Mark Carney: Growth in the age of deleveraging
Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the
Financial Stability Board, to the Empire Club of Canada/Canadian Club of Toronto, Toronto,
Ontario, 12 December 2011.
* * *
Introduction
These are trying times.
In our largest trading partner, households are undergoing a long process of balance-sheet
repair. Partly as a consequence, American demand for Canadian exports is $30 billion lower
than normal.
In Europe, a renewed crisis is underway. An increasing number of countries are being forced
to pay unsustainable rates on their borrowings. With a vicious deleveraging process taking
hold in its banking sector, the euro area is sinking into recession. Given ties of trade, finance
and confidence, the rest of the world is beginning to feel the effects.
Most fundamentally, current events mark a rupture. Advanced economies have steadily
increased leverage for decades. That era is now decisively over. The direction may be clear,
but the magnitude and abruptness of the process are not. It could be long and orderly or it
could be sharp and chaotic. How we manage it will do much to determine our relative
prosperity.
This is my subject today: how Canada can grow in this environment of global deleveraging.
How we got here: the debt super cycle
First, it is important to get a sense of the scale of the challenge.
Accumulating the mountain of debt now weighing on advanced economies has been the
work of a generation. Across G-7 countries, total non-financial debt has doubled since 1980
to 300 per cent of GDP. Global public debt to global GDP is almost at 80 per cent, equivalent
to levels that have historically been associated with widespread sovereign defaults.1
The debt super cycle has manifested itself in different ways in different countries. In Japan
and Italy, for example, increases in government borrowing have led the way. In the United
States and United Kingdom, increases in household debt have been more significant, at least
until recently. For the most part, increases in non-financial corporate debt have been modest
to negative over the past thirty years.
In general, the more that households and governments drive leverage, the less the
productive capacity of the economy expands, and, the less sustainable the overall debt
burden ultimately is.
Another general lesson is that excessive private debts usually end up in the public sector one
way or another. Private defaults often mean public rescues of banking sectors; recessions
fed by deleveraging usually prompt expansionary fiscal policies. This means that the public
debt of most advanced economies can be expected to rise above the 90 per cent threshold
historically associated with slower economic growth.2
The cases of Europe and the United States are instructive.
Today, American aggregate non-financial debt is at levels similar to those last seen in the
midst of the Great Depression. At 250 per cent of GDP, that debt burden is equivalent to
almost US$120,000 for every American (Chart 1).3
Several factors drove a massive increase in American household leverage. Demographics
have played a role, with the shape of the debt cycle tracking the progression of baby
boomers through the workforce.
The stagnation of middle-class real wages (itself the product of technology and globalisation)
meant households had to borrow if they wanted to maintain consumption growth.4
Financial innovation made it easier to do so. And the ready supply of foreign capital from the
global savings glut made it cheaper.
Most importantly, complacency among individuals and institutions, fed by a long period of
macroeconomic stability and rising asset prices, made this remorseless borrowing seem
sensible.
From an aggregate perspective, the euro area's debt metrics do not look as daunting. Its
aggregate public debt burden is lower than that of the United States and Japan. The euro
area's current account with the rest of the world is roughly balanced, as it has been for some
time. But these aggregate measures mask large internal imbalances. As so often with debt,
distribution matters (Chart 2).
Europe's problems are partly a product of the initial success of the single currency. After its
launch, cross-border lending exploded. Easy money fed booms, which flattered government
fiscal positions and supported bank balance sheets.
Over time, competitiveness eroded. Euro-wide price stability masked large differences in
national inflation rates. Unit labour costs in peripheral countries shot up relative to the core
economies, particularly Germany. The resulting deterioration in competitiveness has made
the continuation of past trends unsustainable (Chart 3). Growth models across Europe must
radically change.
It's the balance of payments, stupid!
For years, central bankers have talked of surplus and deficit countries, of creditors and
debtors. We were usually ignored. Indeed, during a boom, the debtor economy usually feels
more vibrant and robust than its creditors. In an era of freely flowing capital, some even
thought current account deficits did not matter, particularly if they were the product of private
choices rather than public profligacy.
When the leverage cycle turns, the meaning and implications of these labels become
tangible. Creditors examine more closely how their loans were spent. Foreign financing
constraints suddenly bind. And to repay, debtors must quickly restore competitiveness.5
Financial globalisation has provided even greater scope for external imbalances to build
(Chart 4). And its continuation could permit larger debt burdens to persist for longer than
historically was the case. However, experience teaches that sustained large cross-border
flows usually presage liquidity crunches.6
The global Minsky moment has arrived
Debt tolerance has decisively turned. The initially well-founded optimism that launched the
decades-long credit boom has given way to a belated pessimism that seeks to reverse it.
Excesses of leverage are dangerous, in part because debt is a particularly inflexible form of
financing. Unlike equity, it is unforgiving of miscalculations or shocks. It must be repaid on
time and in full.
While debt can fuel asset bubbles, it endures long after they have popped. It has to be rolled
over, although markets are not always there. It can be spun into webs within the financial
sector, to be unravelled during panics by their thinnest threads. In short, the central
relationship between debt and financial stability means that too much of the former can result
abruptly in too little of the latter.
Hard experience has made it clear that financial markets are inherently subject to cycles of
boom and bust and cannot always be relied upon to get debt levels right.7 This is part of the
rationale for micro- and macroprudential regulation.
It follows that backsliding on financial reform is not a solution to current problems. The
challenge for the crisis economies is the paucity of credit demand rather than the scarcity of
its supply. Relaxing prudential regulations would run the risk of maintaining dangerously high
leverage - the situation that got us into this mess in the first place.
The implications of deleveraging
As a result of deleveraging, the global economy risks entering a prolonged period of deficient
demand. If mishandled, it could lead to debt deflation and disorderly defaults, potentially
triggering large transfers of wealth and social unrest.
History suggests that recessions involving financial crises tend to be deeper and have
recoveries that take twice as long.8 The current U.S. recovery is proving no exception
(Chart 5). Indeed, it is only with justified comparisons to the Great Depression that the
success of the U.S. policy response is apparent.
Such counterfactuals - it could have been worse - are of cold comfort to American
households. Their net worth has fallen from 6 1⁄2 times income pre-crisis to about 5 at present
(Chart 6). These losses can only be recovered through a combination of increased savings
and, eventually, rising prices for houses and financial assets. Each will clearly take time.
In Europe, a tough combination of necessary fiscal austerity and structural adjustment will
mean falling wages, high unemployment and tight credit conditions for firms. Europe is
unlikely to return to its pre-crisis level of GDP until a full five years after the start of its last
recession (Chart 7).
Managing the deleveraging process
Austerity is a necessary condition for rebalancing, but it is seldom sufficient. There are really
only three options to reduce debt: restructuring, inflation and growth.
Whether we like it or not, debt restructuring may happen. If it is to be done, it is best done
quickly. Policy-makers need to be careful about delaying the inevitable and merely funding
the private exit. Historically, as an alternative to restructuring, financial repression has been
used to achieve negative real interest rates and gradual sovereign deleveraging.
Some have suggested that higher inflation may be a way out from the burden of excessive
debt.9
This is a siren call. Moving opportunistically to a higher inflation target would risk unmooring
inflation expectations and destroying the hard-won gains of price stability. Similarly,
strategies such as nominal GDP level targeting would fail unless they are well understood by
11
the public and the central bank is highly credible.10,
With no easy way out, the basic challenge for central banks is to maintain price stability in
order to help sustain nominal aggregate demand during the period of real adjustment. In the
Bank's view, that is best accomplished through a flexible inflation-targeting framework,
applied symmetrically, to guard against both higher inflation and the possibility of deflation.
The most palatable strategy to reduce debt is to increase growth. In today's reality, the
hurdles are significant.
Once leverage is high in one sector or region, it is very hard to reduce it without at least
temporarily increasing it elsewhere.
In recent years, large fiscal expansions in the crisis economies have helped to sustain
aggregate demand in the face of private deleveraging (Chart 8). However, the window for
such Augustinian policy is rapidly closing. Few except the United States, by dint of its reserve
currency status, can maintain it for much longer.
In most of Europe today, further stimulus is no longer an option, with the bond markets
demanding the contrary.
There are no effective mechanisms that can produce the needed adjustment in the short
term. Devaluation is impossible within the single-currency area; fiscal transfers and labour
mobility are currently insufficient; and structural reforms will take time.
Actions by central banks, the International Monetary Fund and the European Financial
Stability Facility can only create time for adjustment. They are not substitutes for it.
To repay the creditors in the core, the debtors of the periphery must regain competitiveness.
This will not be easy. Most members of the euro area cannot depreciate against their major
trading partners since they are also part of the euro.
Large shifts in relative inflation rates between debtor and creditor countries could result in
real exchange rate depreciations between euro-area countries. However, it is not clear that
ongoing deflation in the periphery and higher inflation in the core would prove any more
tolerable than it did between the United Kingdom and the United States under the postwar
gold standard of the 1920s and 1930s.
The route to restoring competitiveness is through fiscal and structural reforms. These real
adjustments are the responsibility of citizens, firms and governments within the affected
countries, not central banks. A sustained process of relative wage adjustment will be
necessary, implying large declines in living standards for a period in up to one-third of the
euro area.
We welcome the measures announced last week by European authorities, which go some
way to addressing these issues.
With deleveraging economies under pressure, global growth will require global rebalancing.
Creditor nations, mainly emerging markets that have benefited from the debt-fuelled demand
boom in advanced economies, must now pick up the baton.
This will be hard to accomplish without co-operation. Major advanced economies with
deficient demand cannot consolidate their fiscal positions and boost household savings
without support from increased foreign demand. Meanwhile, emerging markets, seeing their
growth decelerate because of sagging demand in advanced countries, are reluctant to
abandon a strategy that has served them so well in the past, and are refusing to let their
exchange rates materially adjust.
Both sides are doubling down on losing strategies. As the Bank has outlined before, relative
to a co-operative solution embodied in the G-20's Action Plan, the foregone output could be
enormous: lower world GDP by more than US$7 trillion within five years (Chart 9). Canada
has a big stake in avoiding this outcome.
To summarize thus far
The market cannot be solely relied upon to discipline leverage.
It is not just the stock of debt that matters, but rather, who holds it. Heavy reliance on
crossborder flows, particularly when they fund consumption, usually proves unsustainable.
As a consequence of these errors, advanced economies are entering a prolonged period of
deleveraging.
Central bank policy should be guided by a symmetric commitment to the inflation target.
Central banks can only bridge real adjustments; they can't make the adjustments
themselves.
Rebalancing global growth is the best option to smooth deleveraging, but its prospects seem
distant.
What it means for Canada
Canada has distinguished itself through the debt super cycle (Chart 10), though there are
some recent trends that bear watching. Over the past twenty years, our non-financial debt
increased less than any other G-7 country. In particular, government indebtedness fell
sharply, and corporate leverage is currently at a record low (Chart 11).
In the run-up to the crisis, Canada's historically large reliance on foreign financing was also
reduced to such an extent that our net external indebtedness was virtually eliminated.
Over the same period, Canadian households increased their borrowing significantly.
Canadians have now collectively run a net financial deficit for more than a decade, in effect,
demanding funds from the rest of the economy, rather than providing them, as had been the
case since the Leafs last won the Cup.
Developments since 2008 have reduced our margin of manoeuvre. In an environment of low
interest rates and a well functioning financial system, household debt has risen by another 13
percentage points, relative to income. Canadians are now more indebted than the Americans
or the British. Our current account has also returned to deficit, meaning that foreign debt has
begun to creep back up.
The funding for these current account deficits has been coming largely from foreign
purchases of Canadian portfolio securities, particularly bonds. Moreover, much of the
proceeds of these capital inflows seem to be largely, on net, going to fund Canadian
household expenditures, rather than to build productive capacity in the real economy. If we
can take one lesson from the crisis, it is the reminder that channelling cheap and easy capital
into unsustainable increases in consumption is at best unwise.
Canada's relative virtue throughout the debt super cycle affords us a privileged position now
that the cycle has turned. Unlike many others, we still have a risk-free rate and a
wellfunctioning financial system to support our economy. It is imperative that we maintain these
advantages. Fortunately, this means largely doing what we have been doing - individuals
and institutions acting responsibly and policy-makers executing against sound fiscal,
monetary and regulatory frameworks.
It cannot entirely be business as usual. Our strong position gives us a window of opportunity
to make the adjustments needed to continue to prosper in a deleveraging world. But
opportunities are only valuable if seized.
First and foremost, that means reducing our economy's reliance on debt-fuelled household
expenditures. To this end, since 2008, the federal government has taken a series of prudent
and timely measures to tighten mortgage insurance requirements in order to support the
long-term stability of the Canadian housing market. Banks are also raising capital to comply
with new regulations. Canadian authorities are co-operating closely and will continue to
monitor the financial situation of the household sector.
To eliminate the household sector's net financial deficit would leave a noticeable gap in the
economy. Canadian households would need to reduce their net financing needs by about
$37 billion per year, in aggregate. To compensate for such a reduction over two years could
require an additional 3 percentage points of export growth, 4 percentage points of
government spending growth or 7 percentage points of business investment growth.
Any of these, in isolation, would be a tall order. Export markets will remain challenging.
Government cannot be expected to fill the gap on a sustained basis.
But Canadian companies, with their balance sheets in historically rude health, have the
means to act - and the incentives. Canadian firms should recognize four realities: they are
not as productive as they could be; they are under-exposed to fast-growing emerging
markets; those in the commodity sector can expect relatively elevated prices for some time;
and they can all benefit from one of the most resilient financial systems in the world. In a
world where deleveraging holds back demand in our traditional foreign markets, the
imperative is for Canadian companies to invest in improving their productivity and to access
fast-growing emerging markets.
This would be good for Canadian companies and good for Canada. Indeed, it is the only
sustainable option available. A virtuous circle of increased investment and increased
productivity would increase the debt-carrying capacity of all, through higher wages, greater
profits and higher government revenues. This should be our common focus.
The Bank of Canada is doing its part by fulfilling its mandate to keep inflation low, stable and
predictable so that Canadian households and firms can invest and plan for the future with
confidence. It is also assisting the federal government in ensuring that Canada's
worldleading financial system will be there for Canadians in bad times as well as good and in
pushing the G-20 Action Plan because it is in Canada's interests.
Conclusion
It makes sense to step back and consider current challenges through the longer arc of
financial history. Today's venue is an appropriate place to do so. A century ago, when the
Empire Club and the Canadian Club of Toronto would meet, the first great leveraging of the
Canadian economy was well under way. During the three decades before the First World
War, Canada ran current account deficits averaging 7 per cent of GDP. These deficits were
largely for investment and were principally financed by long-term debt and foreign direct
investment.
On the eve of the Great War, our net foreign liabilities reached 140 per cent of GDP, but our
productive capacity built over the decades helped to pay them off over time. Our obligations
would again swell in the Great Depression. But in the ensuing boom, we were again able to
shrink our net liabilities.
When we found ourselves in fiscal trouble in the 1990s, Canadians made tough decisions, so
that on the eve of Lehman's demise, Canada was in the best fiscal shape in the G-7.
We must be careful, however, not to take too much comfort from these experiences. Past is
not always prologue. In the past, demographics and productivity trends were more
favourable than they are today. In the past, we deleveraged during times of strong global
growth. In the past, our exchange rate acted as a valuable shock absorber, helping to
smooth the rebuilding of competitiveness that can only sustainably be attained through
productivity growth.
Today, our demographics have turned, our productivity growth has slowed and the world is
undergoing a competitive deleveraging.
We might appear to prosper for a while by consuming beyond our means. Markets may let us
do so for longer than we should. But if we yield to this temptation, eventually we, too, will
face painful adjustments.
It is better to rebalance now from a position of strength; to build the competitiveness and
prosperity worthy of our nation.