With recent data showing that German exports fell 5.8% from July to August, and that industrial production shrank by 4%, it has become clear that the country’s unsustainable credit-fueled expansion is ending. But frugal Germans typically do not see it that way. After all, German household and company debt has fallen as a share of GDP for 15 years, and public debt, too, is now on a downward path. “What credit-fueled expansion?” they might ask.
The answer lies in the reality of our interconnected global economy, which for decades has depended on unsustainable credit growth and now faces a severe debt overhang. Before the 2008 financial crisis hit, the ratio of private credit to GDP grew rapidly in many advanced economies – including the United States, the United Kingdom, and Spain. Those countries also ran current-account deficits, providing the demand that allowed China and Germany to enjoy export-led expansion.
Credit-driven growth enabled some countries to pay down public debt. The ratio of Irish and Spanish public debt to GDP, to cite two examples, fell significantly. But the overall advanced-economy debt/GDP ratio, including public and private debt, grew from 208% in 2001 to 236% by 2008. And total global debt rose from 162% of world GDP to 175%.
Credit growth fueled asset-price increases and further credit growth, in a self-reinforcing cycle that persisted until the bubble burst and confidence collapsed. Faced with falling asset prices, households and companies then attempted to deleverage. The ratio of household debt to GDP in the US has indeed fallen – by 15% since 2009. But the debt did not go away; it simply moved from the private sector to the public sector.
Private deleveraging depressed the economy as households cut consumption and businesses cut investment. Tax revenues fell and social expenditures rose. Fiscal deficits therefore soared. As a result, for every percentage reduction in private debt, the ratio of public debt to GDP rose by a greater amount.
This was a repeat of Japan’s experience over the last 25 years. After the country’s 1980s credit boom went bust, large fiscal deficits were essential to prevent a severe depression. But the inevitable consequence was that, while Japanese companies slowly deleveraged, public debt rose to 245% of GDP.
Leverage shifted not only from private to public sectors, but also among countries. From 2002 to 2008, China’s total debt/GDP ratio was relatively stable and below 150%. It is now around 250%. This was the deliberately chosen policy response to deleveraging in advanced economies.
Fearing that post-crisis recession in advanced economies would produce a socially dangerous decline in Chinese employment, the government instructed its banks to open the credit floodgates, triggering an infrastructure and housing-construction boom. Commodity and capital goods producers – such as Germany – benefited from credit-driven demand.
Household and company debt grew rapidly in many other emerging markets as well. Overall emerging-market debt has grown from 114% to 151% of GDP, and total global leverage is 37% higher than it was in 2008. As the recent 16th Geneva Report on the Global Economy puts it, “Deleveraging? What deleveraging?”
Today’s total debt level seems both unsustainable and impossible to reduce without depressing the economy. Eurozone rules demand fiscal consolidation, but the result is slow growth, which makes deleveraging even more difficult. Likewise, Japan raised its consumption tax in April to cut the fiscal deficit, but the increase has tipped the economy into recession.
China now faces the dilemma that arises in the late stage of any credit boom. Faced with falling property prices and credit growth, should it accept a hard landing as inevitable, or keep the boom going, which would undoubtedly lead to bigger problems later? Whatever its choice, growth will slow significantly, and inflation already is well below the central bank’s 4% target.
Slower growth in major markets in turn depresses Germany, until recently, the eurozone economy’s only strong motor. And simultaneous slowdowns in Japan, China, and the eurozone threaten to slow the US and UK recoveries. With global growth anemic and inflationary expectations falling, further growth in debt looks unsustainable. And yet total global leverage continues to rise.
This poses two questions to which orthodox economics and conventional policy have provided an inadequate response. First, how can we ensure that economies grow without rapid private credit growth, which leads to crisis and a debt overhang? Second – and the crucial issue today – how can we escape the debt trap in which past credit growth has left us?
As the International Monetary Fund’s latest Global Financial Stability Report warns, relying solely on ultra-easy monetary policy is dangerous. It encourages excessive financial risk-taking, increases inequality, and can work only by regenerating the rapid private credit growth that got us into this mess in the first place.
Relying on competitive exchange rates, meanwhile, is collectively impossible. The Bank of Japan considers a weak yen crucial to its quantitative easing strategy. The European Central Bank hopes that negative interest rates will help drive the euro down. And in China, economists are discussing the merits of a lower renminbi to offset the impact of a cooling property market.
But the whole world cannot devalue against other planets. If all countries except the US devalue, the US economy will face the deflationary impact of their attempted deleveraging.
We need to stimulate growth and increase inflation without generating higher private or public leverage. The only way to do that is to run increased fiscal deficits, permanently financed by central-bank money. Otherwise, the world will either become mired in deflation and slow growth, or will need to accept further increases in leverage – thereby simply postponing the problem and making it still more intractable. The end of Germany’s credit-fueled expansion has now made that choice clear.
Published in collaboration with Project Syndicate
Author: Adair Turner, a former chairman of the United Kingdom’s Financial Services Authority and former member of the UK’s Financial Policy Committee, is Senior Fellow at the Institute for New Economic Thinking and at the Center for Financial Studies in Frankfurt.
Image: A man walks past buildings at the central business district of Singapore February 14, 2007. REUTERS/Nicky Loh