A Foray into the Fundamentals of Austerity in Anticipation of the Outcome.

A recent IMF report pointed out some supposed vast amounts of room available for the world’s economies to step up government borrowing to finance consumption, investment and production decisions.   Oddly the report appeared to ignore other forms of debt and material deterioration in key areas of the economic frame.  

When the crisis broke back in 2007 it was clear to me that monetary and fiscal policy would likely need to go for broke to support economic growth and employment at a time of collapsing asset values, debt defaults and a world wide retrenchment in expenditure of all kinds.   As it happened a great deal of that support went into asset prices and financial institutions.

But some years after the crisis, after a slow and drawn out recovery with interest rates locked to the floor, economies still appear to be borderline reliant on debt financed government expenditure.  Any attempt to reduce borrowing, to either raise taxes or cut expenditure to pay back debt would be considered by many to have an adversely negative impact on economic growth, especially at such low growth rates. 

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The Geneva report and my points on the debt/asset value/IR chokehold

Many of the points I made in my choke point blog are also reflected in the latest Geneva report, Deleveraging? What Deleveraging?

One thing I would like to touch on before I highlight excerpts from that text is that high levels of debt and misallocations of capital may well be a feature of many a boom, but what makes the current situation much different is the fact that interest rates lie on a lower bound, almost incapacitated by a higher bound debt level, itself tied to highly valued asset markets.   High debt levels and weak growth dynamics are dangerous, irrespective of whether you are undecided as to whether high debt led to growth or low growth to high levels of debt, although I tend to believe that the reality is that weakening developed economy growth dynamics accompanied the debt build up prior to the onset of the crisis.  Beyond that point in time, high debt levels I would say are clearly impacting growth.

Whereas all significant debt misallocations have an impact on subsequent bank lending and new credit growth (the stock of broad MS is tied to these low or non performing loans), not all such instances have occurred at such low interest rate levels.  I think this is key, critical and as the Geneva report suggests “poisonous” intersect, although the report itself strays from emphasising what I consider to be the greater risk of high debt levels at low IRs..

Another point that I have laboured is the present value of future output growth or national income relative to debt is out of balance and this is the first time I have seen explicit reference to this in any other document I have read.

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Is the balance sheet recession over? Financial sector debt…

Financial sector debt (and as noted consumer debt) has fallen significantly since the crisis:

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Yet, if we look at the financial sector assets with respect to non financial sector credit market debt, we start to see an interesting picture:

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The Reinhart and Rogoff debate: does debt matter?

Debt accumulation needs to be related to prospective economic growth and where the NPV of future returns (growth) is less than the present value of the debt and equity, the difference will be adjusted for in GDP growth until the two are in parity.

I would have to say that overall debt must matter and that much recent press commentary has got its hands on the wrong stick.   But how much debt matters depends on a number of dynamics.

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As it came to pieces in my hands…

Paul Weller: “I stood as tall as a mountain; I never really thought about the drop; I trod over rocks to get there; Just so I could stand on top; Clumsy and blind I stumbled;…I didn’t stop to think about the consequences; As it came to pieces in my hands.”

The 2008 crisis told us that there was a mismatch between asset values and debt, asset values and future return, and debt and economic growth as well as some rather large structural economic imbalances.

We have tried to delay the eventuality implied by the difference in the hope that the “true” magical economic growth rate should return. Have we built up a bigger monster, and if so, how do we slay the beast?

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We have two adjustment phases likely to impact growth: a debt and a structural economic adjustment…

A country heavily in debt will depend on a) future human capital earnings and b) returns on invested productive capital to reduce debt and increase GDP.  

Weak prospective returns on capital invested and low expected returns on human capital increase the risks of default where the present value of the debt exceeds the present value of future returns on capital. 

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