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How to escape the vicious circle of debt-deflation

Much of the Western world is in a dangerous debt trap that is spiralling out of control. Now that the USA, the UK and the Eurozone are suffering the full impact of the recession, budget deficits will continue to soar and this will inflate public debt. Falling prices, expected later in 2009, will increase the real value of debt. In America and Britain in particular, corporate and private debt levels are unsustainable, amounting to over 300% of the capital base and 140% of annual income, respectively. Neither governments nor opposition have the right ideas to avoid the slump in economic activity or to mitigate unemployment. Parallels with the Great Depression of 1929 are increasingly evident.

In the west and elsewhere, governments and central banks are desperately trying to unblock the frozen credit markets. Through a combination of re-capitalisation, state-guaranteed loans and quantitative easing, the hope is to inject more money into an illiquid banking sector, drive down real interest rates and thus restore the flow of capital to cash-starved businesses and struggling homeowners. However, none of this activism will work unless and until policy-makers address the problem of excessive corporate and private debt that caused this crisis in the first place. In fact, permanent emergency crisis fighting is blinding governments and central banks to the adverse long-term effects of ill-conceived short-term measures like costly bank bailouts with no strings attached. What is required instead is large-scale debt conversion.

The trouble is that many countries trapped in a vicious circle of attempted debt reduction and real asset deflation. Faced with a mountain of debt caused by speculation-fuelled investment in dodgy mortgage schemes, US and European banks are forced to continue to de-leverage, i.e. offloading risky assets from their balance sheets to avoid the fate of insolvency and full-scale nationalisation. The forced sale reduces the price of assets and thereby increases the liabilities of other financial and non-financial institutions, forcing them to sell assets and so on. With the value of assets declining, real debt actually goes up – a process that will be reinforced as the recession bites harder and moderate inflation gradually turns into deflation.

Moreover, the problem of debt will get much worse before it might get any better. Banks and other financial institutions are bracing themselves for another wave of debt defaults – this time not from dodgy mortgage schemes but from commercial real estate, credit cards, car and student loans, corporate bonds, insurance and pension funds. Only last week, the IMF raised its estimate of financial sector write-downs from its October 2008 forecast of $1,400bn to a staggering $2,200bn. According to Nouriel Roubini, the economist dubbed "Dr Doom" for his gloomy predictions three years ago (which turned out to be broadly accurate), total US financial losses from the credit crunch could reach as much as $3,600bn, compared with a capital base of $1,400bn. In that case, says Roubini, «the financial system is insolvent. It's technically bankrupt".

This dangerous dynamic explains why the credit flow that keeps the economy alive has not been restored by state interventions. Take the case of the UK. The British Government's latest policies fall short because in the current climate of fear and distrust, banks hoard public money in order to insure against further write-offs of bad debt. With historically high leverage ratios – the relationship between a bank's debts and its capital resources – and private capital hard to get by, Britain's banks continue to reduce lending. That is why the credit flow has been disrupted, as the Governor of the Bank of England Mervyn King explained in a speech on Jan. 19 at an event organised by the Confederation of British Industry (CBI).

As a result, lower real interests alone won't do the trick because in a falling market, banks have few incentives to lend and every reason to keep on hoarding the public money that was injected as part of the double re-capitalisation in September 2008 and last month. Why? Because the ongoing fall in the value of assets increases liabilities, forcing further sell-offs and putting more pressure on assets – a vicious cycle of debt-deflation. Lending will only be restored to adequate levels if and when unsustainable debt is restructured, more demand for goods and services is generated (making investments once more profitable) and, yes, real interest rates are lowered.

The idea of the Conservative opposition to promote household saving is equally flawed because even those who can afford to save are unlikely to trust high-street banks on the verge of bankruptcy. Moreover, most households have to service not only their mortgages but also their consumer debts, including credit card balances, car loans and store cards. In 2008, average household debt reached over 140% of annual disposable income. With falling house prices and stagnant real wages, disposable incomes are so squeezed that people will be forced to take out more personal loans at interest rates well in excess of the Bank of England's base rate, which now stands at a historical low of just 1% (lowered on Feb. 5 from 1.5%).

In response to this unprecedented crisis, the US and many European governments are dramatically expanding public expenditure in a desperate attempt to bail out the corporate financial sector and to compensate for falling private consumption. The trouble is that the state is running up debts that will not just burden future generations but could threaten the recovery, as expectations of higher taxes will reduce spending and investment.

Again the case of Britain is instructive. Labour's expensive spending is adding an extra layer of public debt to the growing debt mountain, whereas the Conservatives' proposed expenditure cuts will further reduce aggregate demand, deepening the recession and thereby raising the debt-to-income ratios of both the public and the private sector. As such, neither will enable Britain to escape this debt spiral.

The Obama Administration hopes that – over a full business and budget cycle – higher US productivity will help reduce the soaring fiscal deficits, massively inflated by the proposed stimulus plan of more than US $850 billion.

If the full flow of credit is to be restored in these conditions of debt-deflation, then governments and central banks must now enact bolder measures than acquiring equity shares that are impossible to value or buying up the toxic assets that undermine trust in the international financial sector.

Two radical steps are needed: first, converting private (and some corporate) debt to avoid bankruptcy and home repossession and, second, monetizing public debt to minimise public debt levels and limit as much as possible future tax increases.

Debt conversion whereby mortgages and consumer credit are converted into long-term, low and fixed-interest loans is now urgently required. Governments should urgently consider proposals by the Harvard economist Martin Feldstein. He has suggested that the state offer mortgage holders the option of replacing a share of mortgage (20-50%) with a low-interest loan from the government, subject to a maximum amount.

Adapted to Europe, this could be up to, say, €75,000-100,000. The annual interest rate could be as low as 1-2% (the current base rate in the UK and the Eurozone, respectively) and the loan would be amortised over a period of 20-30 years. Such a scheme would almost certainly help minimise home repossessions and stabilise the property market in which more than 60% of the UK's wealth is tied up (around ?4,000bn out of about ?7,000bn). This sort of state assistance should be made available not just to individual borrowers but also to housing associations, especially those that have formed joint ventures with building companies and are now facing an acute funding shortage. Similar debt conversion programmes could be extended to other sectors that are crippled by debt, including commercial real estate and consumer loans.

One key advantage of debt conversion is that it deals with the immediate debt burden whilst reducing private and corporate bankruptcy and also avoiding the need for total debt cancellation, both of which would further depress assets. By interrupting the vicious circle of debt-deflation, debt conversion helps establishing a floor to asset prices. Lending will only be properly restored when assets stop falling, and assets will only stop falling when debt is brought under control through conversion. This would reconnect debt to assets and constitute a new approach to finance, something which Pope Benedict XVI, the new Patriarch of Moscow and All Russia Kirill I and the Anglican Archbishops of Canterbury and York Rowan Williams and John Sentamu already called for last autumn.

Indeed, reconnecting debt to assets would prevent the destructive bubble cycle whereby unrestrained, debt-financed speculation leads to a huge hike in asset and commodity prices and creates trillions of dollars in fake wealth, with devastating consequences for the real economy once the artificial bubble bursts and the edifice built on cheap credit collapses – exactly what the global credit crunch is.

By enacting debt conversion, governments and banks can address the problem of debt-deflation and put the economy on a more balanced footing.

The second policy that should be considered is quantitative easing for the purposes of a short, targeted and coordinated fiscal expansion. The US Federal Reserve, the Bank of England and the European Central Bank need to monetize public debt by purchasing additional government debt. In the current economic climate where private capital is hard to come by, central banks would not sell private securities to raise money but instead expand the monetary base – or quantitative easing to aid a fiscal expansion without further raising public debt levels.

In other words, central banks can use quantitative easing to help both the corporate sector (by buying private assets) and the public sector (by acquiring government debt). That way, the public deficit is monetized and no financial crowding out occurs (no unnecessary competition between public and private borrowing in a market starved of fresh capital).

There is yet time to mitigate the worsening slump, but the Western world cannot afford current official policies or the proposals of opposition parties. Fire fighting to stabilise the financial system and building a different economic model should have never been seen as separate. Taken together, debt conversion and monetization provide a more effective way out of the West's predicament of debt-deflation, asset destruction and mass unemployment. A debt jubilee, coupled with a short-term fiscal expansion, can help avoid the deepening recession turning into a full-blown depression.

Adrian Pabst teaches religion and politics at the University of Nottingham and is a research fellow at the Luxembourg Institute for European and International Studies.

Adrian Pabst

Adrian Pabst teaches religion and politics at the University of Nottingham and is a research fellow at the Luxembourg Institute for European and International Studies.

*1 Статья написана для журнала «Вся Европа.ru». Сокращенная версия опубликована газетой «Гардиан» (Великобритания) 04.02.2009.

№2(30), 2009