Back to Mesopotamia? The Looming Threat of Debt Restructuring

BCG has issued a report worth reading: www.bcg.nl/documents/file87307.pdf

Below you will find a summary. Although the painted picture is gloomy, Enjoy!

We believe that some politicians and central banks - in spite of protestations to the contrary - have been trying to solve the crisis by creating sizable inflation, largely because the alternatives are either not attractive or not feasible:

• Austerity - essentially saving and paying back - is probably a recipe for a long, deep recession and social unrest
• Higher growth is unachievable because of unfavorable demographic change and an inherent lack of competitiveness in some countries
• Debt restructuring is out of reach because the banking sectors are not strong enough to absorb losses
• Financial repression (holding interest rates below nominal GDP growth for many years) would be difficult to implement in a low-growth and low-inflation environment

Inflation will be the preferred option - in spite of the potential for social unrest and the difficult consequences for middle-class savers should it really take hold. However, boosting inflation has not worked so far because of the pressure to deleverage and because of the low demand for new credit. Moreover the inflation "solution" while becoming more tempting, may come to be seen as having economic and social implications that are too unpalatable. So what might the politicians and central banks do?



Since the publication of Stop Kicking The Can Down The Road, a number of readers have asked us what would happen if governments persisted in playing for time. To what measures might they have to resort? In this paper, we describe what might need to happen if the politicians muddle through for too much longer.



It is likely that wiping out the debt overhang will be at the heart of any solution. Such a course of action would not be new. In ancient Mesopotamia, debt was commonplace; individual debts were recorded on clay tablets. Periodically, upon the ascendancy of a new monarch, debts would be forgiven: in other news, the slate would be wiped clean. The challenge facing today's politicians is how clean to wipe the slates. In considering some of the potential measures likely to be required, the reader may be struck by the essential problem facing politicians: there may be only painful ways out of the crisis.

A Program for the United States

The situation in the U.S. is different from that of the euro zone and, in a way, would be less complicated to resolve. The U.S. has all the levers with which to address the crisis and would not need to coordinate 17 countries with divergent interest. But some facts would need to be acknowledged before decisive action could be taken:

• In spite of massive intervention by the Fed and the US government, growth remains anemic
• The deleveraging of private households will have to go on for many years
• The real estate market has not yet stabilized. About 11 million US households suffer from negative equity (their mortgage outstanding is higher than the value of their home). And the supply of homes is still in excess by 1.2 to 3.5 million (depending on the data used to estimate this number).
• The US government deficit is not sustainable and will need to be brought to acceptable levels, which will slow growth and amplify the problems of the private sector.
• In spite of a significant weakening in the dollar, the U.S. is still running a trade deficit that cannot be blamed on China alone. It reflects a lack of competitiveness in some key markets and the low proportion of manufacturing in the U.S. economy compared with countries such as Germany and Japan.
• There is a striking similarity between the US and Japan in the development of stock and real estate prices (See chart below). A correlation does not mean causality, but it is a sobering picture should Ben Bernanke and his team fail to reflate the economy.
• The interventions of the Fed, notably the programs designed to buy financial assets, have created a monetary overhang that could be the basis for sizable inflation in the future.

Addressing the debt overhang.

The US would also need to reduce the debt overhang of the government, of consumer loans besides mortgages, and of non-financial corporate sector in the same way as in Europe. As exhibit 2 shows, the total debt overhang in the US equals $11.5 trillion or 77% of GDP. In the somewhat unlikely event of the US following the same path that Europe might pursue, a one-time wealth tax of 25% of financial assets would be required. As in Europe, this would also require the following initiatives.

• Cleaning up the banking sector by calculating the losses and recapitalizing as needed – even if it means wiping out existing shareholders.
• Additional taxes on real estate, including an increased capital-gains tax to offset the support for the real-estate market.
• Creating an incentive for corporations to invest in R&D and new machinery by taxing profits not reinvested.
• A commitment by the government to restrict its debt level and to prepare for the increasing costs of an aging population by either limiting benefits or raising the retirement age.

Addressing the fundamental issues of the US Economy.

We have argued for a long time that the US economy needs to address some fundamental issues in order to become globally competitive again. In putting an end to muddling through, the government might also embark on a major restructuring of the economy:

• Reindustrialize and grow the share of the manufacturing sector from the current low of 12% of GDP to 20% of GDP . This might then allow a rebalancing of trade flows.
• Revisit income distribution. Most U.S. families cannot make up for their income shortfall with increased credit – and 41 million Americans are officially considered to be below the poverty line.
• Take action to reduce dependency on imported oil by investing in new technologies and modernizing existing infrastructure.
• As in Europe, an administration that truly bit the bullet would take a long-term view and invest more in education.

All this is still speculation. But history shows that the US economy, like no other, is capable of adjusting and implementing quite radical changes. And in our view, some of the actions described above might be pursued by the US government if things do not improve soon.

BCG's conclusion:

The programs we have described would be drastic. The would not be popular, and they would require broad political coordinate and leadership – something that politicians have replaced up til now with playing for time, in spite of a deteriorating outlook. Acknowledgment of the facts may be the biggest hurdle. Politicians and central bankers still do not agree on the full scale of the crisis and are therefore placing too much hope on easy solutions. We need to understand that balance sheet recessions are very different from normal recessions. The longer the politicians and bankers wait, the more necessary will be the response outlined in this paper. Unfortunately, reaching consensus on
such tough action might requiring an environment last seen in the 1930s.