Running the Economy - V
In a recession, lowering interest rates work to stimulate borrowing. However, in a deleveraging, lowering interest rates doesn't work because interest rates are already low and soon hit 0% - so the stimulation ends. The difference between a recession and a deleveraging is that in a deleveraging borrowers' debt burdens have simply gotten too big and can't be relieved by lowering interest rates.
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Lenders realize that debts have become too large to ever be fully paid back. Borrowers have lost their ability to repay, and their collateral has lost value. They feel crippled by the debt - they don't even want more! Lenders stop lending. Borrowers stop borrowing. Think of the economy as being not-creditworthy, just like an individual. So what do you do about deleveraging? The problem is debt burdens are too high, and they must come down.
There are four ways this can
happen. People, businesses, and governments cut their spending. Debts are
reduced through defaults and restructurings. Wealth is redistributed from the
'haves' to the 'have nots' and finally, the central bank prints new money.
These 4 ways have happened in
every deleveraging in modern history. Usually, spending is cut first. As we
just saw, people, businesses, banks, and even governments tighten their belts
and cut their spending so that they can pay down their debt. This is often
referred to as austerity. When borrowers stop taking on new debts and start
paying down old debts, you might expect the debt burden to decrease.
But the opposite happens!
Because spending is cut- and one man's spending is another man's income - it
causes incomes to fall. They fall faster than debts are repaid and the debt
burden gets worse. As we've seen, this cut in spending is deflationary and
painful.
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| Scroll: GDP contraction from the recent report |
Businesses are forced to cut costs... which means fewer jobs and higher unemployment. This leads to the next step: debts must be reduced! Many borrowers find themselves unable to repay their loans — and a borrower's debts are a lender's assets. When borrowers don't repay the bank, people get nervous that the bank won't be able to repay them so they rush to withdraw their money from the bank. Banks get squeezed and people, businesses, and banks default on their debts. This severe economic contraction is depression.
A big part of depression is people discovering much of what they thought was their wealth isn't there. When you bought a house and put it on a tab, you promised to repay the lender. Your promise became an asset to the lender. But if you break your promise - if you don't pay him back and essentially default on your tab - then the 'asset' he has isn't worth anything. It has disappeared. Many lenders don't want their assets to disappear and agree to debt restructuring.
Debt restructuring means
lenders get paid back less or get paid back over a longer time frame or at a
lower interest rate that was first agreed. Somehow a contract is broken in a
way that reduces debt. Lenders would rather have a little of something than all
of nothing. Even though debt disappears, debt restructuring causes income and
asset values to disappear faster, so the debt burden continues to get worse.
Like cutting spending, debt reduction is also painful and deflationary. All of this impacts the central government because lower incomes and less employment mean the government collects fewer taxes. At the same time, it needs to increase its spending because unemployment has risen.
Many of the unemployed have inadequate savings and need financial support from the government.
Additionally, governments create stimulus plans and increase their spending to make up for the decrease in the economy. Governments' budget deficits explode in a deleveraging because they spend more than they earn in taxes. This is what is happening when you hear about the budget deficit on the news. To fund their deficits, governments need to either raise taxes or borrow money. But with incomes falling and so many unemployed, who is the money going to come from? The rich. Since governments need more money and since wealth is heavily concentrated in the hands of a small percentage of the people, governments naturally raise taxes on the wealthy which facilitates a redistribution of wealth in the economy - from the 'haves' to the 'have nots'. The 'have-nots,' who are suffering, begin to resent the wealthy 'haves.' The wealthy 'haves,' being squeezed by the weak economy, falling asset prices, higher taxes, begin to resent the 'have nots.'
If the
depression continues social disorder can break out. Not only do tensions rise
within countries, but they can also rise between countries - especially debtor
and creditor countries. This situation can lead to political change that can
sometimes be extreme. In the 1930s, this led to Hitler coming to power, a war
in Europe, and depression in the United States. The pressure to do something to
end the depression increases.
Remember, most of what people
thought was money was credit. So, when credit disappears, people don't have
enough money. People are desperate for money, and you remember who can print
money?
The Central Bank can.
Having already lowered its interest rates to nearly zero - it's forced to print money. Unlike cutting spending, debt reduction, and wealth redistribution, printing money is inflationary and stimulative. Inevitably, the central bank prints new money — out of thin air — and uses it to buy financial assets and government bonds. It happened all over the world in the 2008 crisis.
By buying financial assets with this money, it helps drive up asset prices which makes people more creditworthy. However, this only helps those who own financial assets.
You see, the central bank can
print money but it can only buy financial assets.
The Central Government, on
the other hand, can buy goods and services and put money in the hands of the people
but it can't print money. So, to stimulate the economy, the two must cooperate.
By buying government bonds,
the Central Bank essentially lends money to the government, allowing it to run
a deficit and increase spending on goods and services through its stimulus
programs and unemployment benefits. This increases people's income as well as
the government's debt. However, it will lower the economy's total debt burden.
This
is a very risky time. Policymakers need to balance the four ways that debt
burdens come down.
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