Michael Pettis has a good piece on debt and credit that I ran on the blog this morning. His thoughts on loss socialization are important not just in the context of China but also of other markets like Europe, the US, Canada and Australia where private debt levels have increased markedly. Some of this has resulted in phantom growth which in turn will lead to secular stagnation as the credit excess gets unwound as credit writedowns. Some thoughts below
In the wake of the BIS warning, I have been writing a lot about over-indebtedness recently. And I think it’s an important topic from a macro perspective because credit dynamics explain the divergence between upbeat cyclical trends and secular fragility. It is very possible – actually even necessary – for secular fragility to increase when cyclical trends are their most upbeat. By definition, growth predicated on credit growth over wage growth is destabilizing in the long-run because speculative borrowers and Ponzi borrowers have to predominate.
Mainstream academic economics today doesn’t do justice to credit and debt dynamics. And this is why the profession was blindsided by the financial crisis and also why economics has lost a lot of credibility among investment professionals. As Michael writes:
Investors usually take the topic of debt much more seriously than economists. They have no choice, I guess. Their conceptual failures cost money. This is probably why until very recently brilliant economists like Hyman Minsky, Irving Fisher and even Marriner Eccles were far more likely to be read by thoughtful investors than by academic economists
What Minsky, Fisher and Eccles recognized that mainstream economics does not is that credit accelerates growth in large part because loans create deposits, meaning credit is additive, allowing banks to create money out of thin air. My point has been that, to the degree that credit to speculative and Ponzi borrowers cannot be repaid out of wages and earnings, the growth associated with it is fictitious. And what that means is that during the credit writedown phase, you get a sort of growth payback to the downside.
Fisher’s insight on debt deflation dynamics is that this growth payback doesn’t happen in a benign way but rather is a self-feeding negative loop made worse by debt distress. The example I like to give my wife when we talk about this is Linens ‘N Things. This was an American retailer of home textiles, housewares and home accessories, that together with Bed, Bath and Beyond, dominated the housewares market in the US prior to the financial crisis. My wife and I went to the local Linens ‘N Things many times. It was a good company that we saw as virtually indistinguishable from industry leader Bed, Bath and Beyond. But Linens ‘N Things was acquired at the height of the housing bubble by Apollo, the private equity firm and it was saddled with a massive debt. As a result, when the economy turned down, the company was unable to restructure and was forced into liquidation, costing over 7,000 jobs.
What happens then is that financial fragility at business cycle troughs creates collateral damage. Perfectly satisfactory businesses become distressed and are forced into bankruptcy and liquidation. So, not only is the excess credit unwound, but we also see a further down tick in the economy because of this debt stress. Businesses that would do fine are starved of capital. They shrink and some fail. If enough fail, debt deflation takes hold as the loss of business activity leads to a loss of income and jobs and a further loss of business activity and more debt stress. That’s the process we have seen play out since 2007.
These losses are real in terms of reducing economic growth, just as the gains before them were real in terms of boosting growth. And by that I mean that the concept of socializing losses necessarily connotes apportioning losses from credit writedowns. And because credit writedowns mean slower growth, the result is a credit decelerator. So when Michael headlines his post as “Bad debt cannot simply be ‘socialized’”, I read him to be saying that bad debt cannot just go away without a growth impact. Someone has to take the losses and that necessarily means slower growth.
Loss socialization is a political process. Usually, we see financial repression or bailouts as a way of secretly transferring losses to net recipients of interest and taxpayers as a whole. And that’s what we saw in the US and Europe after 2008. Zero rates, for example, mean that your mother is earning next to nothing on her bank certificate of deposit whereas she was earning 5% before the crisis hit. On $100,000 of savings, that’s a loss of $5,000. This is what socializing bad debts means; it means that someone who is not the creditor of the bad debts takes losses via lower income or earnings in order to help the creditor recoup as much of the debts as possible. In the meantime, the economy grows slower.
What I have been arguing, however, is that the loss socialization is not over – meaning that the scale of credit excess was more than policy makers were able to socialize and firms were able to write down. The cyclical upturn we are experiencing now flies in the face of that still extant balance sheet credit excess. In short, more loss amortization is coming. And to the degree the economy grows now without wage growth, we are adding even more loss amortization to the pile.
Here’s an example from the Guardian on what is happening in the UK:
Unemployment fell last month as Britain’s economy added jobs at an unprecedented pace, according to official figures. But the recovery failed to lift wages by more than a fraction, leaving workers suffering another real-terms cut in living standards.
The jobless rate fell to 6.5% of the workforce, while the number of people in work edged higher to a fresh record of 30.6 million. The proportion of those aged 16 to 64 in work reached 73.1% in the three months to May, a rate only equalled before in 2004-5 and in 1974.
But a 0.7% rise in wages, excluding bonuses, was well short of the 1.5% May inflation rate. With bonuses factored in, wage growth was only 0.3%.
Average wage rises have remained stubbornly below inflation during the recovery and forecasters have repeatedly predicted an imminent return to above-inflation rises in wages over the last year only for each month’s official figures to prove them wrong.
If wages are not growing, the economy can only grow via an increase in corporate earnings at the expense of wage earnings, an increase in interest income, a positive change in the current account or the accumulation of debt (including increased net transfers from the public sector). The numbers I have seen show interest income low and stagnant, reduced net transfers from the public sector and an increasing current account deficit in the UK. Therefore, the increase in British GDP, which is now the highest in the G7, has to be coming from corporate earnings and debt accumulation. Unless we see these earnings getting ploughed back into the economy and increasing productivity, I am sceptical that the recovery in Britain is sustainable.
In the UK, house prices are rising, allowing households to lever up and bolster the economy artificially. Michael is pointing to the same process occuring in China, but on a massive scale, so large in fact that he believes trend growth has to go down to 3-4% in order to amortize the losses associated with accumulated and still accumulating credit excesses.
In Europe, the sovereign debt crisis is not over for the same reasons. The losses have not been recognized, just rolled over. And because the eurozone sovereign governments are also currency users, we have to consider the debt dynamics associated with rolling their debt over as well.
In Canada and Australia, the economy is growing on the back of house price growth and household debt accumulation. And because we have not seen a crisis there, most economists are giving the all-clear. I would say that the huge increase in household sector debt will be unwound eventually and it will end in crisis as a result.
My conclusion here is fairly simple. Over the preceding years, many economies built up unsustainable levels of debt that is now being written down. Writing this debt down implies slower economic growth. And because that slower economic growth is politically unappealing and because of fear about debt deflation dynamics, policy makers have tried to engineer a cyclical recovery predicated on enough credit growth to prevent recession and debt deflation but slow enough to allow previous losses to be partially amortized. This is a political decision to protect creditors from taking losses.
The scale of losses to be amortized is simply too large for the loss socialization process to work smoothly without crisis. Secular stagnation is borne out of the intersection of high private debt, creditor-centric economic policy, and low wage growth. Unless these countries design policies to re-allocate resources in a way that increases wages to help reduce leverage, the debt accumulating to sustain recovery will force another round of deleveraging and crisis will return.