OPINION: The world needs to declare bankruptcy
When something is broken, try to fix it. If that doesn’t work, seek a replacement. This wisdom is applicable to the world’s financial system.
Finance wasn’t exactly humming along like a new Tesla even before the coronavirus took a giant bite out of the global economy. It was more like an old jalopy, half-reconditioned after the 2009 financial crisis. Monetary policy wasn’t very effective, and many asset prices defied economic gravity. But at least banks were better capitalised and private debts were not totally out of control.
Take the private sector of the United States, the proud homeland of financial engineering. The ratio of all corporate and household debts to GDP rose fairly steadily from 55% in 1950 to 168.5% in 2007, according to the International Monetary Fund. Post-crisis deleveraging brought the ratio down to 150% in 2018. That was the level in 2004, when many naysayers were accurately, if prematurely, predicting an imminent crisis.
Governments did not go through even that modest post-crisis deleveraging, outside of Germany. For example, French general government debt increased from 65% of GDP in 2007 to 98% in 2018, the IMF calculates. For the UK, the increase over those years was from 42% to 87%.
No one knows how much damage the coronavirus will do to economies, but abundant lending is sure to increase some debt ratios substantially, both for the private sector and for governments. The flood of credit will limit the damage caused by the shutdown of economic activity. It’s the least bad solution to an urgent problem, but it is still a bad solution.
As companies add leverage, most of them are going to become more cautious about taking risks and making investments. Unless student debts are written down, as some American Democratic legislators are proposing, young graduates will be more hesitant to buy houses and start families. On the other side, the ultra-low interest that reduces the borrowers’ pain also frustrates investors. Their thirst for yield can lead to a reckless “dash for trash”, adding unnecessary risk to the financial system.
In short, finance is doing more harm than good. It is supposed to help the economy run smoothly by channelling money to the places where it can do the most economic good. Instead, it is slowing down growth and adding risk.
What should be done to reduce overall leverage levels, allowing policy interest rates to rise enough to keep savers reasonably happy? None of the traditional methods look doable. Standard policy tools cannot easily discourage borrowing without damaging growth. Some economists suggest financial repression, using higher inflation to reduce the ratio of debts to nominal GDP. That sounds unfair and unlikely to succeed.
There is a better way. Think of the global economy as a single company with a balance sheet that is out of kilter with its revenue – that is, with GDP. The next step would be something like a restructuring under Chapter 11 of the US bankruptcy code. The organisation stays in business pretty much as normal while the balance sheet is reconstructed with a more sustainable level of debt.
Political radicals might want a full debt jubilee – write all debts down to zero and start again. Such a total expropriation would be excessive. It would also be counterproductive, since it would undermine business confidence for years.
However, the restructuring needed to get debts to a manageable level would still be severe. For example, cutting America’s private-sector debt ratio to GDP from the 2018 level back to where it was in 1980 would give creditors a 32% haircut overall. For government debt, the comparable reduction would be 63%. Coronavirus debts will push those numbers higher.
Negotiating a recapitalisation of that scale would be a nightmare. Even when a company’s creditors agree that restructuring is needed, they squabble over how to apportion the losses. The fights will be multiplied by a million for a global deal.
The details matter, for justice as much as for efficiency. For example, a 35% principal reduction is probably too small to be fair and helpful to an unemployed cleaner in hock to a payday lender. The same proportional write-down would give the wrong signal to a private equity firm that has borrowed well past the point of prudence. Creditors also vary. A billionaire who becomes a 700-millionaire merits little sympathy, but the frugal teacher does not deserve having her meagre nest egg smashed.
In a mega-Chapter 11, lenders and borrowers would have to compromise. And in this case, central bankers and politicians would need to get involved. That’s a big ask, especially for cross-border debt and especially with today’s national leaders. It’s hard to imagine, say, Chinese leader Xi Jinping and US President Donald Trump agreeing to cut the value of China’s trillion-dollar U.S. government debt portfolio by half, or at all.
Still, global debt restructuring is an idea whose time may yet come. It is too helpful a solution not to be used. Also, the technical challenge is relatively modest, certainly compared to solving problems like climate change. Even politicians can eventually figure out how to adjust enough ledger entries to make the global balance sheet fit the global economy.
Edward Hadas is a former economics editor at Reuters Breakingviews and also worked at the Financial Times as assistant editor of the Lex column. Before becoming a journalist, he worked for 23 years as an equity analyst in Europe and the United States. He has written a book, 'Human Good, Economic Evils: A Moral Approach to the Dismal Science', and is a visiting senior fellow in the School of Management and Social Sciences at St Mary's University, London.