Monday, April 18, 2011

Macroeconomic challenge of the decade - economic growth in debt-laden economies

The sub-prime mortgage crisis and the resultant Great Recession has had a damaging effect on the fiscal balances of most developed economies. These economies have been squeezed on both the revenues and expenditure sides. On the one hand, they have had to face the cost of financial bailouts and fiscal stimulus spending, while on the other, the weak economy has affected the tax and other government revenues. From all available evidence, it is clear that the former (declining revenues) is the major contributory factor to the increased debt vulnerability.

The stagnation or weak recoveries in these economies have meant that the debt-to-GDP ratios and deficits have been on the rise. In other words, the same debt is now financed with smaller revenues. This forces governments to either cut back on investments (which in turn slows-down growth during recessions, and thereby reduces revenues still further) or borrow more (thereby increasing the debt-to-GDP ratios and also forcing up deficits). Either way, the GDP share of debts and deficits go north. All the major western economies and Japan face the prospect of a long period of grappling with rising deficits and debts.

Then there are the more damaging macroeconomic imbalances generated by this trend. Typically governments facing massive debts and deficits are vulnerable to both domestic and external pressures. On the home-front, debt financing eats into the resources available for productive purposes and also crowds out private investments. The result is a weak economy. Further, an excess supply of domestic debt can potentially generate inflationary pressures.

On the external front, economies like the US and peripheral European countries, which have considerable foreign debt exposure, rely on external financing to meet a considerable portion of their deficits. This in turn puts upward pressure on sovereign yields and domestic interest rates. Then there is the vulnerability to exchange rate fluctuations - if the domestic currency weakens in the face of these troubles (as is to be expected), the real burden of external debts rise.

Hitherto, the ultra-low interest rates prevailing in most western economies and the continuing global savings-glut, manifested in the surging foreign exchange surpluses of the emerging economies, have mitigated the real burden of the rising debts. However, with China already showing signs of paring down its dollar asset exposures, cheap and plentiful credit may soon become history.

There is also the issue of private and government debts. In many of these economies, apart from the governments, corporates and households too are heavily indebted. Many of the peripheral European corporates have significant external debt exposures. It is therefore natural that corporates and households use a greater share of their incomes to pay-off debts. This in turn means that investments and consumption spending take a back-seat.

In simple terms, the dismal economic prospects and stagnant aggregate demand means that there is no engine room available for the debt-laden private sector to drive any economic recovery. However, governments, the only other agency capable of providing some boost to the economy, too is facing steep debts and deficits. So what is the way ahead? How far is the light at the end of the tunnel?

As I have blogged earlier, economic growth, and earlier the better, is the only way out of such huge debt burdens. All other options - inflating away domestic debts, exchange rate depreciation (to lower the real cost of external debts), and sovereign defaults - are too costly and have very adverse long-term consequences for the economy. Exporting the way out of debt is not an option available for many of these economies, except maybe Germany.

Kenneth Rogoff argues that there is no short and easy way out of this mess. A long and painful period of tight-rope walking is inevitable. On the one hand, the balance sheets of all the three players - governments, corporates and households - have to be repaired and their debt burdens lowered. At the same time, the economy has to grow, so as to prevent the debt-burdens spiralling out of control.

In their latest paper examining debts in developed economies, especially in the aftermath of banking crises, Rogoff and Carmen Reinhart find that,

"A buildup in government debt has been a defining characteristic of the aftermath of banking crises for over a century, with government finances deteriorating to produce an average debt rise of 86 percent... Public debts in the advanced economies have surged in recent years to levels not recorded since the end of World War II, surpassing the heights reached during the First World War and the Great Depression. At the same time, private debt levels, particularly those of financial institutions and households, are in uncharted territory and are (in varying degrees) a contingent liability of the public sector in many countries. Historically, high leverage episodes have been associated with slower economic growth and a higher incidence of default or, more generally, restructuring of public and private debts."

Managing this twin challenge - maintaining economic growth while repaying the huge debts - will be the biggest macroeconomic question facing economists and policy-makers across many developed economies over this decade. What should be the government's policy responses to address this twin challenge? How much responsibility should governments shoulder in leading the depressed economies down the recovery path? What are the policy options that are likely to be effective? When should the government exit from their interventions?

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