Greece Is Not Alone: Understanding the Deleveraging Process

Tuesday, July 28, 2015

Brian Tall – Director of Investments

Beyond Greece

On July 1, 2015 Greece earned the dubious honor of becoming the first advanced economy ever to fall into arrears on a loan payment owed to the International Monetary Fund. For Greece—the birthplace of western civilization—to find itself on any list that includes the likes of Sudan, Somalia, Sierra Leone, and Afghanistan is truly cringe-worthy.

But Greece is not entirely alone. In the wake of the 2008 global financial crisis, much of the developed world, including the United States, is flirting with over-indebtedness. Rather than recount the details that led to Greece’s current financial state (which involves a lot of finger pointing), we believe there is greater importance in educating our readers on the various policy tools highly indebted countries have at their disposal in repairing their balance sheets—a process called deleveraging—where the aim for a country is to reduce its debt-to-GDP ratio.

The importance of understanding the deleveraging process cannot be overstated as it will be a recurring theme for many years to come, both economically and politically, in the U.S. and abroad. More specifically, it is important to understand how the deleveraging process involves both fiscal policy (i.e. government spending and taxation) and monetary policy (i.e. interest rates and money supply); and furthermore, it is important to understand how implementing these policy tools involves trade-offs with both economic and social implications.

History suggests that it is possible for highly indebted countries to successfully manage the deleveraging process, but ultimately, many do not. When managed well, coordinated policy actions will result in positive economic growth, stable inflation, healthy levels of unemployment, orderly adjustments to production-consumption balances, and gradually declining debt burdens—essentially, people go on living their lives without experiencing noticeable lifestyle changes. When managed poorly, countries typically experience a significant decline in economic output, double-digit unemployment, and an abrupt and permanent loss in living standards, which often leads to rioting, rationing, and total chaos. Needless to say, the stakes are high (the curious types should Google Image search: “Greece Rioting” and “Greece Bank Run”).

Policy Tools of Deleveraging

When a country’s debt burden becomes too onerous to service (or it can be seen in advance that it will become too onerous), it must enact policies to deleverage its balance sheet. The policy tools a country can employ to reduce its debt-to-GDP ratio are relatively few and are actually quite simple to understand. However, this does not mean the policy tools are easy to implement effectively and in a way that produces the desired outcome. Before explaining the challenges involved in the deleveraging process, let us first provide an overview of the policy tools:

Austerity Measures (via fiscal policy) are employed when governments slash spending and attempt to increase tax revenue in an effort to operate on a balanced budget. Examples of austerity measures include:

    • Government hiring freezes and/or layoffs of government workers
    • Pay freezes and benefit reductions for government workers
    • Reductions in government services and social programs
    • Government pension and/or social security reform (e.g. changing the age of full retirement, freezing cost of living adjustments)
    • Cancellations or suspensions of planned development and infrastructure projects
    • Increased taxes on the wealthy, or alternatively, reduced tax breaks (which generally favor the wealthy)
    • Note: tax policy remains a controversial topic. Republicans hold that lower marginal tax rates increase economic activity, which in turn increases total tax revenue. Democrats hold that redistributing wealth from higher to lower earners via tax policy will increase economic activity because the former have a higher propensity to save than the latter—in other words, they hold that putting money into the hands of those more likely to spend it increases economic activity, which in turn increases total tax revenue. All viewpoints aside, austerity measures tend to go in the direction of higher marginal tax rates, not lower.

Debt monetization (via monetary policy) occurs when central banks (e.g. Federal Reserve, European Central Bank) drive interest rates lower and ease lending standards in order to boost economic activity (to monetize debt, central banks will intentionally keep nominal interest rates below the nominal rate of economic growth).

    • Central banks drive interest rates lower by purchasing large amounts of debt securities from investors in the open market thereby flooding the financial system with liquidity—a monetary policy tool called quantitative easing.
    • Central banks spur economic growth by lending money to institutions against a wider range of collateral (e.g. central banks may accept lower quality collateral to secure loans).
    • A secondary effect of easy monetary policy is currency devaluation, which can also spur growth as domestic products become more competitive relative to foreign products (whereby increasing demand for U.S. products can result in production increases, which in turn results in job creation).
    • Note: central banks regularly purchase debt securities in the open market in the normal course of business. To suggest that a central bank is monetizing its country’s debt, one should first establish that it is their intent to do so (based on underlying economic circumstances) and that the policy measures are extraordinary relative to “normal” operations.

Debt restructuring is a process that allows a sovereign entity facing cash flow problems to renegotiate the terms of its outstanding debt. Negotiations generally result in creditors accepting write-downs on the value of their loans (i.e. “haircuts”) along with reduced interest rates and extended maturities on the renegotiated principal amount. Essentially, the restructuring must result in the debtor country being able to service its new debt payments (using realistic assumptions of economic growth and tax collections).

Unintended Consequences

While the policy tools a country can employ to reduce its debt-to-GDP ratios are relatively few and straightforward, they are extremely difficult to implement in a way that maximizes outcomes while mitigating unintended consequences. Let us explain:

First, it is important to establish that one person’s spending is another person’s income and that one person’s debt is another person’s asset. Thus, when governments slash spending and increase taxes, they are reducing many people’s income; and when they restructure or monetize debt, they are reducing investor’s wealth (by asking them to assume explicit losses in the case of restructuring or by forcing implicit losses upon them in the case of monetization and currency devaluation).

Second, let us point out that debt-to-GDP ratios can decline in one of two ways: (1) a government can implement policies that focus on reducing the numerator (i.e. debt), or (2) a government can implement policies that attempt to increase the denominator (i.e. economic growth).

Of course, when a country’s debt burden becomes too large, the seemingly obvious thing for a government to do is to focus on eliminating deficit spending by implementing austerity measures (i.e. they focus on reducing the numerator). But when harsh austerity measures are implemented too soon (i.e. before the economy transitions into a self-sustaining recovery), spending cuts and tax increases can turn an ordinary recession into a self-reinforcing depression. This can occur not just because the first wave of laid-off employees have less money to spend (thus reducing economic activity), but also because people who fear being laid off in the future will spend less money as well (thus creating the conditions that are likely to necessitate additional layoffs, thereby setting in motion a self-reinforcing feedback loop).

If not timed correctly, harsh austerity measures will result in economic growth (i.e. the denominator) falling at a steeper pace than debt (i.e. the numerator), which will ultimately lead to a higher debt-to-GDP ratio, not lower. Hence, it is important to understand the degree to which policy tools can impact both the numerator and the denominator in the debt equation—a nuance that remains underappreciated by many politicians (who do not always have the foresight to think beyond the first order effects of their policies).

While many more examples of unintended consequences exist, this particular one aptly demonstrates that policy tools must be carefully timed and well-coordinated in order to achieve the intended outcome.

Achieving Balance

Each of the policy tools discussed can potentially reduce debt-to-GDP ratios in isolation, but not likely without causing significant damage to a country, both economically and socially. The best outcomes—those that do not involve a loss in living standards—are achieved by the governments that can strike an economically optimal and socially fair balance between spending cuts, tax hikes, debt monetization, and if necessary, debt restructuring. Hence, the dilemma is twofold:

From an economic standpoint, austerity measures and debt restructurings are both deflationary and economically depressing; whereas debt monetization is inflationary and economically stimulating. Governments in need of balance sheet repair must implement the proper “doses” of each policy tool at the appropriate time such that deflationary policies are offset by inflationary policies (and vice versa) throughout the various stages of the recovery process. This is typically accomplished with a country’s central bank flooding the banking system with liquidity in the early stages of a crisis (such that the inflationary pressures of increased money supply counteract the deflationary pressures typical of a recession), followed by gradually implementing austerity measures once it becomes evident that the economy has transitioned to a self-sustaining recovery (such that the inflationary measures of easy monetary policy are now offset by the deflationary pressures of spending cuts and higher taxes). When policy tools are implemented too late (e.g. United States, 1930’s) or too early (e.g. Greece, 2010’s), countries can be catapulted into a severe economic depression.

On the matter of fairness, we must point out that debt is always resolved in one way or another. Either the obligor makes contracted debt payments as expected or there will be an equivalent payment absorbed by creditors in the form of losses and write-downs if payments are missed. Moreover, we must point out that all the costs associated with servicing and paying down debt are ultimately assigned to different groups of stakeholders. These include workers and ordinary households, small and medium-sized companies, large companies and multinationals, wealthy households, retirees, etc. When determining the appropriate mix of policy tools, a government is essentially assigning costs to these different groups. Spending cuts tend to impact lower income earners, tax hikes will impact higher income earners, and debt monetization will impact households with accumulated savings in financial assets.

Ultimately, the deleveraging process boils down to two questions: (1) what mix of policy tools will lead to the intended goal of restoring a sustainable debt-to-GDP ratio, and (2) assuming that multiple combinations of policy tools will lead to a reduced debt-to-GDP ratio, which is the most “fair” to all stakeholders (i.e. high and low earners, savers and retirees, and businesses of all sizes and domicile)?

Adopting a Pragmatic Viewpoint

We decided not to focus our quarterly update on the details specific to Greece’s current financial debacle in order to discuss, in a more general sense, how deleveragings work. As mentioned, this will be a recurring theme for many years to come. The fact of the matter is many developed countries around the world find themselves at the crossroads of having to make difficult policy decisions that carry both economic and social consequences. It goes without saying that nobody likes paying taxes and everyone would like to earn more interest on their savings. But as the U.S. looks to reduce its debt burden over what is likely to be the next couple decades, everyone is going to have to chip in to some extent; and whatever regimes are voted into office throughout the deleveraging process will be tasked with assigning debt servicing costs to different stakeholders through their views on fiscal and monetary policy. In the aftermath of the global financial crises, these costs have been assigned to low-income earners in the form of stagnant wages, to high earners through increased tax rates, and to savers with accumulated wealth via low interest rates. The fact that every segment of the population seemingly has something to complain about (e.g. stagnant wages, high taxes, and low interest rates) suggests that the government has perhaps struck a reasonable balance (at least for the time being).

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