High Levels of Debt Threaten World Economy

by Frank Thomas

Dean Baker's article is valuable in illuminating the time phasing of deficits as a percentage of GDP before and after the crisis. Public and Household Debt generally always increase in recessions but rose to an extremely high level in 2008-09 recession which was really a "mini depression", now an ongoing double-dip recession for most EU countries. When Debt rises, growth falls which in turn expands Debt and thus intensifies the downward spiral of an already weak growth rate.                         

So adding significantly more debt when it is already so high is NOT the solution adopted to date by EU authorities as Krugman proposes. The focus for the time being is primarily on solving the fiscal problems and keeping savings high. This approach and the ongoing recession will expand unemployment as is now happening in the Netherlands (unemployment rate is now near 6% from 4.8% six months ago. But there are ample unemployment benefit funds to cover this setback. Such benefits amount to €180/day( $240/day up to maximum of ±$42,000/year) for up to 36 months ... more than sufficient to weather the double dip recession. These social nets, as I've said many times, are very important "economic stabilizers" in economic down times which America does not have.                      

Paul Krugman tends to underestimate the stabilizing effects of European social nets which historically have generally made recession downturns slower and less steep in mature EU countries and recoveries slower than in the U.S. But, let's face it: EU authorities failed egregiously in not enforcing the fiscal rules passed in 1991. This left Italy to go its reckless corrupt ways and left Greece, Ireland, Portugal, Spain (and Iceland) to go their reckless financial ways. Greece and Italy share the lead as being the worst tax collection countries in Europe. The ECB never paid any attention to this among other things. 

Italy’s ignored public debt is at such a level that their austerity program is also being directed at politicians whose incomes are substantially above the EU average. While Italian workers’ salaries are among the lowest in Europe, monthly take-home pay for lawmakers ranges from $18,000 to $28,000 plus excellent medical insurance, a car and driver, and free travel within Italy. Little wonder Italy’s Parliament costs about $2.0 billion a year or $33 per capita for a population of 60 million. This compares to our U.S. Congress which costs about $2.2 billion a year to maintain or $7 per capita for a population of 315 million!! This underscores EU focus on weak countries getting their financial houses in order before opening the fiscal stimulus floodgates.  

Carmen Reinhart and Kenneth Rogoff’s exhaustive study of recessions and the financial crises after recessions confirms that results vary broadly depending on how policy makers respond to the crisis. Their research showed that nations already at high debt levels and/or in an unhealthy financial state have historically not responded well to fiscal stimulus measures. For example, China and South Korea have recovered quicker than the U.S. and Europe because the fiscal status of these countries was far sounder before the recession hit them. In Reinhart and Rogoff’s opinion, the policy response to the banking system which caused the crisis is far more important. To make a system less vulnerable to a financial crisis, they warn there must be no hesitation in implementing and enforcing appropriate rules and regulating on the banking system. Europe is doing this now as well as seeking disciplined enforcement of a 3% of GDP deficit brake and a 60% of GDP public debt brake.

The theme in the paper, "The Real Effects of Debt," is that a country trying to go too far to buy itself out of a recession only makes the already High Debt situation and intermediate term inflation risk even worse. Better to tighten spending, reform social nets, and raise taxes progressively, support banks with longer term loans. low interest benchmark rates and, and stick as much as financially possible to planned sustainable investment projects. Name economists forget that Ireland and Iceland are now slowly recovering from economic disaster with the former receiving modest support from the ECB and the latter practically nothing (except some aid from Norway).

The following ratios of Debt as a percentage of GDP come from the Federal Reserve Bank paper. They are alarming, and the Debt mix management problem is quite different for most countries:

TABLE  1

.......................................1980......1990......2000......2010

Government debt

U.S...................................46%.......71%......58%.......97%

U.K...................................58%.......42%......54%.......89%

Germany...........................31%.......42%......54%.......77%

France..............................34%.......46%......73%.......97%

Italy...................................54%.......93%....126%.....129%

Netherlands......................65%.......97%......67%.......76%

Spain................................27%.......49%......71%.......72%

Greece.............................26%........83%....124%.....132%

 

TABLE  2 

Household Debt

U.S..............................52%........64%......74%.......95%

U.K..............................37%........73%......75%......106%

Germany......................50%........61%......73%........64%

France.........................27%........46%......47%........69%

Italy................................6%........21%......30%........53%

Netherlands.................43%........49%......87%......130%

Spain...........................24%........41%......54%........91%

Greece...........................8%.........9%.......20%........65%

 

TABLE  3

Non-Financial Debt (Corporate Debt)

U.S..............................53%........65%.......66%.......76%

U.K..............................64%........88%.......93%......126%

Germany......................46%........35%.......91%.....100%

France.........................99%.......106%.....123%.....155%

Italy..............................48%.........66%.......96%.....128%

Netherlands.................98%.......119%.....140%.....120%

Spain..........................120%.........97%.....133%.....193%

Greece.........................59%.........47%.......51%.......65%

 

One can quickly see why the Netherlands is undertaking a sharp five year budget reduction of €23-26 billion particularly with its very high household debt ratio ... which is also very high for U.S., UK, and Spain but surprisingly low for Greece.                               

U.S., France, Italy, and Greece have very high government debt ratios. Non-financial debt ratios are extremely high for Spain and France and rather high for all other countries, but very low for U.S. and, again surprisingly, very low for Greece.

The Federal Reserve Bank paper concludes after exhaustive study that certain thresholds should not be exceeded for the three forms of debt above. These thresholds are: 85% for government debt; 85% for household debt; and 75-90% for non-governmental debt. The research paper concludes that going above these thresholds begins to have a significant impact on GDP growth.

This is a main factor behind the EU's reluctance to print large sums of money now or purchase excessive bundles of bad debt. The next step is to come to agreement on some innovative bail-out funding solution for the ECB that is financially responsible ... while still holding both financially weak and strong countries to the agreed fiscal discipline rules.

Easing of the euro and credit crunch crisis by the ECB's just announced $639 billion loan liquidity offer -- at a very low benchmark interest rate of 1% and loan terms of 3 years -- to over 500 EU banking institutions BUYS TIME to solve longer-term issues such as:

• reducing very high government or household debt among EU member countries noted in TABLE 1
• achieving real EU 17 and EU 27 fiscal unity including:  consistentcy and harmonization in financial reporting, transparency, and effective operation/enforcement of EU rules for government deficit and debt levels
• implementing Basel III stricter capital (equity) reserve requirements for banks of 3% of total assets among other provisions

Concerning debt levels, the Dutch have come up with a thoughtful idea. Authorities are now serioiusly considering offering new and existing homeowners an income tax benefit if their home mortgages are paid off more quickly. As TABLE 1 shows, the Netherlands has an excessive level of household debt amounting to +-130% of GDP. 

 

Over thirty years living in the Netherlands has taught me never to give up on the Dutch multi-party coalition governance to ultimately reach balanced solutions to serious societal challenges -- like the Dutch multi-faceted strategy approach to the current financial crisis of CUT, REFORM, RAISE TAXES, and INVEST. And the goal is to try to undertake these actions simultaneously so as not to create a long period of "stand-still" growth as the Japanese experienced in their 1992-2002 self-inflicted prolonged economic   

stagnation.

 

Comments

[Frank Thomas]

John,

As noted in my writing
"The Euro Zone Crisis," the ECB has been buying (and will continue to buy) distressed debt of countries like Greece, Portugal, Italy and Spain to hold down interest borrowing costs. However, the amounts to date are very modest compared to the trillions of dollars of quantitative easing employed by the Fed. Experts are pushing that the ECB be authorized to purchase bonds at much higher levels to stimulate economies.

The standard argument is that doubling the liquidity in the system would not create inflation. But this action amounts to stimulating or saving an insolvent government and is thus not only not the ECB´s mandate but is also not its desired goal given the already high debt levels (in government, household, and non/financial sectors) of most EU countries. Purchases of government bonds is seen as justified only only on basis of keeping interest rates under control as part of ECB´s monetary price stability responsibility.

The EU Emergency Fund will be used as a last resort to bail out governments as was done in the case of Ireland ... which lately is experiencing tougher GDP contractions than expected due to global economic unrest.

[Frank Thomas]

John,
As I've stated in my last writings about the EU financial crisis, the ECB will help the banks liquidity situation given fact banks are now having trouble issuing bonds or borrowing from other banks as potential lenders fear they won't be paid back.

Yesterday, the ECB announced a €489 billion ($639 billion) credit infusion to hundreds of banks for the exceptionally long period of 3 years! This is to avoid a credit crunch which could halt growth and thus spread the debt crisis.

While this is a much welcomed substantial liguidity injection to the banks, it does not address the low levels of bank reserves against potential losses nor does it reduce the debt levels of governments.

Still, it shows European authorities are taking step-by-step actions to address deficit, debt and liquidity problems. The next step will be to address the High Debt EU countries like Italy, Spain, Greece that are on a rather thin line of being nearly insolvent. I´m confident the right actions will be taken here also to restore confidence in the euro.