Total non-financial debt had risen substantially over the last 15 years. Public finances are not yet under control. Debt is excessive and poses a serious risk in a number of countries.
What are the main risks? First, there is a risk of debt deflation – a situation in which the attempt to repay debt reduces demand further and so is self-defeating. Second, high and rising debt levels risk triggering loss of market confidence in borrowers’ capacity to service debt. Access to market finance can be threatened. Recent history demonstrates that long periods of complacency are often followed by episodes of “market tantrums”. Low yields on sovereign debt do not imply that the market is “begging” governments to borrow more. Thirdly, high debt levels can hamper the use of monetary policy – they make it hard to raise rates without damaging the economy.
So we are in a debt trap. Yet we have great difficulties in escaping. Why? The reason is simple. We have not yet addressed the root causes.
The main cause is that, in the attempt to maintain employment levels, monetary policy has been eased aggressively to counter economic downturns – by QE and ultra low rates – but has not been tightened equivalently during booms. So household debt levels ratchet up during those booms until they reach dangerous levels.
Another cause is that fiscal policy has also been too loose, leading to rising public debt ratios.
The risks of these policies have been concealed by ultra low rates, which makes high public debt levels appear more affordable.
Of the two root causes of the global financial crisis, only the microeconomic one has been addressed, through regulatory reform (Basel III) that aims at improving banks’ capital buffers, risk management and incentives. The macroeconomic policy causes – the flaws of the debt-driven growth model and the loose policy mix that led to the crisis – have yet to be addressed. How do we get out of this unsustainable debt-driven growth model?
Central bankers are scared of deflation. That is why they maintain near zero rates despite the fact that they encourage the build up of more debt. Yet is this fear of deflation rational? The recent decline in inflation is largely explained by falling commodity prices, which are known to be volatile. Underlying inflation has been quite stable. Moreover, there is no sign that the public or the markets expect deflation. There would be great dangers in transforming “inflation targeting” into “targeting more inflation”.
At the same time, continuation of ultra low rates may undermine public confidence in central banks and thus their independence. This is because the effects may increasingly be perceived to be unfair. In the United Kingdom, for example, the old have benefited from the housing booms more than the young. The housing boom before the crisis was accompanied by larger increases in net wealth among older age groups. Ownership rates have also increased for older groups and decreased for younger ones. And the age at which a young household can purchase a house has increased significantly.
In other words, there is a risk of a perception in the public that unconventional monetary policies could increase inequality by boosting asset prices. True, we do not know enough on the complex distributional effects of such policies to be certain of this. Economists are looking into this issue currently. That said, however, it is clear that the public’s willingness to persist in the patient effort needed over the medium to long-term to achieve the re-absorption of the debt overhang will importantly depend on governments’ ability to address the problem of rising inequality in advanced economies.
The case for keeping interest rates so low relies on two conditions. The first is that the potential costs of deflation outweigh the negative side effects of further monetary easing. The second is that monetary policy is still effective in boosting demand. Both are questionable.
On the first point, in today’s circumstances, it seems that the most plausible worst-case scenario is one of mild deflation – similar to what was experienced in Japan. In this scenario the costs of deflation and the costs of slipping into it are not necessarily as high as many commentators seem to think. There is no risk of a collapse of prices as in the Great depression of the 1930s.
On the second point, current monetary policies may not be effective in boosting demand. Businesses and households respond not by increasing investment or consumption but by building up cash and/or repaying debt. They would rather wait until they observe a recovery that is likely to prove sustainable. In these circumstances, policymakers should focus on policies to speed up the repair of bank balance sheets, improve credit allocation, pursue credible fiscal consolidation plans and ensure that overdue structural reforms are finally implemented. That will assure businesses and households that any new growth will not be brought to a shuddering stop.
There is a great danger that, if governments’ efforts to consolidate their finances were to falter, under repeated calls for an end to “austerity”, central banks would come under increasing pressure to keep interest rates at the current near-zero levels. Yet further delay in normalising monetary policy would carry many risks. It would encourage households, corporations and governments to take on even more debt. It might also push investors to take on excessive financial risk. And it could damage the supply side of the economy by worsening credit misallocation and allowing policymakers to postpone essential reforms.
In short, the cost of keeping interest rates at unprecedentedly low levels probably outweighs any potential benefit.
Central banks and the global debt overhang, Speech by Hervé Hannoun, Deputy General Manager, BIS, 50th SEACEN Governors’ Conference Port Moresby, 20 November 2014
Why we remain in the debt trap
Hervé Hannoun gave an important speech last week (see link below). This is my own paraphrase of it.
Total non-financial debt had risen substantially over the last 15 years. Public finances are not yet under control. Debt is excessive and poses a serious risk in a number of countries.
What are the main risks? First, there is a risk of debt deflation – a situation in which the attempt to repay debt reduces demand further and so is self-defeating. Second, high and rising debt levels risk triggering loss of market confidence in borrowers’ capacity to service debt. Access to market finance can be threatened. Recent history demonstrates that long periods of complacency are often followed by episodes of “market tantrums”. Low yields on sovereign debt do not imply that the market is “begging” governments to borrow more. Thirdly, high debt levels can hamper the use of monetary policy – they make it hard to raise rates without damaging the economy.
So we are in a debt trap. Yet we have great difficulties in escaping. Why? The reason is simple. We have not yet addressed the root causes.
The main cause is that, in the attempt to maintain employment levels, monetary policy has been eased aggressively to counter economic downturns – by QE and ultra low rates – but has not been tightened equivalently during booms. So household debt levels ratchet up during those booms until they reach dangerous levels.
Another cause is that fiscal policy has also been too loose, leading to rising public debt ratios.
The risks of these policies have been concealed by ultra low rates, which makes high public debt levels appear more affordable.
Of the two root causes of the global financial crisis, only the microeconomic one has been addressed, through regulatory reform (Basel III) that aims at improving banks’ capital buffers, risk management and incentives. The macroeconomic policy causes – the flaws of the debt-driven growth model and the loose policy mix that led to the crisis – have yet to be addressed. How do we get out of this unsustainable debt-driven growth model?
Central bankers are scared of deflation. That is why they maintain near zero rates despite the fact that they encourage the build up of more debt. Yet is this fear of deflation rational? The recent decline in inflation is largely explained by falling commodity prices, which are known to be volatile. Underlying inflation has been quite stable. Moreover, there is no sign that the public or the markets expect deflation. There would be great dangers in transforming “inflation targeting” into “targeting more inflation”.
At the same time, continuation of ultra low rates may undermine public confidence in central banks and thus their independence. This is because the effects may increasingly be perceived to be unfair. In the United Kingdom, for example, the old have benefited from the housing booms more than the young. The housing boom before the crisis was accompanied by larger increases in net wealth among older age groups. Ownership rates have also increased for older groups and decreased for younger ones. And the age at which a young household can purchase a house has increased significantly.
In other words, there is a risk of a perception in the public that unconventional monetary policies could increase inequality by boosting asset prices. True, we do not know enough on the complex distributional effects of such policies to be certain of this. Economists are looking into this issue currently. That said, however, it is clear that the public’s willingness to persist in the patient effort needed over the medium to long-term to achieve the re-absorption of the debt overhang will importantly depend on governments’ ability to address the problem of rising inequality in advanced economies.
The case for keeping interest rates so low relies on two conditions. The first is that the potential costs of deflation outweigh the negative side effects of further monetary easing. The second is that monetary policy is still effective in boosting demand. Both are questionable.
On the first point, in today’s circumstances, it seems that the most plausible worst-case scenario is one of mild deflation – similar to what was experienced in Japan. In this scenario the costs of deflation and the costs of slipping into it are not necessarily as high as many commentators seem to think. There is no risk of a collapse of prices as in the Great depression of the 1930s.
On the second point, current monetary policies may not be effective in boosting demand. Businesses and households respond not by increasing investment or consumption but by building up cash and/or repaying debt. They would rather wait until they observe a recovery that is likely to prove sustainable. In these circumstances, policymakers should focus on policies to speed up the repair of bank balance sheets, improve credit allocation, pursue credible fiscal consolidation plans and ensure that overdue structural reforms are finally implemented. That will assure businesses and households that any new growth will not be brought to a shuddering stop.
There is a great danger that, if governments’ efforts to consolidate their finances were to falter, under repeated calls for an end to “austerity”, central banks would come under increasing pressure to keep interest rates at the current near-zero levels. Yet further delay in normalising monetary policy would carry many risks. It would encourage households, corporations and governments to take on even more debt. It might also push investors to take on excessive financial risk. And it could damage the supply side of the economy by worsening credit misallocation and allowing policymakers to postpone essential reforms.
In short, the cost of keeping interest rates at unprecedentedly low levels probably outweighs any potential benefit.
Central banks and the global debt overhang, Speech by Hervé Hannoun, Deputy General Manager, BIS, 50th SEACEN Governors’ Conference Port Moresby, 20 November 2014
Written on November 21, 2014 at 10:40 pm, by robert
Categories: Homepage, News and Comment, RP's Diary | Tags: BIS, debt trap, Herve Hannoun