As much as there was a deafening silence on the build-up of private debt, there is a loud cacophony on the build-up of public debt. One can make a pretty good case for stating that the first was the more serious economic problem. The same people who argue that when consumers lend at 6-10-12-14% and go out and shop is good for the economy (even if they buy largely imported goods) have a hard time explaining why it would not be good if the public sector borrowed at the inflation rate and did stuff (education, R&D, infrastructure) that not only increased demand in the short-run, but strengthened the supply side in the long-run. Well, there are of course good reasons to be very careful with running up public debt; it already is very high. Although there doesn't seem to be immediate reasons for worry, as there is a world savings glut, one cannot count on interest rates continuing to be this low forever. Click to enlarge
That is, sooner or later something has to be done about the level of public debt. But why didn't we raise the same alarm flags when the level of private debt was escalating? After all, that has resulted in a crisis, and a rather big one.
Irving Fisher and Steve Keen:
Irving Fisher produced an interesting theory of the 1930s depression in an 1933 paper titled "The Debt-Deflation Theory of Great Depressions." Steve Keen, maverick economist, has an interesting rendition of Fisher's theory. In this theory, he largely blamed over-indebtedness of the private sector as the cause of both the roaring 1920s as well as the Great Depression of the 1930s. When that bubble burst, it led to distressed selling, basically liquidation selling at any price, taking asset prices far lower. That is a great asset price deflation, doing great damage to balance sheets and creating an urgent need to reduce debt. Just as private debt increases had fueled demand for goods and services (and hence economic activity, producing the roaring twenties), debt reduction led to demand destruction and a fall in economic activity: In essence, this links aggregate demand to changes in levels of private debt. When private demand is increasing, aggregate demand boosts the economy and we're experiencing boom times, like in the 1920s. When the private sector is repaying debt, because asset prices have fallen, and has made the levels of private debt unsustainable, the economy falls into a slump. Click to enlarge Applying the same concepts delivers an interesting picture of the last decade: Click to enlarge
Of course, none of this is terribly surprising. People who are familiar with the concept of 'balance sheet recession' will have yawned. But there are some lessons and conclusions to be drawn. 1) Private debt can be as toxic as public debt, perhaps even more so. Consider the example of Ireland and Spain. While some portray the euro zone crisis in terms of excessive public debt, Spain and Ireland were models of fiscal rectitude before the 2008 crisis. Both enjoyed budget surpluses and very low public debt, by international standards.
What they did have was high levels of private debt. Very high levels, as it happens (see table below). 2) Monetary policy should take the levels of private debt into consideration. 3) Let's look at levels of private debt to identify possible other trouble spots: Click to enlarge The list is somewhat surprising. Portugal is to be expected perhaps, but if you look at developments and levels, you see countries like Denmark, The Netherlands, the UK with household debt rapidly rising to levels exceeding their GDP. One might also look at Italy, the country now in the eye of the storm of the euro zone crisis. As it happens, Italy has very modest levels of household debt compared to these countries 4) There is, at least in principle, a case to be made for public expenditure (or better, public investment) as long as shedding of debt of the private sector keeps being a drag on the economy.
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