Thursday, February 18, 2010

Developed economies are yet to start the process of reducing non-financial leverage:

As we noted Wednesday (It’s Simple: Too Much Debt), borrowers have three options:

1. Pay down the debt. This means increasing saving rates (typically by spending cuts).

2. Swap the debt. Find someone else to bear (or share) the burden.

3. Default on the debt. This could be overt or covert (some form of currency debauchment).

The focus now is on public sector debt: Public sector debt is rising (although, on average, below the levels seen after World War

2) and budget deficits are very large.
It may be unusually difficult to restore fiscal policy to sustainable levels:

First, the private sector is also highly indebted in many economies: This means that aggregate nonfinancial sector leverage is very high. We don’t know of any examples of a country reducing leverage from a starting point as high as it is now in many developed economies, without serious crisis, default or inflation.

Second, as far as we can tell, it is unusual for very high leverage to be as widespread as it is now: The highly leveraged economies include many major western
economies. The closest precedent was after World War

2, but aggregate leverage then was lower than now. Prevalence matters: To increase national saving, an individual country can depress domestic (and import) demand and depreciate the currency to boost exports. But with so many major economies affected, simultaneous currency depreciation is difficult. Moreover, if countries synchronize their domestic weaknessm the result could be global double-dip.

In some cases depreciation may not even be an option: The countries on the European periphery are effectively only semi-sovereign states. They don’t control their own currency or their own interest rates, and they don’t have recourse to a printing press.

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