It's the Balance of Payment, 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.
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.
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. 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 Implication of Deleveraging.
As a result of deleveraging, the global economy risks entering a prolonged period of deficient demand. If misshandled, it could lead to debt deflation and disorderly defaults, potentially trigegring 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. 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 ½ 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).
