Christopher Worthington: Role of debt overstated in finance crisis

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Opinion

It was always rare to hear a good word for debt, but in the wake of the credit crisis the call for "deleveraging" has reached a religious fervour. But debt is not the smoking gun in the credit crisis as is commonly imagined, and it is unlikely that the future will bring much if anything in the way of deleveraging.

Myth 1: Excessive debt caused the credit crisis.

The popular conception of the credit crisis goes something like this. The American economy had been fuelled by debt for nigh on 20 years, until the credit crisis revealed it all to be a house of cards. From now on there will be years of feeble growth as Americans try and escape their debt burden.

In reality, economies don't work like that. Debt is not some magic economic fairy dust. One person's debt is just someone else's asset; an exchange of consumption now for consumption later. Rising and falling debt levels don't necessarily have any implications for the economy. And any argument that some group or nation needs to save more is equivalently the claim that some other group or nation needs to save less and borrow more.

A sudden change in savings patterns can cause economic problems. Keynes' famous "paradox of thrift" is when everyone tries to save at once and the end result is a recession. Most recessions are accompanied by increases in the saving rate, although cause and effect are hard to disentangle. But this does not suggest that "excessive" debt caused the recent credit crisis or that it bodes unfavourably for the future.

So what did cause the credit crisis? The best explanation that we have so far is that it was modern version of a bank run, which is when all depositors show up and demand their money back at once.

However, this bank run took place in the repo market that banks and other large financial institutions use to borrow from each other, rather than in the traditional deposits market. This novel aspect bamboozled the efforts of central banks to provide temporary liquidity and restore calm, as they would normally during a bank run.

Of course, we still need an explanation for why the run occurred. Here, at least, one could claim that debt was the trigger, specifically in the sub-prime mortgage market. Sub-prime lending was suffering from fraud and had boomed beyond prudent lending practices. But it was only a trigger, not the cause. The losses from sub-prime lending were tiny compared to the losses to come as the financial system collapsed.

The problem was that the crappy sub-prime loans were rolled up into complex securities like CDOs, that were in turn used as collateral in the repo markets. The complex structures meant that it was impossible to tell who held the dodgy loans, and as a result all lending came to a standstill, setting off the crisis.

So was excessive financial leverage to blame? Only in the loosest sense that banks would have had a better chance of surviving the crisis if they'd maintained an adequate capital buffer. But that buffer has real costs (both to the banks and society), and prior to the crisis, government regulators were happy with bank capital requirements.

Myth 2: households and governments need to deleverage in the wake of the credit crisis.

What is there to the claim that post-crisis, households and governments need to reduce debt? It's often noted that total US debt has risen from 160 per cent to 360 per cent of GDP over the past 20 years. It has, but Americans' household debt-servicing burden, as a share of their disposable income, has risen by a marginal 1 per cent of disposable income. Americans are not suffering from crushing usury.

Doesn't the recent Greek crisis show that at least governments need to deleverage? No - Greece's problems are a product of its fixed currency regime. In fact, the big governments of the world (US, Japan, Germany) face historically low interest rates on their debt, despite the fact that outstanding debt is growing rapidly. Lenders cannot get enough of government debt at the moment, and bond yields have shrunk (US 10-year debt pays 2.6 per cent per annum).

The deleveraging story may be completely back to front. The problem is not too much debt, but not enough of the good stuff. The crisis and aftermath are both consistent with the notion that the demand for risk-free bonds is growing faster than supply.

That growing demand was another potential cause of the credit crisis. It led to a large market for newly-created "safe" assets - the CDOs that were manufactured to turn sub-prime mortgages into (supposedly) AAA bonds.

So we come to the final piece of the puzzle: why is there so much demand for safe assets? The first reason is that developed economy assets are very attractive to developing countries like China with weaker social safety-nets, and oil-producing countries looking to sock away the windfalls from high oil prices.

The second reason, and perhaps the strongest argument against the idea of deleveraging, is the ageing of developed world populations. If the baby boomer generation is to maintain a high standard of living in retirement, despite a higher ratio of retirees to workers, then they must build a large claim over future workers' earnings. In other words, they must keep lending to younger workers and allow them to build up their debt.

A world where, instead, debt ratios fall for the next 20 years, is one where the baby boomers either work until they're carted away or eke out their retirement on arrowroot biscuits in Bluff.

* Christopher Worthington is the senior economist at Gareth Morgan Investments.