U.S. President Barack Obama speaks during a press conference in the East Room of the White House in Washington, DC, Thursday. Obama warned Europe's woes could have a “very real” impact on the U.S. economy and said it was therefore even more important that Congress pass his $447 billion jobs bill. / AFP-Yonhap

Governments, central banks urged to speed up efforts to write off debts

By Boston Consulting Group

It seemed that the recovery was well on its way, but recent turbulence in global financial markets came as a surprise. After the signing of the debt deal on August 2, the S&P 500 has lost all its gains for the year. Does this mean we are at the brink of a global double-dip recession? A deeper look at the facts finally reveals that governments have been indecisive and playing for time _ kicking the can down the road, rather than addressing the root causes of the crisis.

The U.S.: worse than expected and no end in sight

The recession in the U.S. in 2008 and 2009 was the deepest since the Second World War and, as recent data show, it was much worse than previously understood. The U.S. has still not managed to return to its pre-crisis level of GDP, and unemployment remains high while new job creation continues to disappoint. The Federal Reserve’s announcement, that it would maintain very low interest levels until 2013, underscores how concerned it is about the economic prospects.

The U.S. is in the middle of a balance sheet recession that shows alarming similarities to Japan’s situation in the 1990s. In some important respects, the U.S. is in a better position than Japan was, but in other important respects, the U.S. position is even worse.

Japan benefited from high domestic savings and from strong exports. However, the U.S. still runs a trade deficit and relies on foreign capital, which will be less inclined to finance continued huge deficits. Moreover, in the U.S., the already fragile level of consumption is under further pressure since consumers are trying to pay down their often crippling levels of debt.

Europe: North versus South

The debt crisis in Europe is far from being solved and looks set to be a drag on growth for many years.

The financial and economic crisis is amplified by the structural limitations of the single-currency area in Europe. The euro zone is not an optimal currency area: it lacks sufficient practical labor-market mobility, coordinated economic policies, and fiscal transfers. In the current crisis, the currency union limits the ability of governments to react.

For example, Spain and the U.K both experienced a significant real-estate bubble, and their total debt loads are similar. Yet the interest rates on government debt and the price for credit insurance are much lower in the U.K. than in Spain.

This is possible because the U.K. could devalue its own currency, it could pursue an inflationary policy, and it can print its own money.

The euro zone will be able to survive only with much closer economic cooperation, fiscal transfers, and at least a partial “socialization” of government debts in the form of a euro bond. In addition, higher inflation rates are needed to support the adjustment process between countries to restore competitiveness.

Global Imbalances

It is widely agreed that global trade imbalances, notably between China and the U.S. (and, to a lesser degree, Europe) and between Germany and some countries in the euro zone (such as Spain, Portugal, and Greece) have contributed to the crisis. This is because current-account deficits can be financed only by increased indebtedness ― and increased indebtedness needs to be paid for, so interest burdens serve to increase the required levels of primary current-account surpluses.

Asian economies, notably China, are responsible for the fact that “water continues to flow uphill” ― emerging markets export capital (the Institute of International Finance estimates $395 billion in 2011) instead of absorbing savings. Without a rebalancing, it will not be possible for highly indebted countries to reduce their debt levels.

Too much debt

In the run-up to the crisis, the debt load of governments, nonfinancial companies, and private households rose to unprecedented levels. Between 2000 and 2007, U.S. debt grew from $18 trillion (183 percent of GDP) to $32 trillion (225 percent of GDP), while in Europe, debt grew from 14 trillion euro to 20 trillion euro (227 percent of GDP). Since the start of the financial crisis, overall debt loads have continued to rise, mainly driven by governments and central banks trying to postpone the inevitable.

The financial-repression solution

In theory, there are four ways to reduce the debt load: grow out of debt, save and pay back (“deleveraging”), write off and restructure the debt, or inflate it away. However, inflation is hard to control once started ― rather like trying to control the flow of ketchup after shaking the bottle.

There is a “softer” version of the inflation solution called "financial repression," which refers to the approach taken by the U.S. and the U.K. to lowering their debt burdens after World War II. Legislation forced investors to invest in lower-yielding government bonds (“risk-free assets”).

With the nominal growth rate of the economy higher than the interest rate on the government debt, the debt-to-GDP ratio came down significantly, on average by 3 to 4 percent of GDP per year. Recent regulation of banks and insurance companies ― Basel III and Solvency II ― goes in the same direction.

When will we see a Plan B?

We believe that it would be preferable to stop the vicious circle of too much debt leading to more debt by executing a program of structured workouts and write-offs. Creditors would need to accept that they have lost a sizable portion of their money. The longer the day of reckoning is postponed, the more money will be lost.

And since the prospect of reduced pensions, negative returns on savings, and outright default would not be popular, we believe that governments and central banks are most likely to resort (eventually) to a policy of aggressive financial repression: that is, high inflation.

The preconditions for high inflation are there. Rewinding its expansive monetary policy may well prove much more difficult than expected. Given the intervention of the Fed since 2008, the potential for inflation in the U.S. is extremely high.

If interest rates are high, people tend to hold low cash reserves, preferring to invest in interest-bearing assets. On the other hand, in a low-interest environment, the public is willing to hold much more cash. In order to create no inflation, any increase in interest rates ― for example, due to investors being insecure about future inflation and/or the ability and willingness of the U.S. to serve its debt ― needs to be accompanied by a reduction in the monetary base. This means that the Fed would have to reduce its balance sheet by the appropriate amount by selling assets that it bought during the crisis.

It is obvious that time and doing nothing cannot solve the problem ― it just grows bigger. The longer we postpone the necessary write-off of debt, the more volatility we will see and the more intervention by governments. It will be very hard to stabilize economies and organize a soft landing. The final outcome, the devaluation of debt, can be postponed but is unlikely to be avoided. Financial markets will start to realize that governments and central banks are running out of ammunition.

This report was provided by The Boston Consulting Group.