Combatting the Debt Addiction

jun. 07, 2014

On May 22nd, joint with Global Utmaning, SIFR hosted an event on “Combatting the Debt Addiction.” Lord Adair Turner, former head of the FSA, and Anders Borg, the Swedish finance minister, spoke on the role of debt in modern societies.

Lord Turner discussed how the accumulation of excessive debt is a recent trend. He argued that although debt clearly exacerbates the severity of financial crisis, it is actually the residual debt overhang and its implications which are more disastrous. Put more simply, a highly indebted society will suffer from stagnated growth and constrained spending for prolonged periods following a crisis. He suggested that this debt overhang is creating the situation we currently experience. The debt overhang looms over societies which have even seen substantial recovery since the past crisis. Turner postulated that instead of seeing Japan as an anomaly in the 1990s we should have viewed Japan as a warning sign for times to come. Turner suggested that the level of leverage is directly related to the length of recession. He proposed that the only way to reduce the risk of prolonged debt overhang is to build stronger fiscal buffers.

One of the core problems with a highly indebted society is that leverage is difficult to remove. In fact, Lord Turner explained how all efforts to fix indebtedness have simply created a shift from private to public sectors globally. As sovereigns load up their balance sheets with debt, this has done little to reduce the overall indebtedness across the private sector. This observation is concerning as problems with indebtedness may simply carry forward to the next crisis. An indebted society may create extreme pro-cyclicality across business cycles going forward.

One major concern of recent monetary policies is that governments are making lending cheap to help stimulate investment. The main problem is that cheap lending may simply fuel the debt addiction fire. As banks and lending entities provide cheap financing, this financing should in theory go to new investments. If instead this lending goes to finance pre-existing loans and indebted assets there is no real growth. In this scenario, reducing interest rates does not stimulate the real economy. This is a key concern of many policy makers. The percentage of new loans that go to finance new investments as opposed to already existing assets is strikingly low. Kristina Persson from Global Utmaning suggested that “banks are creating too much money but of the wrong kind.” This means that low interest rates will not be able to stimulate the economy in the manner that policy makers would like.

One particular area where this is of concern is real estate. In Sweden, real estate bubbles and crashes are always a concern for the ministry of finance and of course the Riksbank. Indebtedness in real estate has risen in Sweden and it provides new challenges for policy makers. Anders Borg suggested that they plan to do things slowly to avoid jolting the system. Borg cited the drastic tightening in the Netherlands and the severe complications that resulted. Plans to fix the debt addiction in the Swedish housing market are going to be slow and steady.

Pehr Wissen, SIFR, discussed the externalities of tightened regulation. He suggested that we should be wary of the flow of capital outside the net of regulation citing concerns over shadow banking. Put more simply, capital tends to flow to sectors which have less regulation. Increasing constraints simply creates new passageways for capital to evade regulation so we must be particularly cognizant of this effect.