[p2p-research] Eroding a Mountain Range of Debt

[Ryan]

Why debt is the problem...along with deflation.

Ryan

Sent to you by Ryan via Google Reader: Eroding a Mountain Range of Debt
via Early Warning by Stuart Staniford on 7/3/10
The above data shows the debt outstanding of various sectors in the US
economy. It comes from the Federal Reserve Z1 release, and the data are
annual except for the 2010 point, which is for Q1 (on the graph, the
annual data are shown at the mid-point of the year, and the Q1 point is
shown 1/8 of the way into the year, so slopes should still be accurate).

My operating assumption is that the main current problem with the US
economy is Too Much Debt in the private sector, and that all will not
be well until both the household and financial sectors have deleveraged
back down at least to something like the levels of the 1990s (at a
rough guess). On the pace so far, it appears likely that that will take
at least a decade. I don't think any of us should be planning on living
in a great economy any time soon.

At the moment, there is a great debate occurring between Keynesians
such as Paul Krugman, who argue the government should run deficits to
stimulate the economy, and the forces of fiscal austerity who argue the
government needs to reduce its debt.

In thinking about this, it seems like the key fact is the accounting
identity that

Private Sector Balance + Government Balance + Foreign Balance = 0
Now, there are deep structural reasons why the US is running a current
account deficit that cannot be changed soon (dependence on foreign oil,
offshoring of labor-intensive work). Developments in Europe are making
it even more difficult for the US to run a current account surplus. So
the third term in the accounting identity pretty much has to be
positive (foreigners are net lenders to the US). If we want the private
sector to deleverage, then the private sector balance should be
positive. That means the government balance must be negative (the
government should be a net borrower). This is the argument against
government fiscal austerity, and it's quite compelling.

At the same time, I think there's a serious magnitude problem with the
idea that the US government should run big deficits until the private
sector is sufficiently deleveraged. The private sector is much larger
than the government sector, and its debts are too big. Here's a stacked
graph of the private sector debts outstanding:


If the government runs sufficiently large deficits for long enough for
this to get back down to, let's say, the level of 1995, the government
is going to end up with a debt to GDP ratio approaching that of Japan,
and I would say it's politically inconceivable that the US government
could sustain that level of debt.

My conclusion is that the private sector deleveraging process is not,
and should not, be mainly a "pay down the debt" process. That appears
to me to be impossible. It needs to be mainly a "write off the debt"
process. Households, businesses, and financial firms with weak balance
sheets will need to go through the appropriate restructuring processes
- whether it is short sales on houses, principal renegotiations on
mortgates, debt restructurings and bankruptcy of individuals and firms.
Obviously, there will be lots of nasty feedbacks as we go through this
process: household debts being written down make the balance sheets of
financial firms worse, financial firms shrinking and laying off workers
reduce demand for the output of other businesses and worsen their
cashflow, etc.

The main role of the government should thus not be "borrower of last
resort", but rather "bankruptcy trustee of last resort". Clearly, in
this kind of environment, the largest financial firms could become at
risk again. In that scenario, it's critical that the government is in a
credible position to take them over and conduct a restructuring, and
that requires that the government's own balance sheet is in decent
shape. Therefore, I don't think the government should either try to
massively increase its own debt, or massively reduce it. I think it
should aim for approximate balance, and in the meantime should place
its focus on improving the speed, efficiency, and fairness of the
various processes for resolving excessive private sector leverage. I
think given the scale of what needs to happen, we should try to find
ways to make the processes more compassionate for the individuals
involved.

Fundamentally, we've spent the last two decades borrowing and lending
far too much, and there now isn't any painless path back to a healthy
situation. We need to get rid of a lot of this debt, and we need to get
a lot less comfortable with borrowing as a solution to our problems.

As a side effect of this, it seems to me that many classes of assets
are still very much over-priced. Houses and stocks are likely to be in
an overall bear market for as long as the deleveraging process is going
on.

It's not going to be any fun.
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