Righteousness is Killing The Global Economy

Opinion: history shows us mass deleveraging does not work

Stop me if you’ve heard this before: the world economy appears to be stumbling. For a while things seemed to be looking up, and there was talk about green shoots of recovery. But now growth is stalling, and the shadow of deflation looms.

If this story sounds familiar it should; it has played out repeatedly since 2008.

As in previous episodes the worst news is coming from Europe, but this time there is also a clear slowdown in emerging markets – and there are even warning signs in the United States despite pretty good job-growth at the moment.

Why does this keep happening? After all, the events that brought on the Great Recession – the housing bust, the banking crisis – took place a long time ago. Why can’t we escape their legacy?

The answer lies in a series of policy mistakes: austerity when economies needed stimulus, paranoia about inflation when the real risk is deflation, and so on.

But why do governments keep making these mistakes? In particular, why do they keep making the same mistakes year after year? The answer, I’d suggest, is an excess of virtue. Righteousness is killing the world economy.

What, after all, is our fundamental economic problem? A simplified but broadly correct account of what went wrong goes like this: in the years leading up to the Great Recession we had an explosion of credit. Old notions of prudence, for both lenders and borrowers, were cast aside; debt levels that would once have been considered deeply unsound became the norm. Then the music stopped, the money stopped flowing, and everyone began trying to “deleverage”, to reduce the level of debt. For each individual this was prudent. But my spending is your income and your spending is my income, so when everyone tries to pay down debt at the same time you get a depressed economy.

So what can be done? Historically, the solution to high levels of debt has often involved writing off and forgiving much of that debt. Sometimes this happens explicitly: in the 1930s FDR helped borrowers refinance with much cheaper mortgages, while in this crisis Iceland is outright cancelling a significant part of the debt households ran up.

‘Financial repression’

More often debt relief takes place implicitly through “financial repression”: Government policies hold interest rates down, while inflation erodes the real value of debt.

What’s striking about the past few years, however, is how little debt relief has actually taken place. Yes, there’s Iceland – but it’s tiny. Yes, Greek creditors took a significant “haircut” but Greece is still a small player (and still hopelessly in debt).

In major economies very few creditors have received a break. And far from being inflated away, the burden of debt has been aggravated by falling inflation, which is running well below target in America and near zero in Europe.

Why are debtors receiving so little relief? As I said it’s about righteousness – the sense that any kind of debt forgiveness would involve rewarding bad behaviour.

In America the famous Rick Santelli rant that gave birth to the Tea Party wasn’t about taxes or spending – it was a furious denunciation of proposals to help troubled homeowners.

In Europe austerity policies have been driven less by economic analysis than by Germany’s moral indignation over the notion that irresponsible borrowers might not face the full consequences of their actions.

So the policy response to a crisis of excessive debt has been a demand that debtors pay off their debts in full. What does history say about that strategy? That’s easy: it doesn’t work.

Whatever progress debtors make through suffering and saving is more than offset through depression and deflation. That is, for example, what happened to Britain after the first World War, when it tried to pay off its debt with huge budget surpluses while returning to the gold standard. Despite years of sacrifice it made almost no progress in bringing down the ratio of debt to GDP.

But it has been very hard to get either the policy elite or the public to understand that sometimes debt relief is in everyone’s interest. Instead, the response to poor economic performance has essentially been that the beatings will continue until morale improves.

Maybe, just maybe, bad news – say, a recession in Germany – will bring an end to this destructive reign of virtue. But don’t count on it.

Paul Krugman