The debt dilemma

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By Adair Turner & Susan Lund

Greece’s divisive negotiations with the EU have placed debt back at the center of debates about economic growth and stability.

But Greece is not the only country struggling to repay its existing debt, much less dampen borrowing. Its fraught negotiations with its creditors should spur other countries to take action to address their own debt overhangs.

Since the global financial crisis erupted in 2008, the world’s debt has risen by $57 trillion, exceeding GDP growth. Government debt has increased by $25 trillion, with the advanced economies accounting for $19 trillion – a direct result of severe recession, fiscal-stimulus programs, and bank bailouts.

While American households have reduced their debt considerably (mainly through mortgage defaults), household debt in many other countries has continued to grow rapidly. In all major economies, the debt-to-GDP ratio (including both public and private debt) is higher today than it was in 2007.

Much of this debt accumulation was driven by efforts to support economic growth in the face of deflationary headwinds after the 2008 crisis. That was especially so in China, which, together with other developing economies, accounts for nearly half of the debt incurred since 2008.

To be sure, debt itself is not bad. But excessive reliance on debt creates the risk of financial crises, which undermine growth. Given this, the world needs to find both less credit-intensive routes to growth and ways to eliminate existing debt burdens.

To help limit future debt accumulation, countries have three options. First, they can employ countercyclical macroprudential measures to dampen credit cycles and prevent excessive borrowing. For example, stricter loan-to-value-ratio limits and higher capital requirements for banks could slow credit growth when housing or commercial real-estate markets are overheating. Yet precisely the opposite approach is now being taken in the United States, where some first-time homebuyers have now been given access to 97% loan-to-value mortgages.

A second strategy for curbing the buildup of debt could be to introduce mortgage contracts that enable more risk sharing between borrowers and lenders, essentially acting as debt/equity hybrids. As the Great Recession grimly illustrated, when a period of soaring real-estate valuations and rising household debt is followed by a period of falling prices, and households attempt to deleverage, the results can be catastrophic. The talent for financial innovation that produced harmful new home-mortgage options before the crash should now be harnessed to develop more flexible mortgages that help borrowers avoid default.

One example is “shared responsibility” mortgages, in which payments are reduced under certain circumstances, such as when home prices dip below the borrower’s purchase price. In exchange for this flexibility, the lender receives a share of any capital gain that is realized when the home is sold. Similarly, the continuous-workout mortgage adjusts payments and terms in specific cases, such as job loss.

A third option for limiting debt accumulation is to reconsider tax rules that favor debt. In many countries, interest accrued on a mortgage remains tax deductible. Though phasing out this policy is politically contentious, some countries – such as the United Kingdom in the 1980s – have managed to do so. Similarly, it would be difficult – but not impossible – to reduce the incentives, created by almost all countries’ tax regimes, for corporate leverage.

Governments must also work to reduce existing debt – and the deficient global demand to which it contributes. It is simply not feasible for the most highly leveraged governments to grow their way out of debt. Nor can austerity alone suffice, as it would require countries to make such large fiscal adjustments – 5% of GDP, in Spain’s case – that citizens would likely resist them, as the Greeks have done.

A more effective approach would employ a broader range of tools, including debt restructuring. In some countries, sales of public assets and the levying of one-off wealth taxes would also be helpful.

Investors, analysts, and other commentators, for their part, must take a more nuanced view of governments’ true debt liabilities. Much of the sovereign-debt accumulation of recent years has been enabled by quantitative easing, with central banks making large-scale purchases of government bonds. The US Federal Reserve, the Bank of England, and the Bank of Japan now own 16%, 24%, and 22%, respectively, of all bonds outstanding.

Given that central banks are owned by the government, and that interest paid on outstanding bonds is remitted back to the national treasury, these government bonds are fundamentally different from those owned by other creditors. Focusing on “net” government debt (which excludes intra-government debt holdings, such as the bonds owned by central banks) is a more effective approach to assessing and ensuring the sustainability of public debt.

The global economic crisis laid bare the challenge of debt reduction – and the risks that excessive indebtedness raises. Yet the crisis also intensified government and household dependence on leverage, causing debt levels to continue to rise – a trend that, left unchecked, will lead to more crises in the future.

It is time to redirect financial innovation toward developing new tools and approaches to address these challenges. Only then can the world economy move onto a sustainable growth path.

Adair Turner is Chairman of the Institute for New Economic Thinking and former Chairman of the UK Financial Services Authority. His book Between Debt and the Devil will be published by Princeton University Press in fall 2015. Susan Lund is a partner at the McKinsey Global Institute, which recently published the report “Debt and (not much) Deleveraging.”

 
Copyright: Project Syndicate, 2015.

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