In a speech given by Mark Carney, Governor of the Bank of England in Dublin, entitled “Fortune favours the bold” there is a good summary of the debt trap which is underlying the current economic environment. The speech describes how the debt trap was set, and how it is wagging the market dog.
Setting the debt trap
Building the debt that now weighs on our economies was the work of a generation. In the decade before the crisis, private financial balances became unsustainable. UK households borrowed 4% of GDP year after year; Irish households at more than twice that rate. Household debt peaked close to 100% of GDP in the UK, and 120% in Ireland. This borrowing was largely for consumption and real estate investment rather than businesses and projects that would generate the earnings necessary to service those obligations. Property prices soared as a result. Such excesses were possible because a decade of non-inflationary, consistent expansion turned initially well-founded confidence into dangerous complacency. Beliefs grew that globalisation and technology would drive perpetual growth, and that the omniscience of central banks would deliver enduring stability.
With a growing conviction that financial innovation had transformed risk into certainty, underwriting standards slipped from responsible to reckless and bank funding strategies from conservative to cavalier. Financial innovation made it easier to borrow. Bonus schemes valued the present and discounted the future. Banks operated in a heads-I-win-tails-you-lose bubble and were capitalised for perfection. And a steady supply of foreign capital from the global savings glut – and in Ireland’s case, the initial euphoria of European Monetary Union – made it all cheaper. When the Minsky moment finally struck, debt tolerance decisively turned and the kindness of strangers evaporated. UK households swung from borrowing 4% of GDP annually to saving 2% of GDP. The comparable swing in Ireland was more than twice as large.
In the wake of the crisis, three truths came back to the fore.
- First, while asset prices rise and fall, debt endures.
- Second, the distribution of debt and assets matters.
- And third, it is very hard to reduce high debt in one sector or region without at least temporarily increasing it in another.
The debt tail is wagging the market dog.
These realities continue to weigh on the European financial system. It is often argued that the world is awash with liquidity and excessive risk taking. And yet the rain is falling unevenly on the plain leaving some regions parched and others sodden. Savings aren’t flowing freely to the areas that need them the most. This is certainly true in the euro area, where many savings are trapped and much of finance remains fragmented. The result is demand compression, weighing on the outlook for growth and sustaining fears that another major adverse shock is possible. Risk appetite is more fleeting than median growth forecasts suggest. The constellation of asset price moves since last summer bears this sober assessment out. Yields on sovereign bonds have fallen across all maturities. France hasn’t borrowed this cheaply since the ‘50s – the 1750s. Real rates are negative as far as the eye can see, suggesting perpetually anaemic growth.
In the past six months, estimates of the equity risk premium have risen by over 100bps in the UK and the euro area back to levels last seen in the heart of the crisis. In addition, the probability of large declines in equity prices implied by options prices rebounded during 2014. This all suggests that investors may be attaching some probability to very bad outcomes, possibly the tail risk of economies becoming stranded in a debt trap. This market view is mirrored in elevated corporate caution. Investment remains subdued and businesses continue to build cash in many advanced economies. This is one reason why the so-called ‘equilibrium’ real interest rate is negative in many advanced economies, though it has risen and is possibly now positive in others like the UK. Reflecting these real dynamics, central bank interest rates have had to be set at extraordinarily low levels and supplemented by large scale asset purchases simply for monetary policy to
remain neutral.
Escaping a debt trap requires a suite of measures including structural reforms to boost productivity. But above all an economy needs to be able to channel all available savings – household, corporate and foreign – to those sectors willing and able to spend.
