Saturday, December 24, 2011

The Global Debt "Minsky Moment"

FT Alphaville points to an excellent speech by Canada’s central bank governor Mark Carney where he points to the inevitability of a prolonged period of deleveraging among the developed economies to shake off the mountains of accumulated debt. He feels that the global "Minsky moment" has arrived, and a combination of debt restructuring, inflation and growth need to be deployed.

The speech contains several superb graphics that beautifully captures the debt trap in which US and Europe have entrapped themselves. The balance sheets of households and governments on both sides of the Atlantic have worsened dramatically over the past decade or so.

Following the bursting of the sub-prime mortgage bubble, net household wealth of Americans dropped spectacularly. This wealth can be regained only through a combination of increased savings and recovery in asset values.

Europe experienced a hugely imbalanced and unsustainable economic growth after the monetary union. Cross-border lending exploded, capital was cheaply available, public spending grew, and booms ensued. This eroded competitiveness, especially among the peripheral economies with respect to Germany. Euro-wide price stability masked large differences in national inflation rates. Unit labour costs in peripheral countries shot up relative to the core economies, particularly Germany.

Financial globalisation, driven by savings glut in emerging Asia and consumption demand in the developed economies, led to the build up of external imbalances. The magnitude of these savings glut, best exepmlified by China's monstrous foreign exchange surpluses, allowed larger debt burdens to persist for longer than historically was the case.

All this was obviously not sustainable. When the bubble burst and Great Recession took hold, the consequences were severe. The World Bank estimates the world GDP output gap to be more than $7 trillion by 2017.

As these graphics reveal, all these economies built-up several critical structural imbalances over the past two decades. In all of them, compared to the previous two decades, public debts rose sharply, household wealth rose spectacularly, cross-border capital flows increased dramatically, and unit labour costs climbed. A fortunate confluence of favorable factors were inflating these bubbles and boosting economic growth.

Now that the bubbles have been deflated and the business cycle has changed direction, all these aforementioned macroeconomic indicators are naturally on the way down to their pre-bubble (not pre-crisis) norms. In many respects, this is a natural correction and there may be little that governments can do to avoid them.

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