The debt crisis

FOR those who haven't read the excellent This Time is Different, Carmen Reinhart has produced a succinct view of her thinking in a new paper, A Series of Unfortunate Events (alas, you may have to pay if you're not a member for the Centre for Economic Policy Research).

There is a useful list of the factors that tend to precede financial crises: large capital inflows, sharp run-ups in equity prices, sharp run-ups in house prices, inverted V-Shaped growth trajectory and a marked rise in indebtedness. What is striking is that the Alan Greenspan school might not have worried about anything on that list, bar the growth trajectory. Many cited the capital inflows into the US (the obverse of the current account deficit) as a sign of confidence in the American model; similar reasoning applied to higher asset prices, while the increase in debt was being driven by a more "sophisticated" economy.

A further point relates to the response of the central bank when things go wrong. Ms Reinhart writes that

If the exchange rate is heavily managed (it does not need to be explicitly pegged), a policy inconsistency arises between supporting the exchange rate and acting as lender of last resort to troubled institutions.... more often than not, the exchange rate objective is subjugated to the lender of last resort role.

I would add that the same problem crops up even with floating currencies, as the central bank faces a conflict between its role as lender of last resort and its inflation target. In Britain, the inflation target has been repeatedly missed while rates have been held at 0.5% because the Bank of England has decided (probably correctly) that the economy and financial system are too fragile to withstand higher rates.

The big issue is how we get out of this. Ms Reinhart raises again the prospect of financial repression, as used after the Second World War; making the rate on government debt negative in real terms. Of course, that raid on creditors was made easier by capital controls, whereas today money flows freely across borders.

But as Ms Reinhart points out, that has barely mattered. Real rates have been negative in the US, UK and Germany (occasionally they have been negative in nominal terms as well) and investors have proved gluttons for punishment. Macroprudential regulation ( a new enthusiasm for central banks) could be code for financial repression; by insisting that banks, pension funds, insurance companies etc own more government bonds as a means of "protecting clients". In addition, QE, by driving bond yields down, makes it easier for government to finance themselves or as Ms Reinhart more tactfully puts it

A large role for non-market forces in interest rate determination is a key feature of financial repression.

The other big issue is the willingness of emerging market central banks to keep financing western governments.  This issue is also raised by Maurice Obstfeld in a piece for the forthcoming book "In the Wake of the Crisis". He points to a similarity with the Triffin paradox that emerged in the 1960s. The Bretton Woods system was built on the dollar and needed a growing supply of dollars to keep the system oiled. but the more dollars that were supplied, the less confidence that investors had in the ability of the Federal Reserve to redeem dollars for gold. Eventually, the system broke down.

Currently Asian central banks have an appetite for government bonds. As Mr Obstfeld writes

If (they) prefer safe government debt, then governments have to issue more debt. If these countries keep accumulating reserves at the rate they have been, and if present growth trends continue as we expect, how will this demand for reserves possibly be satisfied?

My thesis has been that some kind of grand bargain might eventually be reached, in which China trades a steady rise in its exchange rate for a limit on the size of the US deficit. This system would require restrictions on capital movements, such as the Chinese favour. It is good to see Ms Reinhart has similar thoughts arguing that

While emerging markets may increasingly look to financial regulatory measures to keep international capital out, advanced economies have incentives to keep capital in and create a domestic captive audience to facilitate the financing of the high existing levels of public debt.