion).

...the necessary condition for resolving the debt crisis is a reduction in the outstanding volume of debt, an increase in nominal GDP, or some combination of the two, to reduce the debt-to-GDP ratio to a more sustainable level.

...having governments buy distressed assets from the banks, or provide loan guarantees, is not an effective solution. It does not reduce the volume of debt, or force recognition of losses. It merely re-denominates private sector obligations to be met by households and firms as public ones to be met by the taxpayer.

This type of debt swap would make sense if the problem was liquidity rather than solvency. But in current circumstances, taxpayers are being asked to shoulder some or all of the cost of defaults, rather than provide a temporarily liquidity bridge.

Avoiding Depression

Trying to cut debt by reducing consumption and investment, lowering wages, boosting saving and paying down debt out of current income is unlikely to be effective either. The resulting retrenchment would lead to sharp falls in both real output and the price level, depressing nominal GDP. Government retrenchment simply intensified the depression during the early 1930s. Private sector retrenchment and wage cuts will do the same in the 2000s.

Shrinking the Real Beast

The solution must be some combination of policies to reduce the level of debt or raise nominal GDP. The simplest way to reduce debt is through bankruptcy, in which some or all of debts are deemed unrecoverable and are simply extinguished, ceasing to exist.

But widespread bankruptcies are probably socially and politically unacceptable. The alternative is some mechanism for refinancing debt on terms which are more favorable to borrowers (replacing short term debt at higher rates with longer-dated paper at lower ones).
The final option is to raise nominal GDP so it becomes easier to finance debt payments from augmented cashflow. But counter-cyclical policies to sustain GDP will not be enough. Governments in both the United States and the United Kingdom need to raise nominal GDP and debt-service capacity, not simply sustain it.

There is not much government can do to accelerate the real rate of growth. The remaining option is to tolerate, even encourage, a faster rate of inflation to improve debt-service capacity. Even more than debt nationalization, inflation is the ultimate way to spread the costs of debt workout across the widest possible section of the population.

Could Kemp possibly have this right? Are the governments, especially the American and British administrations, simply squandering trillions of dollars in bailouts and stimulus spending?

If Kemp is right, America has a near lethal addiction to debt, one that its foreign lenders have been willing to keep supplied. One flaw in his thinking is that he's looking at solutions to clean up the mess that's accumulated since the Nixon days. What he doesn't address is what an America, freed of debt addiction, would look like. How is America to function, how are its people to live, if they have to operate on a reality budget, if they have to live within their means?

Suddenly Stevie Harper's grand vision of America the Beautiful doesn't look nearly as grand any longer.

No comments: