The deleveraging of the developed world

In the post-war period we witnessed a gradual build-up of debt in the developed world. Integral to this trend was a belief that it was optimal for policy makers to macro-manage the economy, stimulating growth every time the economy entered a recession. In the event of deficient private sector demand, either the government would step in to fill the void (increased spending and/or reduced taxation) or interest rates were reduced to encourage businesses and households to borrow and spend, writes Jean Dutil, Portfolio Manager with RBC Wealth Management.
 
Although these policies certainly helped to reduce the amplitude of economic cycles in the short-term, they actually weakened the underlying health of the economy in the long run. This is perhaps best demonstrated by the fact that each US recession required a bigger increase in debt to produce the same increase in economic output (see chart below). Ultimately this trend was unsustainable. Eventually the trend of rising debt levels, rising asset prices and rising prosperity had to end, at which point the virtuous circle would go into reverse.
 
The question is when does excessive debt become too much debt? It seems the events of the past three years suggest that the credit cycle has come to an end and that the heavily indebted economies of the world may have entered a long period of deleveraging. The real question is will this be done via balanced budgets which may result in deflation and possible economic depression or will real debt burdens be reduced via inflation?
 
The policies adopted in the aftermath of the recent Credit Crunch were consistent with the 1970s path; printed money, government bailouts and cloaked protectionism. These were all policies which prevented the crisis developing into a depression, but which also have the capacity to push up inflation in the long run. More recently however, a split has developed in the international community. America and Britain are following roughly the same game plan and are reluctant to do anything that might threaten the recovery while Germany is taking Europe down a very different path as it is faced with a unique and particular situation.
 
During the good times, the introduction of the Euro was a blessing to countries like Greece and Spain. In 1995 the yield on the benchmark Spanish 10-year bond was over 12% and by 1999 (with the launch of the euro) that same yield was below 4%. With interest rates at their lowest levels for generations, these countries went on a borrowing binge. On the surface their economies looked pretty healthy; growth was strong and budgets were generally balanced. However, it was an illusion of prosperity, one based heavily on borrowed money. When their property bubbles burst in 2008, their economies entered a deep recession and budget balances moved significantly into the red. In the past, when faced with such a predicament, they would have devalued the drachma, but with the Euro currency that is no longer an option. To worsen the situation, under the terms of the Maastricht Treaty, they are required to reduce their deficits to below 3% of GDP.
 
delevgraph.png
 
Trying to balance a budget during a recession is like bailing out a boat with a colander. Higher taxes cause the economy to contract further which reduced the size of the tax-take, which then necessitates further tax hikes; and so the negative spiral continues. It was a similar balanced budget mentality, combined with fixed currencies which brought about the economic depression of the 1930s, and now history seems to be repeating itself in Europe. The current package will provide Greece with the breathing space it needs to address its deficit. The problem is that Greece has very little, if any chance of balancing its budget, the numbers are simply too big. And even if it is economically possible, political instability will likely prevent it from happening.
 
There are already signs that the crisis is spreading to Portugal, Spain and Italy. This is a worrying development as Greece may be too big to fail but Spain is probably too big to save as Spain’s debt problem is twice that of Greece and Portugal combined. This situation is not helped by the fact that European banks are still heavily leveraged and own huge amounts of government bonds. Banks that survived the Credit Crunch may not be so lucky this time around.
 
In addition, external rescue packages in the past were typically accepted by the citizens of the problem country. But this is hardly the case in Greece. The population seems to think that the world owes them something — the strikes, riots and deaths have left the global marketplace with a view that Greece will never have any intention of accepting the caveats attached to the rescue package, especially since the fiscal restructuring is so intense that we are talking about 3 to 4 per cent GDP contractions annually for at least the next three years.
 
How does the crisis end? Ultimately sense will prevail as it always does, but not before the markets have been through the mill.  It will be technically difficult for countries to leave (or be ejected from) the Euro as a great deal of political capital has been invested in the project.  The European Central Bank (ECB) could elect to monetise the debt problem, ie buy Greek, Spanish and Portuguese bonds with printed money, but such a move would also be deeply unpopular with German voters. One idea that has been floated is to break up the euro into two separate currency areas, with that of the southern states devaluing against that of the northern area dominated by Germany. If that proves to be the end game of this crisis, getting there will likely prove to be a tortuous process.
 
It increasingly looks like Europe will be the catalyst for the next period of instability. In 2008 markets rallied in response to the Bear Stearns bailout, but the downtrend resumed two months later when it was clear that Bear Stearns was merely a symptom of a deeper malaise. I suspect that the Greek rescue package will prove to be a similar staging post in the current crisis and that more volatility lies ahead.

The views expressed are the opinions of the writer and may differ from the views of Royal Bank of Canada.

deleveragingSM

Jean Dutil

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