Yves Mersch: Challenges of excessive indebtedness
Keynote lecture by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the
Euro Finance Week, Frankfurt am Main, 15 November 2011.
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Ladies and Gentlemen,
It is my pleasure and privilege to contribute to the Euro Finance Week. This conference has
a long tradition of bringing together experts in finance, economics and politics. In recent
years it has become a distinguished forum to discuss ways to get out of the financial crisis
we are still facing.
The global rise in debt levels
The financial crisis weighs heavy on the global economy for more than four years. It erupted
in August 2007with the epicentre at the US subprime mortgages markets and deteriorated
dramatically in September 2008 when the US investment bank Lehman Brothers collapsed.
And it triggered the sovereign debt crisis in the euro area in spring 2010 that has not been
resolved until today.
The debt crisis has deeper roots. And indebtedness has not been only a feature of the
financial industry and public finances. According to figures of the Bank of International
Settlement (BIS) the aggregate gross financial liabilities of industrial country governments,
households and non-financial corporations (represented by 18 countries) have grown from
about 165% of gross domestic product (GDP) in 1980 to a record 320% of GDP by 2010.
By contrast, most emerging market (EME) countries have been doing better. BIS data since
the mid-1990s suggest that EME debt levels have remained relatively modest and stable.
Their debt stands now at about 110% of GDP on average, i.e. - a little more than one third of
that in advanced countries.
The indebtedness of industrial countries is not only high. It is still rising. The average debt
levels of industrial countries have risen to reach 320% of GDP by 2010, starting from a
modest level of 165% of GDP in 1980. This is an annual average increase of more than
5 percentage points.
Both private and public sector debt levels have risen dramatically. Adjusted for inflation,
corporate debt has risen by three times, government debt by 41⁄2 times and household debt
by six times.
This dramatic rise is widespread across advanced countries. Total non-financial sector debt
now exceeds 450% of GDP in Japan, 350% in Belgium, Portugal and Spain, and 300% in
two thirds of the countries. But also other major industrial countries have also experienced a
substantial increase in their debt ratios. Household and non-financial corporate indebtedness
in the United Kingdom began to rise rapidly in the early 2000s. In Germany and France, the
aggregate debt ratio started to increase rapidly beginning in the mid-1990s, led by the
growing indebtedness of both the government and the private sector.
These high levels of indebtedness imply serious risks. Borrowers' ability to service their debt
becomes progressively more difficult due to the sensitivity to decreases in income and
increases in interest rates. For any external event, the likelihood of default rises together with
the level of debt. Even for a mild shock, highly indebted borrowers may suddenly no longer
be regarded as creditworthy.
Highly indebted governments may be constrained both in their scope for engaging in
traditional countercyclical stabilisation policies and in their role as lenders of last resort during
an economic or financial crisis.
Moreover, growth might be hampered by excessive debt levels. Following the empirical
findings of Kenneth Rogoff and Carmen Reinhart, who concentrated on the impacts of public
debt on growth, recent BIS research also looked at corporate and household debt. The main
finding is that there is a threshold of about 85% of GDP beyond which an additional
10 percentage points of debt reduces average per-capita growth by 13-14 basis points.
What has caused this trend of accelerated borrowing? The main reasons were the
liberalisation of credit markets since the late 1970s and the introduction of (complex) financial
innovations which made it easier to borrow.
In several countries the accumulation of debt was financed by property investment, which
could be used as collateral for even more borrowing.
Moreover, since the mid-1980s until the current crisis, the economic environment has been
more stable, a period that has been coined the Great Moderation. Lower unemployment and
inflation rates and less uncertainty made investors more optimistic. Borrowers borrowed
more and lenders lent more - while inflation remained low.
In addition financial innovation stabilized the credit supply. This allowed risks to move away
from the banking system. General economic stability was improved, risk primea compressed,
and future income prospects were boosted.
On the political level a persistent deficit bias in fiscal policy has been en vogue which
additionally pushed debt levels upwards. The lack of fiscal discipline was accompanied by
households' and firms' behaviour that did not properly discount a higher future tax liability in
their spending decisions but instead increased their own liabilities.
Last but not least, tax incentives distorted financing choices. Preferential tax treatment of
interest expenses may have played a major role in boosting corporate borrowing to finance
ever larger mergers and acquisitions as well as leveraged buy-outs. Likewise, generous tax
deductions for mortgage interest payments, combined with public policy intervention to boost
home ownership, may have contributed to a sharp growth in household debt in some
countries.
Global economic challenges
To tackle the threat of a debt trap three main approaches are generally discussed: fiscal
consolidation to reduce the public fraction of debt, economic growth to increase the
affordability of given liabilities, and inflation to lower the debt burden in real terms.
Fiscal consolidation decreases the vulnerability of public finance. And public finance is the
water mouth of debt from all sectors in an economy in times of crisis. Regardless of whether
private debt has been socialized or the problem was from the beginning in public finances
itself, the outcome was a drastic increase in the public debt burden. Even John Maynard
Keynes was aware of the limits of public expenditure based on borrowing has to its limits.
After the Great Depression, Keynes acknowledged: "Just as it was advisable for the
government to incur debt during the slump, so for the same reasons it is now advisable that
they should incline to the opposite policy." To bring public finances in order is of additional
importance in mature economies where the demographic challenge kicks already in and
might challenge the sustainability of established pension systems.
Growth should be stimulated. To this goal, structural reforms can strengthen confidence,
market dynamics and job creation. Higher competitiveness will increase the flexibility of the
economy and lift the longer-term growth potential. In particular, rigidities on labour market
should be removed to increase wage flexibility. Structural reforms to increase competition in
product markets, particularly in services and the privatisation of services currently provided
by the public sector might further accelerate growth. To improve supply side conditions will
also help to dampen the negative short term impacts on aggregate demand that kick it when
the necessary fiscal consolidation measures are implemented.
Inflation, by contrast, is not a feasible option. This statement might not come as a surprise
from a central banker. But there are sound reasons behind:
1. Accelerated inflation would raise the risks of even higher future inflation and greater
output volatility. Uncontrollable wage-price spirals would be likely.
2. It would reduce incentives for governments to lower their public debt levels.
3. Financial markets would probably not buy the story of, for instance, a temporary
modest increase in the inflation target. Rather they would add an inflation risk
premium when public debt is rolled over. Real refinancing costs of governments
could become even higher once the genie of higher inflation rates was out of the
bottle.
4. It is a myth that accelerated inflation can be a substitute for economic adjustment.
Remember that the necessary disinflation policies of the late 1970 and early 1980
came along with high costs including severe recessions and sharp increases in
unemployment.
The case of the euro area
Although elevated debt levels are a common feature of advanced economies the euro area
has been at the epicentre of the current public debt crisis since spring 2010.
Strangely enough, on a consolidated base public finances in the euro are in a more
favourable position than for example in the US. The euro area as a whole will run a budget
deficit of about 4.5% of GDP this year. The International Monetary Fund (IMF) expects a US
budget shortfall of about 10 percent of GDP this year.
According to the Commission's spring forecast, the euro area deficit ratio is projected to
decline to 3.5% of GDP by 2012. By comparison, in the US and Japan fiscal deficits are
expected to be at 8.6% and 9.8%, respectively, in 2012.
On the other side of the channel, the UK expects for this fiscal year to meet its deficit target
of 7.9% of GDP, down from 9.3% of GDP in the previous one ending in April 2011. The
budget forecasts however are based on the assumption that the economy will grow 1.7% in
2011 - a euphemistic view compared to private sector economists' recent forecasts of 1.0 to
1.3%.
According to the IMF the aggregate public debt-to-GDP for the euro area stands at
87 percent. Figures for the UK are similar. For the US the debt-to-GDP ratio in 2011 is
expected to be 100 percent. In Japan public debt-to-GDP exceeds 200 percent.
Under market scrutiny
Still, it is the euro area that is under particular market scrutiny. Market judgement can
sometimes deviate from economic fundamentals. Even wealthy states with sound economic
fundamentals are in trouble to refinance themselves at reasonable conditions. Comparing for
instance Britain and Spain based on debts, deficits and inflation, Britain should be the riskier
credit. But British bonds yield around 2.3% while Spain's yield around 5.5%.
Moreover, market sentiments can deteriorate dramatically within days - although economic
fundamentals might not have changed. In mid October Italian one year bonds yielded around
3.5%. Last week they yielded around 7%.
Main differences to other countries
Although financial markets might temporarily be irrationally pessimistic there is no room for
complacency and the challenges must still be addressed. In order to do so, it seems
reasonable to recall what makes the euro area different from other currency areas.
The euro area is an alliance of sovereign countries without a central government or budget.
Most of the relevant political decisions - including public finance - are taken by national
governments. In this constellation member states share a common monetary policy and lack
the instrument of the nominal exchange rate to react to internal or external imbalances.
In this institutional environment there has always been a risk embedded: moral hazard could
arise when fiscal profligacy of one single member state can be compensated on average by
the sound economic behaviour and stable public finances of the majority of the other
countries. Such an incentive structure is flawed in so far as it can lead to unsustainable fiscal
policies of individual member states which in turn would generate negative spill over effects
to the monetary union as a whole and make financial markets to paint other members states
with the same brush.
With hindsight, the original attempt to substitute a single government by rules, market and
peer pressure has not been sufficient. Although the no-bail-out clause and the Stability and
Growth Pact (SGP) were installed to exclude free rider incentives and to ensure the
alignment of national fiscal policies, imbalances have emerged and the current crisis has not
been prevented.
Particularly, there was a lack of political will to commit to sustained stability-oriented fiscal
policy. The weak commitment was evident when the Stability and Growth Pact was watered
down under the pressure of France and Germany in 2003.
Moreover, a crisis was not included in the scenarios to be prepared for. No crisis resolution
mechanism for the euro area was foreseen.
Political and institutional challenges
Crises always must be seen as opportunities. As the Swiss writer Max Frisch once said: "A
crisis is a productive time. It just has to be cleansed of the taint of a catastrophe."
All advanced economies have to take swift, decisive and credible action to tackle the
challenges that go along with the global debt crisis. This clearly includes the euro area.
Having discussed the feasible options to overcome the debt challenge and the particularities
of the euro area it is important that the consolidation of national budgets and the
strengthening of the growth potential have to be put in place in a more coordinated way.
Important decisions have already been taken. In late September the European Parliament
approved new legislation to tackle the shortcomings in the existing economic governance
framework for co-ordinating fiscal and structural policies. The so-called "Six Pack" is a step in
the right direction as the Stability and Growth Pact will be strengthened; imbalances and
competitiveness will be monitored at an earlier stage.
In addition to the "Six-pack" the Heads of State or government of the euro area agreed in
March 2011 on a "Euro Plus Pact" with the aim to strengthen policy coordination in the areas
of competitiveness and convergence. A set of common indicators will be used to monitor the
progress of labour-market reforms, reforms to wage-setting arrangements and reforms
addressing the sustainability of pension, health care and social benefit systems.
Regarding the most urgent current challenges the Heads of State and Government of the
euro area agreed on 26 October on a set of measures to restore confidence and address the
current tensions in financial markets. These include a significant leveraging of the European
Financial Stability Facility (EFSF) resources which shall increase the fund's ability to extend
loans, finance bank recapitalisations and conduct bond purchases in the primary and
secondary markets. The crisis mechanism based in Luxembourg had been set up to help
countries with stressed liquidity positions. This support should allow them to return to a
sustainable level of debt and regain competitiveness as soon as possible.
As stated earlier, accelerated inflation is not a feasible option. Therefore, monetary policy in
the euro area must remain focussed on delivering price stability. By doing so, the ECB can
also best contribute to financial stability, by including a firm anchoring of inflation
expectations and supplying the financial system with the necessary liquidity. Monetary policy,
however, cannot replace governments which have to live up to their own responsibilities.
But challenges remain beyond today's institutional framework to safeguard the own life of a
currency union within a common market to further proceed. In the medium to long run, we
will need an institution that is solely responsible for the euro zone. A single monetary policy
needs support from sound public finances and closer economic policy coordination with an
agreed framework for national budgetary policies. This could be monitored ideally by an
independent body be it a European Commissioner with special authority or a finance minister
(not necessarily with a huge budget), as it has been suggested by former ECB President
Jean-Claude Trichet. But in any case, the institutional vacuum that currently exists must be
filled in the long term.
Ladies and gentlemen, thank you for your attention.