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 delevraging. Some have suggested that higher inflation may be a way out from the burden of excessive debt.
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 the public and the central bank is highly credible.
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 cross-border 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.
