Wednesday, January 28, 2009

On Debt to GDP

Martin Wolf (hat tip S) has put out a piece describing the massive levels of debt outstanding in major economies and the options available to them in resolving that debt overhang.  What does debt to GDP really mean, though?

It seems like a meaningless ratio on its own: as he notes, debt nets to zero.  A highly financial economy might have a lot of credit outstanding, as individuals choose to obtain mortgages with one hand while investing in corporate debt with the other.  A less financial economy may involve individuals paying cash for houses.

But there are likely very important structural changes when debt to GDP increases.  It generally coincides with financial deepening.  The real economy becomes more responsive to changes in financial conditions, and the financial system becomes more responsive to changes in growth.

Financial Deepening and Stability

Well-developed financial systems are tightly interwoven with the real economy.  Some degree of financial service is very beneficial for an economy, helping investment and growth occur.  Without intermediation of savings and investment funding, a lot of opportunities would be missed.

But dangerous instability arises when there is too much financial servicing, and as a general consequence, too much debt.  The overgrown financial system becomes extremely sensitive to changes in trust, securitization, interest rates, risk preferences, credit availability, and so forth.  Because this financial system has also become deeply connected to the real economy, booms and busts become much more likely.

Current levels of debt are apparently associated with severe financial frailty.  I don't know where the right level is, but around 130% debt to GDP is a historically stable ratio.

The level may well be different for different economies and different financial systems, giving us leeway to believe we were in a brave new financial world.  All the esoterica being traded and the general stability of output and inflation made that transition more credible.

Investment Finance or Consumption Finance?

Banks are not simple intermediaries between saving and investment.  Through fractional reserve lending, they can finance many projects on a small base of savings.  From a Keynesian perspective, this means the bank is effectively replacing current savings with investment finance.  Whether a loan will be issued depends on the anticipated proceeds from the loan and the cost of the lending, not whether there's actually savings to lend from.

This means that a growing debt-to-GDP ratio indicates that the financial system is funding a lot of current consumption and investment, in anticipation of a future increase in production resulting from that consumption and investment.

In essence, the bank is a recursive bridge between the current supply of saving and anticipated future production.  If future production fails to reach the levels anticipated, someone has to take damage.  Savings act as a cushion for that damage, which is why RRR's and leverage limits are important, even though they're difficult to enforce.

But most investment in modern economies comes from retained earnings.  Since corporations saw little better to do with their earnings during the best of times than buy back stock and pay dividends, and most GDP growth was consumption anyway, I'm a little doubtful that there will be much in the way of new production resulting from this accumulation of debt.  I strongly suspect it went via HELOC's and other channels towards current consumption.

With these details in hand, the debt-to-GDP ratio looks a little more ominous.

Reducing Debt Levels

To cut debt-to-GDP, either defaults occur, inflation rises, or we wait for that future production to arise, the three options Wolf lays out.  He concludes it's best to drag the repayment out long enough that the debtor promises can eventually be repaid.

If the projects that have received the funding can indeed grow production eventually, then lenders will be made mostly whole.  Funding available to new projects will be limited for awhile, as resources are dedicated to the old projects.

But implicit in that selection is an assumption that sustaining the projects that were funded will lead to more GDP growth than would the tedious process of bankrupting the old debtors and funding new ones with the newly vacated resources.

I'm skeptical.  First, I don't trust zombies.  I am fond of creative destruction and controlled default.  Second, most of this borrowing probably went towards consumption, with a bit to residential investment.  These claims on individual households aren't likely to result in future production unless we have a major outbreak of productivity.  I see little reason to spare households from bankruptcy for their own good: bankruptcy is very kind to them.  There's a much stronger incentive to prevent bankruptcies for the owners of the claims on the households.

On that point, I've got two more posts coming on how I believe, based on the rise in financial depth and debt-to-GDP, the concentration of wealth in the hands of the few and the tilt towards consumption were inevitable.  For now, count me as a Mellonite.

14 comments:

S said...

nice post. Kedrosky has a piece sighting Ferguson re private debt restructuring. Level of debt is as important as rate paid on debt. Perhaps it may not be the level but the rate that mortally wounds. I am channeling BB and his standby status on the Tbonds.

cap vandal said...

Through fractional reserve lending, they can finance many projects on a small base of savings.

I would say small base of capital. They have to attract deposits or funding sources.

Other comments:

Financial debt is used to fund assets. Most of the assets aren't simple consumer loans but some may amount to it -- HELOCs or strip malls that contain boutiques.

A decent amount of debt was used to fund higher education and health care expenses. Even if a lot of this is a waste, a non trivial fraction is an "investment" in human capital. I almost hate to type it since it sounds so flakey, but most capital expenditures are inefficient.

People tend to be scornful of a service based economy, but wealthier countries want to spend on services. Plus all the lines are blurred when things become more digitally based. Not to get all Tom Friedman here.

If you look at the total debt since 1985 and the cost to service it -- it has been pretty flat since nominal interest rates have been cut in half or more.

If debt doubles and interest rates are cut in half, then payments are stable. It is more complex, but directionally, thats what happened -- especially with housing. I think this is under appreciated.

People get so nutty about mark to market, but if interest rates decrease, assets that represent future cash flows are worth more. People are always wanting to isolate part of the balance sheet without looking at the total picture. The portion of total assets that can be valued via deep, liquid markets is pretty small. What is the value of a factory and should it be "marked" daily? It is a "level 3" asset and could be modeled using observable inputs like interest rates, etc. Instead -- people have decided to just value them at historic cost less depreciation and let it go. People that want the entire economy and be run like a derivatives firm -- simply because that perspective corresponds to financial theory are getting things backwards.

As far as creative destruction, virtually every industry in the US has been through one or two "depressions" since WW II. You can get substantial change fairly quickly but I think that orderly is better then a panic. Most of the post WWII shakeups have hit certain industries or geographical areas to the extent that the overall system continued to function.

Texas was liquidated in the late 1980's but the national economy gave it an opportunity to rebuild. We could afford to let the entire banking system in a region go bust, since it was absorbed by banks like the North Carolina regional banks that became national mega banks and are now imploding.

The "solution" or outcome doesn't have to be one single thing, unless it is a deflationary spiral. That is, asset deflation in some areas, inflation in others, the government bulking up a little to buffer unwinding in the financial sector, etc. Maybe 10% of the population needs to do a BK of primarily credit card debt to get healthy. Maybe there are a couple of million houses that need some sort of government assisted mortgage workout to minimize total losses.

It took the US class I railroads 100 years to work down over capacity and become profitable businesses. In the 1970's, they were in as bad a shape as the auto industry.

ndk said...

I would say small base of capital. They have to attract deposits or funding sources.

Yes, that's what I should've said, cap vandal. Thanks.

If you look at the total debt since 1985 and the cost to service it -- it has been pretty flat since nominal interest rates have been cut in half or more.

Right. The FOR for households has increased somewhat, but not dramatically. This relates to S's point that the rate of repayment is presumed to be the main thing that causes problems, and that repayment rate can indeed always be relaxed.

But again, I think the absolute level of debt also matters, as it correlates with financial depth. An extremely deep financial system becomes extremely exposed to systemic changes in trust, interest rates, and other variables.

Extremely low interest rates can cause practical problems themselves, beyond debt-deflation. Some financial units with fixed liabilities or costs like money market funds, annuities, pensions, and so forth have trouble adjusting. Banks should become reluctant to lend, since they would never charge an interest rate lower than the envisioned default probability, and bad stuff always happens. The government has stepped in to forcibly reduce that risk, but I don't see a solution there.

As you go parabolic, the basic mathematical relationship between chopping rates, extending repayment, and a reduced debt service cost will always hold, but I think other things will eat you as you ascend the curve.

As far as creative destruction, virtually every industry in the US has been through one or two "depressions" since WW II. You can get substantial change fairly quickly but I think that orderly is better then a panic.

I'm certainly not arguing in favor of a panic, but instead gradual, orderly purging of the rottenness. We've had an extraordinarily low default rate on corporate debt for many years, and we continue to have few bankruptcies even today. Spreads reached record wides in 2008, yet we saw relatively few bankruptcies. It may be just lagging, or a hangover from the 2005 law-changing purge, but I suspect we've got an inordinate number of walking dead entities out there.

S said...

"Not to get all Tom Friedman here" that is your first problem.

"If debt doubles and interest rates are cut in half" artificially then the result is asset bubbles. That indeed is what happened.

"What is the value of a factory and should it be "marked" daily? It is a "level 3" asset and could be modeled using observable inputs like interest rates, etc. Instead -- people have decided to just value them at historic cost less depreciation and let it go." the value of a factory is a simply NPV calculation using projected cash flows. People are not using historical cost, they are using market based indicies that are seeking to forcast embeeded losses in these toxic mortgages. The debate is about future performance not past marks. Past marks represent a fantasy and as such are retrospective and wrong. These mortgage assets are like a bomb with a delayed fuse. The idea is to pas the potato before detonation while convincing the copunterparty (the US taxpayer) that there is "value" or as the like to say money good. All that said, I wonder how many espousing the model methodology (based by the way on HISTORICAL performance) would pony up thier own capital to swallow these radioactive assets based of course on their surperior model? So far approximately 0. Call me crazy but I trust the private capital over the government capital.


"Maybe there are a couple of million houses that need some sort of government assisted mortgage workout to minimize total losses"

Actually seems to me the idea of keeping people in their homes is less about benevolence and more about more price manipulation. See Gross comments (yesterday)on stabalizing asset prices. The irony in all those shouting for principal reduction is that it merely accelerates the repricing of every house in the neighborhood. JPM sees the threat to the Jumbo protfolios - which is the real clear and present danger. How does the concentric circle of suburbs around NYC maintian thier levels when the prices are 3x what they were in 1998? The current price reductions have everything to do with the secular dynamics that have compressed wages over the past decade - which is why people like Stigilitz is part of a team to evelauate why GDP is not an accurate measure (picture) of what is transpiring in the economy (FT yesterday). We need a msery measure.

Now, if you are willing to bet on the Fed controlling rates indefinetly perhaps it makes sense to own a house (or car, or building etc). But if you believe the rates revert or go up next few years, buying anything now merely locks in a capital loss - unless you see wages spiraling up? I am not sanguine.


"It took the US class I railroads 100 years to work down over capacity and become profitable businesses"

Amtrak is part of the Stimulus - they are still losing money -- the more things change they more they stay the same I guess.

NDK "absolute level of debt also matters, as it correlates with financial depth" -- totally agree. This is akin to those genuises (who still inhabit the Fed) who argued during the house boom that price doesn't matter it is the rate/payment. Yeah, until the music stops. or you just start handing out money.

Detroit Dan said...

This is a test. My posts keep disappearing, for unknown reasons...

cap vandal said...

S:

Amtrak isn't a business, so the fact that passenger rail is a legacy government service is immaterial to my point The comment still stands that all private railroads were a disaster even after Amtrak was split out. Neverthless, after 100 years the business has worked out of overcapacity is both a fact and interesting, at least to me.

Factories are never valued based on discounted cash flows in financial statement. The use a number of methods, but historical cost less depreciation is common. Most assets on most non financial balance sheets aren't marked to market. That hasn't prevented businesses from functioning. It has made the use of book value fairly meaningless for non financial firms in a lot of cases.

I have no great idea for valuing complex structured finance assets, but it makes no sense to mark them to a failed market. The correct price is a range of values at best and to pretend that they could be liquidated in a functioning market is fantasy.

The best idea I have heard is paying the employees of financial firms with them at their current booked value and let them try to extract the value. Especially any and all bonuses.

I don't see most people with problem mortgages being in a position for a subsidized workout. However, there were at least a couple of million people that were put into toxic mortgages that could have qualified for a 30 year conventional. There are a lot of costs to foreclosures that should be minimized -- and not all of them are bourn by the lender and buyer. The number of people that can be helped is a fairly small fraction, but since there is such political support for it, I am in favor of them trying.

The only point in subsidizing mortgage interest rates in the near future is that prices would tend to overshoot on the downside without some support. Longer term, everything will have to unwind and find a sustainable level. If someone wants to buy a house and can get a 5% mortgage today, and believes that prices will be higher in 5 years, then that sounds perfectly rational. Especially If they miss the bottom, I don't see it as a bad deal. They would need to have some confidence that prices are currently reasonable, but that can be confirmed by comparing with rentals, replacement costs, etc.

The only point of the various schemes is to keep a viable buyer in the particular home he/she purchased on economic terms that have a lower cost then foreclosure and running the house through the friction heavy housing market process with real estate commissions, inspection fees, etc.

S said...

I am not debating the conventions of historical cost on balance sheet. When you buy a company (or a bond or stock) you are concerned only with the future earnings potential of that particular asset - not the historical cost or any other accounting metric. A factory is worth either the productive potential of the equipment henceforth less capex at a reasonable discount rate or its equipment liquidation value.

The canard that markets overshoot and that housing is going to also is really ministry of truth stuff. The market will clear when prices reflect the reality of not just earnings potential (future look which is bleak) but right sized interest rates. This will or should be captured in the much higher lending standards that the government is trying to retard. Making overshoot arguments is a really just a veiled argument for intervention a la Bill Gross - "I am long bonds stop asset prices from falling" - no matter if it indentures me to an overpriced asset for a generation.

"I have no great idea for valuing complex structured finance assets, but it makes no sense to mark them to a failed market"

Why are you assuming that the market failed and not the securities. That is CNBC drivel

Detroit Dan said...

Well, I'll try again to post on the subject of Chinese currency manipulation. This has gotten a log of coverage, including a denunciation from the "maverecon" guy (Buiter). I'm not sure why he's so upset -- isn't it incontrovertible that the Chinese manipulate their currency? Can't we say this out loud?

Harold Meyerson makes more sense to me...

currency manipulation, which generally has a far greater effect on the price of internationally traded goods than tariffs do, was a wrong that the Bush administration was loath to right. As Thea Lee, the AFL-CIO's chief international economist, has pointed out, the U.S. trade representative's office has for years routinely referred complaints about currency manipulation to the Treasury, which has referred them to the International Monetary Fund, which, according to a report in Monday's Financial Times, has not discussed China's currency policy since 2006.

Such a discussion would be of more than academic interest, since the economic relationship between the United States and China is the linchpin of the global economy -- that is, a central cause of the global economic crisis.

babar ganesh said...

I have a simple question.

Say I owe $10 to NDK. That is $10 of debt.

Say I owe $10 to S and S owes $10 to NDK. That is $20 of debt.

Comparing these two situations I'm supposed to infer some conclusion based on the $20 number versus the $10 number. I'm a bit lost as to what exactly I can conclude by looking at the sum.

If it's obvious, sorry.

Mikkel said...

Whenever I read a post of yours NDK I want to quit my job and steal you away so we can huddle with Yves Smith and make a new school of economic thought.

I had some thoughts very similar to yours here and here a few months ago. You are more specific though.

As for the "sensitivity" of financial system feedbacks based on absolute debt...IMO that is exactly right and why our commonly used models are so awful. In many nonlinear systems there is a volatility contraction near the points that are most crazy (or even chaotic) and I've noticed a lot in my own work that I can start to intuitively predict when a system is about to switch to a highly variable state based on volatility contraction and other things.

In finance it's even worse because by focusing on servicing it is a positive feedback loop that will naturally cause volatility to decrease along with risk tolerance...so when there even a historically normal event it can quickly balloon into much more.

Mikkel said...

babar ganesh:

The thing you are missing is interest and default risk.

So let's say ndk loans $10 to S @2% interest and he loans $1 to 10 people (including you) at @5% interest. If you can all pay it back then S is richer, ndk is richer, and if all the borrowers used to for productive purposes then they have increased efficency and GDP will rise. This will let them be richer too even as they pay interest.

However, the GDP needs to rise (due to productivity increases) in order for the borrowers to have money to pay back the loan plus interest...otherwise they start defaulting and then S can't pay back ndk.

And even though my example is without leverage, in reality there is a lot of leverage so there is less room for error.

The higher the debt:GDP ratio, the more productively that the economy has to use that debt in order to service it...and at some point when it is too high then it is just a matter of time before there are asset bubbles and too much consumption. Then a small change will case a crash.

cap vandal said...

S....

The government subsidized housing in numerous ways for decades. The most harmful and latest was the absence of regulatory oversight. They also sanctioned the transformation of housing from simple consumption into financial assets. They are the market of last resort for these assets and they can either support them or let them collapse with the attendant social costs. I haven't heard any serious proposals that the government should pull the plug on the GSE's. Once you accept government subsidization, it is a matter of degree, effectiveness, and efficiency. All matters of principle have already been decided, and it is just a matter of debate regarding the cost/benefits of various interventionist policies. We only have to look back on the RTC to have an idea of what happens when real estate assets are quickly liquidated -- and in that case, real estate prices clearly and significantly "overshot" the values that were established under less extreme conditions within a year or two.

You may not have wanted to debate accounting conventions, but the real world lives and dies by them. Capital ratios are based on point estimates in balance sheets, and those are based or rules that have evolved over an extended period of time. Given financial innovation, we now have a lot of assets without a good way to account for them. Simply stating or wishing that efficient, functioning markets for valuation purposes doesn't make it so.

I'm not assuming that the markets have failed, but do assert that markets can fail and have failed in this situation. If you believe that markets can't fail, then there is nothing to talk about. I feel confident that markets for a lot of structured financial products have failed. The reason they failed has a lot to do with defects in the way they were created. However, they initially were liquid, the markets had reasonable depth, and the pricing was relatively efficient. All of those conditions have deteriorated significantly. That signifies a market failure to me. If you want to argue that the real problem was that the prior market conditions did not recognize the defects in the products and subsequently, the always self correcting market system has improved and is now succeeding -- that's fine.

Nevertheless, the major point of the initial post was impact of the overall level of debt on a developed economy. I don't know that there is an optimal level, but the overall thesis seems reasonable that beyond a point, it makes an economy more susceptible to internal and external shocks, as well as a dependence on low nominal interest rates. Sounds convincing to me.

babar ganesh said...

> I feel confident that markets for a lot of structured financial products have failed. The reason they failed has a lot to do with defects in the way they were created. However, they initially were liquid, the markets had reasonable depth, and the pricing was relatively efficient.

a lot of the reason the 'markets have failed' for these instruments is that their value depends very much on the health of the holder and the holders of these instruments are having problems. it is not correct to say that the theoretical value equals the NPV of cash flows. there are often built in stop loss triggers (triggers to post more capital based on ratings, defaults, other instruments etc) which fire up long before NPV is impaired. these are not unique aspects of these instruments (they are true of all leveraged portfolios) but they are especially bad here. in short the 'markets have failed' because these instruments destroyed or scared away all the buyers and sellers.

ndk said...

Whenever I read a post of yours NDK I want to quit my job and steal you away so we can huddle with Yves Smith and make a new school of economic thought.

That would be way cool, Mikkel, but unless the MacArthur Foundation suddenly takes an interest in our work, I'm unlikely to be able to join you just yet.

You definitely did anticipate many of the same ideas, particularly the trend of financial deepening leading to wealth concentration. It makes me feel encouraged when others independently arrive at the same conclusions. :D Maybe there's something to this explanation after all.