FT writers published several articles about debt over the past few days. Not surprising for a week in which the Treasury announced "plans to boost U.S. borrowing from April through June by an unprecedented $3 trillion".
Articles include
- Monday: Robin Wigglesworth's A solution to the looming debt crisis in emerging markets
- Tuesday: Martin Wolf's How to escape the trap of excessive debt
- Wednesday: Robert Armstrong's Companies are dangerously drunk on debt
- Thursday: Martin Sandbu's Rebuilding better after Covid-19, part 2
- Friday: Robert Armstrong's Debt relief for US consumers leaves investors flying blind
How to escape the trap of excessive debt
"Debt creates fragility. The question is how to escape from the trap. To answer it, we need to analyse why today's global economy has become so debt-dependent. That did not happen because of the idle whims of central bankers, as many suppose. It happened because of an excessive desire to save relative to investment opportunities. This has suppressed real interest rates and made demand far too reliant on debt."Princeton's Atif Mian, Chicago's Amir Sufi, and Harvard's Ludwig Straub (MSS) have two recent papers on this topic: The Saving Glut of the Rich and the Rise in Household Debt, which shows that the saving glut of the rich has been financing government deficits and the household debt of the non-rich, and Indebted Demand, which uses a two-agent OLG model to explain how debt overhangs weaken demand and lower interest rates in a feedback loop.
The rich save, the less rich dis-save
"Beyond a point, inequality weakens an economy by driving policymakers into a ruinous choice between high unemployment or ever-rising debt. Rising inequality in the US has resulted in a large increase in the savings of the top 1 percent of the income distribution, not matched by a rise in investment. The investment rate has been falling despite declining real interest rates. The savings surplus of the rich has been matched by consumption above income ("dissaving") of the bottom 90 percent.
"The savings of the rich might have led to a current account surplus, as in late 19th century UK [where net foreign assets reached 191 percent of national income in 1914 -- Piketty C&I p. 278]. But the rich of the rest of the world have sought to accumulate US assets [since the wealthy "cannot bank their money in the retail banking system", as Feygin and Leusder explain] , and so generated a persistent US current account deficit. Except when the pre-financial crisis housing bubble drove up private investment, this has also remained too weak. The chief users of excess foreign and domestic savings have been less well-off households and the government."
"There is a clear link between the saving of the rich and dissaving of the less rich, and the accumulation of credit and debt." The rich hold claims on the less rich not only via bank deposits but also through equity holdings in businesses that hold such claims. "This phenomenon of rising household debt and rising inequality is not unique to the US."
Why does the rising debt matter?
Wolf proposes three explanations for why the rising debt matters. First, David Levy argues that as borrowers become more overburdened, the economy becomes increasingly driven by finance and fragile. Second, MSS introduce the idea of "indebted demand": large household and government debt burdens lower aggregate demand and thus natural rates because borrowers and savers differ in their marginal propensities to save out of permanent income [a theory developed by Milton Friedman]. "When demand is sufficiently indebted, the economy gets stuck in a debt-driven liquidity trap, or debt trap." Third (similar to indebted demand) is Richard Koo's balance sheet recessions in which a debt-financed bubble bursts, and businesses and households realize that the value of assets they bought with borrowed funds have collapsed, while their liabilities are still on the books, so they have no choice but to pay down debt as quickly as possible. While this is the right thing for an individuals to do, we fall into a fallacy of composition [because if one person is saving or paying down debt, someone else must be borrowing and and spending the same amount for the economy to move forward].
Ultimately, "As debt soars, people are ever more unwilling to borrow still larger amounts. So interest rates have to fall, to balance supply with demand and avoid a deep slump." This is one mechanism driving what Lawrence Summers [borrowing from Alvin Hansen] has called"secular stagnation".
Wolf mentions that "We must focus on the US first, because that is where global demand and supply tend to balance." But he notes that rising inequality and savings are evident elsewhere such as China, which used to export excess savings to the US but now absorbs it in domestic investment, and Germany, which has driven its eurozone (and other) trading partners into rising debt.
How do we escape from the debt trap?
There are some short-term solutions: (1) diminish the incentive to finance businesses with debt rather than equity by eliminating the tax preference of debt, (2) shift from debt to equity financing of housing (suggested by Mian and Sufi), and (3) replace government lending to companies with equity purchases.
"Yet none of this would fix the ongoing dependence of macroeconomic stability on ever more debt. There are two apparent solutions." First, government can keep on borrowing, but this is likely to eventually be problematic. Alternatively, "shift the distribution of income, in order to create more sustainable demand and so stronger investment, without soaring household debt."
In the last paragraph Wolf quotes Marriner Eccles' 1933 Congressional testimony in making the case for reduced inequality: "It is for the interests of the well to do ... that we should take from them a sufficient amount of their surplus to enable consumers to consume and business to operate at a profit."
Notes from other articles
Wigglesworth on emerging markets
For emerging markets facing a looming debt crisis, there's a proposal that the World Bank set up a "central credit facility", which would be topped up with money from the World Bank or IMF, who would then lend the money and debt payments directly "back to the countries at concessional rates." There are indications that the World Bank and IMF might be open to these types of solutions -- IMF managing director Kristalina Georgieva said the fund "may need to venture even further outside our comfort zone."
Armstrong on corporate debt
US non-financial corporate debt was $10 trillion at the start of the crisis -- a record high at 47% of GDP. Since debt is cheap and tax deductible, using more boosts earnings. The government is helping, with the Fed announcing purchases of $750 billion in corporate debt and $600 billion in lending to midsized companies through its Main Street Lending Program. Moral hazard is obvious [especially considering Ruchir Sharma's estimate that 16% of companies are "zombies"]. You can't contain corporate debt by regulating banks because then that risk-taking shifts to the shadow banking sector -- more promising to end the tax deductibility of interest.
Solving these problems won't be easy:
"The main reason debt is cheap is not central bank policy but low growth. As the world ages and productivity slows, there are more savings and less demand for investment. Savers can charge less for lending their money."
Sandbu on rebuilding
Sandbu summarizes Wolf's concern about inequality driving debt resulting secular stagnation -- perenially inadequate demand resulting in weak growth. But he points out that 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."
He also points out that because of falling interest rates, debt burdens (service costs as a ratio to disposable income) are at their lowest level since 1980, although that doesn't take away from the point that large debt balances create fragility, since "a smaller proportionate change in economic prospects suffices to cause cascading insolvencies, with all their legal and economic repercussions" such as a debt deflation, a debt overhang, and lower mobility of workers and capital.
Chart: Level of consumer credit and mortgage debt, and debt service payments
https://fred.stlouisfed.org/graph/?g=qUuX
Sandbu suggests making financing (including the financing governments are now directing at companies) more equity-like due to the problems inherent to debt financing:
"That is the great paradox of debt finance: individuals choose it for its predictability, but collectively it makes for greater instability."
Armstrong on consumer debt
There was $14.3 trillion consumer debt on the eve of this crisis, according to the NY Fed's quarterly Household Debt and Credit Report. As Sandbu pointed out as well, the debt burden (~10 percent of disposable income) was historically low at the start of the crisis, but auto loan and credit card delinquencies had been ticking steadily up for a couple of years.
Visa reported credit card spending down 30 percent in April. Unsecured consumer loans 8 percent lower than six weeks ago, erasing two years of growth. 6% of mortgages held at banks are in forbearance (source: Autonomous Research) [but I think 70% of mortgages are backed by GSEs and maybe not covered by this stat? GSE's are slightly higher, Ginnie Mae, the highest, is already over 10%]
Final notes
https://www.bloomberg.com/news/articles/2020-05-03/treasury-s-4-trillion-funding-task-signals-record-auction-slate?sref=FayydLbB.
Merryn Somerset Webb's article from last week on converting government loans to equity, and the Reconstruction Finance Corporation, deserves its own post: https://www.ft.com/content/1eaec3b2-8b90-11ea-a01c-a28a3e3fbd33.
As companies try to shore up balance sheets, Carnival and Southwest made April the highest month of convertible bond issuance ($13 billion) in a dozen years https://www.ft.com/content/15dc5dcd-89a4-4047-9a56-24b808e2dcf5.
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