Rolf Englund IntCom internetional
Excessive debt is the key to this crisis
We are living through the painful end of an age of leverage which saw total private and public debt in the US rise from about 155 per cent of gross domestic product in the early 1980s to something like 342 per cent by the middle of this year
The writer is a professor at Harvard University and Harvard Business School, a fellow of Jesus College, Oxford, and a senior fellow of the Hoover Institution, Stanford
Excessive debt is the key to this crisis; it is the reason we are confronting no ordinary recession, curable by a simple downward adjustment of interest rates. It is the reason we still have to fear, if not a second Great Depression, then very likely the biggest recession since the 1930s.
With average household debt rising from about 75 per cent of annual disposable income in 1990 to very nearly 130 per cent on the eve of the crisis, a large proportion of American families are submerging under the weight of their accumulated borrowings.
Looking back, we now see just how big a proportion of US growth since 2001 was financed by mortgage equity withdrawals. Without that as a means of financing consumption, the economy would barely have grown at 1 per cent a year under President George W. Bush.
The financial sector’s debts grew even faster as banks sought to bolster their returns on equity by “levering up”. According to one recent estimate, the total leverage ratios (on- and off-book assets and exposure divided by tangible equity) for the two biggest US banks were 88:1 for Citibank and 134:1 for Bank of America.
What makes this crisis of burning interest to financial historians is the knowledge that we are witnessing a real-time experiment with not one but two theories about the Depression.
On one side, Ben Bernanke, Fed chairman, is applying the lesson of Milton Friedman’s and Anna Schwartz’s A Monetary History of the United States, which argued that the Depression was in large measure the fault of the central bank for failing to inject liquidity into an imploding financial system. Mr Bernanke has not merely slashed the federal funds rate to below 0.25 per cent. He has lent freely to the banks against undisclosed but probably toxic collateral. Now he is buying securities in the open market.
On the other side, Mr Paulson has emerged as an unwitting disciple of Keynes, running a huge government deficit in an effort not merely to bail out the financial sector but also to provide a public sector substitute for sharply falling private sector consumption.
Once, monetarism and Keynesianism were considered mutually exclusive economic theories. So severe is this crisis that governments all over the world are trying both simultaneously.
For the time being, the distress-driven demand for dollars and risk-free assets is pushing down the cost of all this borrowing. Treasury yields are at historic lows. But it is not without significance that the cost of insuring against a US government default has risen 25-fold in little over a year. At some point, with most big economies adopting the same fiscal policy, global bond markets are going to start choking.
Is it really plausible that the cure for excessive leverage in the private sector is excessive leverage in the public sector?
Noted historian Niall Ferguson warns that a geopolitical shock, such as a wider Mideast conflict, could dry up financial liquidity and shut global stock exchanges, as happened at the start of World War I.