Benjamin Franklin, one of the founding fathers of the United States, said «Rather go to bed without dinner than to rise in debt». Some economists seem to have taken good note of this and are in favour of reducing the high level of debt in numerous countries. They believe that excessive debt is a source of crisis and hinders the chances of recovery, so that reducing it is a prerequisite to establishing the basis for sustainable growth in the long term. Other economists believe that this advice, although perhaps pertinent at an individual level, could be counterproductive at a collective level under certain circumstances. If the situation is one of insufficient demand, high unemployment and deflationary pressure, prioritising deleveraging merely makes a crisis worse. Logically, the economic policies recommended by both groups differ quite widely.
To examine how to tackle recession and recovery in an environment of high debt, we should first present the basic framework accepted by most economists regarding the relationship between crisis, debt and economic policy. In this relationship, financial variables (such as credit) generally move in the same direction as real economic variables (such as GDP and employment). Specifically, when the situation and outlook for activity and employment improve, there is an increase both in the debt capacity of agents and in the availability of financing. In other words, the cycles are synchronous. The problem is that, on some occasions and for various reasons, financial variables move much more sharply than economic variables. In fact, it is not unusual for financial booms characterised by a sharp rise in the level of debt to be decoupled from the economic or business cycle. This situation usually results in significant cost: it can lead to a financial bust which, in turn, pushes the country towards economic recession.
This scenario of decoupling between financial and real variables is not unrelated to the economic policies adopted by a country as these can encourage excessive debt that would affect macroeconomic stability. This is the case of monetary policy which has traditionally focused on moderating the cycle of real economic variables without paying enough attention to the effect on financial variables. A monetary regime that focuses exclusively on controlling inflation in the medium term could be too accommodative in financial terms in a scenario of low economic volatility, significant growth and moderate inflation, as happened between the middle of the 1980s and 2007 (unsurprisingly known as the «the Great Moderation»). By way of example, after the dot.com bubble burst in 2000, the Federal Reserve (Fed) decided to cut the official interest rate to counteract losses in the stock markets and the economic slowdown. Interest rates fell quickly and then remained low until 2004 (see the first graph). The success attributed to the Fed's strategy at that time, given the country's fast exit of the economic crisis, did not take long to be questioned. Economists such as Raghuran Rajan and the Bank for International Settlements (BIS) have been highly critical.1 In their opinion, the Fed's monetary expansion continued to fuel US debt and pushed up real estate prices which then collapsed years later, turning the financial crisis starting at the end of 2007 with subprime mortgages into the Great Recession, whose effects are still being felt today.
Today critics believe there is once again cause for concern claiming that the ultra-expansionary monetary measures, both conventional and unconventional, carried out by most developed economies have added even more fuel to the fire of debt. The BIS, for example, argues that, although it was initially a good idea to handle the crisis decisively in order to avoid financial collapse, in a second phase efforts should have been (and should be) aimed at sorting out the balance sheets of highly indebted economic agents instead of continuing with additional expansionary measures.2 The BIS's analysis concludes that many of these measures (such as monetary) have not only lost a large proportion of their capacity to stimulate the economy but are also pushing up the level of debt and reducing incentives to implement the structural reforms which are crucial to achieve sustainable economic growth in the long term.
At the other end of the scale, economists such as Nobel prize-winner Paul Krugman and Larry Summers, among others, support measures such as quantitative easing by central banks and other, rather unconventional expansionary policies such as the direct financing of public expenditure by the central bank. They argue that such policies have played a fundamental role and prevented an even worse situation given the exceptional crisis. Moreover, opposing those who believe that US monetary policy was already too accommodative before the crisis erupted in 2007, they claim that, if this had been the case, we would have seen inflationary tensions. Certainly growth in the consumer price index was moderate during the pre-crisis period. However, other prices not included in the basket of goods, such as housing, underwent sharp increases in the US economy (see the second graph).3 These economists also add that we cannot ignore the fact that today's high level of debt actually restricts the economic measures that are feasible. For example, an excessively fast rise in interest rates could harm the already deteriorated public finances of many countries by increasing financing costs and slowing down growth and tax revenue. It might also push up the NPL ratio within a context of heavy private borrowing, once again putting pressure on the financial sector.
In spite of the many disagreements between one point of view and the other, both acknowledge that macroprudential policy will play a vital role over the coming years. Although the BIS economists are in favour of normalising monetary policy as soon as possible, they admit the process must be gradual. All the evidence therefore points to interest rates remaining low for a long time in the main developed countries. In this scenario, further pressure on some asset prices is very likely. Should this happen, macroprudential policy could be more accurately aimed at the imbalance it is attempting to correct. Specifically, if the aim is to counteract a bubble in a certain type of asset (equity or high-yield bonds) by raising the reference interest rate (the monetary policy tool par excellence), this would affect the whole economy while macroprudential policy attempts to affect only the asset with symptoms of overheating in order to deflate it, for example by limiting the level of risk banks can take on with such assets.
In short, there is no consensus regarding how an economic crisis should be tackled in an environment of high debt. While some criticise the use of ultra-expansionary policies, claiming they are sowing the seeds for the next recession, others see them as the only way to support an anaemic economy. This is a fundamental debate and, whatever the measures employed, they must not fall too wide of the mark, given the fragility of the recovery.
Macroeconomics Unit, Strategic Planning and Research Department, CaixaBank
1. See Claudio Borio (2012), «Financial cycle and macroeconomics: what have we learnt», BIS paper #395.
2. BIS 84th Annual Report, June 2014.
3. The consumer price index contains one housing component based on the cost of rented accommodation but not house prices, so it does not reflect sharp rises or falls in these prices.