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.

And now the excerpts:

Deleveraging and slower nominal growth are in many cases interacting in a vicious loop, with the latter making the deleveraging process harder and the former exacerbating the economic slowdown. Moreover, the global capacity to take on debt has been reduced through the combination of slower expansion in real output and lower inflation.

Debt capacity in the years to come will depend on future dynamics of output growth, inflation and real interest rates. We argue that potential output growth in developed economies has been on a declining path since the 1980s and that the crisis has caused a further, permanent decline in both the level and growth rate of output.

Moreover, we observe that output growth has been slowing since 2008 also in emerging markets, most prominently China. In this context, the
equilibrium real interest rate – that is, the interest rate compatible with full employment – is also poised to stay at historical low levels and debt capacity will be under pressure
if the actual real rate settles above its equilibrium level……. This is likely to be the case in jurisdictions subject to the combined pressure of declining inflation and the zero lower bound constraint.

This feedback loop between leverage and asset prices is a primary channel
linking financial and housing markets with macroeconomic performance.

Contrary to widely held beliefs, six years on from the beginning of the financial crisis in the advanced economies, the global economy is not yet on a deleveraging path. Indeed, according to our assessment, the ratio of global total debt excluding financials over GDP (we do not have, at this stage, a reliable estimation of financial-sector debt in emerging economies) has kept increasing at an unabated pace and breaking new highs: up 38 percentage points since 2008 to 212%.

…the ongoing poisonous combination of high and rising debt documented in Chapter 2 and the slowdown in GDP growth discussed in this section is a source of concern for debt sustainability as well as for any prospect of sustained global recovery

..Credit expansion disguises, for a time, the second bend to the S. Only over time does the slowing in growth prospects become evident. On that realisation, it becomes necessary to shift the entire path of expected future income lower. At that point, the nation’s debt capacity, or the present value of all future income, is marked lower. Correspondingly, there is a scaling back of expectations about the amount of credit that is sustainable on balance sheets…

Much more bracing to economic prospects is a reduction in debt capacity to below current debt levels. The recognition of excessive optimism triggers the understanding that the nation has already over-borrowed relative to its capacity to repay. To live within the limit of this lower level of debt capacity, borrowing has to contract, representing a more  significant headwind to continued economic expansion.

In this report, we have argued that potential output growth in advanced economies has been on a declining trend for decades, accelerating after the crisis, with structural forces putting downward pressure on the natural rate of interest. In such a context, and with leverage still very high, allowing the real rate to rise above its natural level would risk killing the recovery, pushing the economy into a prolonged period of stagnation while putting at risk the already challenging deleveraging process.

Now that US home values at the national level have expanded at a double-digit pace but headwinds still seem evident, a more direct approach that is closer to the first-best solution of mortgage relief for still-stressed households might be in order.

monetary policy is not the appropriate tool to solve debt sustainability and debt overhang problems for which, in extreme cases, some form of debt restructuring should be considered together with adequate structural policies.28

Finally, I would refer readers to the discussion at the end of the document, in particular the Federal Reserve representative comments, which IMO overly downplay the issue, and comments from the Pictet representative which raise the question I noted above in the intro, did debt cause the low growth or low growth the debt?   I think the answer is both, but one part applies pre and the other post crisis…pre crisis weakening growth dynamics in developed economies, enhanced by global structural imbalances, accompanied rising debt, and post crisis high debt levels impact growth and financial system stability.   

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