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The persistence of debt - A special report on the world economy

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The persistence of debt


But the relief is likely to be short-lived. Just over a year ago, the day Lehman Brothers filed for bankruptcy, the world economy fell off a precipice. When you are falling, you do not look up. Only when you hit bottom can you stop and contemplate the cliff you must now climb. This special report will argue that although a “new normal” for the world economy is now in sight, it will be different from the old normal in a number of ways. Demand in rich countries will remain weak and emerging economies will not be able to compensate. The report will explain why many governments will have to keep their stimulus packages going for longer than expected, or face entrenched unemployment that will permanently lower their economic potential. Public debt will rise so that private debt can fall. The banks, the report will show, will remain cautious about lending again, which will slow up the recovery but also make companies more careful about their investment; and the securitisation markets that became so fashionable during the boom will recede, though not disappear altogether. A persistent shortfall in demand will weigh on supply. By the time this crisis is over, as many as 25m people may have lost their jobs in the 30 rich countries that belong to the Organisation for Economic Co-operation and Development (OECD). The danger is that several million may never regain them. The mobilisation of capital will be fitful as the financial system copes with past mistakes and impending regulation. The travails of finance, in turn, may prevent the recovering economy from backing and exploiting innovations. Like Japan’s bubble years, the years that led to the global financial crisis have left a heavy legacy of debt on the balance-sheets of banks and households, especially in Britain and America. It is this legacy that allows past losses to depress future gains. Fisher, again, put it best: “I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt.” There is no better example of that than American consumers.

2. From Ozzie to Ricky. The crisis was a big setback for American consumers. Will it usher in a new era of thrift?


IN “THE Adventures of Ozzie and Harriet”, a situation comedy that ran on American television from 1952 to 1966, Ozzie Nelson, his wife and their two sons played fictionalised versions of themselves. Tucked away in their shingled Californian home, the Nelson family became synonymous with the 1950s: happy and square.Christina Romer, chair of President Barack Obama’s Council of Economic Advisors, in a speech in May asked whether America could grow without bubbles. “Yes we can” was her (predictable) conclusion. But it was telling that she had to reach back to the era of Ozzie and Harriet for her best examples. Throughout the 1950s, she pointed out, America experienced “healthy” growth and “sensible asset markets”. And from 1962 to 1967, as the show came to an end, America grew by an impressive 5% a year, with a balanced budget and modest trade surpluses.During the Ozzie and Harriet era, America’s households saved over 8% of their disposable income. In the decadent years from 2002 to 2007, by contrast, that rate averaged only 2.7%. Americans had an alibi for their meagre saving: the rising value of their homes. To take just one example, Ozzie and Harriet’s house in Los Angeles, where the family lived and the show was set, jumped in value from about $2m in 2002 to over $3.5m in 2007, according to zillow.com, a property site.American households sat and watched their wealth grow without straining to add to it. Their collective net worth increased from $42.1 trillion in 2001 to $63.9 trillion in 2007. But since then they have looked on in horror as their wealth plunged to $51.1 trillion in the first quarter of 2009. According to Martin Baily and his colleagues at the McKinsey Global Institute, a think-tank, the crisis destroyed a bigger proportion of household wealth, in real terms, than was lost during the Depression. These epic losses produced a “behavioural convulsion”, in the phrase of Bruce Kasman of JPMorgan Chase. Households cut their spending abruptly at the end of last year. By the second quarter of 2009 their saving had risen to 5% of disposable income. Every extra percentage point of saving reduces annual spending by about $109 billion, so aggregate demand contracted violently. The question now is whether the convulsion is over.

Proceed with caution


There are reasons to hope so. Households whose members are still working, but stopped spending anyway, should resume shopping. The economy should also benefit from some catch-up purchases. But even households that kept their jobs lost some of their savings. By the end of the first quarter 14m American households (27% of mortgage-holders) owed more than their homes were worth, according to estimates by Deutsche Bank. As these facts sink in, household saving rates will return to Ozzie and Harriet levels and beyond, according to analysts such as David Rosenberg of Gluskin Sheff. He thinks the saving rate could exceed 10%. According to this view, the past decadent decade will give way to a new era of thrift, reminiscent of the strait-laced 1950s. Will American consumers pick up where they left off two years ago, or 50 years ago? The most likely answer lies somewhere in between. If Mr Rosenberg is right that American households now intend to save over 10% of their disposable income, the obvious question is: what are they waiting for? To be sure, consumers often respond sluggishly to events, but this crisis has not suddenly crept up on people. Surveys reveal a collapse in consumer confidence last winter. Whatever economies people mean to make, they should already be in train. Consumers may take another quarter or two to back down from spending commitments that are hard to revoke instantly. If you have a year-long contract on your fancy mobile phone, one economist points out, you will have to wait to replace it with a cheaper model. Taking such delays into account, the saving rate may still be shy of its peak, but not by much.There is a second reason why American households will not retreat all the way back to the Ozzie and Harriet era. The high saving in those decades was partly involuntary: people suffered from credit constraints imposed by a sleepier financial system that was not bent on lending against every dollar of household wealth or future income.By the early 1980s Americans had large amounts of equity locked away in their houses. In 1982 their property was worth 106% of GDP and their debts amounted to less than 50% of that sum. Two pieces of legislation, the Monetary Control act of 1980 and the Garn-St Germain act of 1982, unlocked this wealth. The new laws made it easier for households to refinance their mortgages and borrow against the value of their homes. What followed was a “borrowing shock of huge macroeconomic magnitude”, according to Jeffrey Campbell of the Federal Reserve Bank of Chicago and Zvi Hercowitz of Tel Aviv University. Shortly after the legislation was passed, household debt began to rise much faster than take-home pay. Ozzie Nelson’s youngest son, Rick, who pursued a career in country rock music after the show ended, was a trendsetter, sinking into debt in the early 1980s after an expensive divorce. By one measure the borrowing shock continued for 25 years: household debt peaked at 138% of disposable income in 2007. But the shock came in two distinct waves. In the first, households took advantage of the lifting of credit constraints to borrow more freely. They purposefully increased their debt relative to the value of their assets. In the second wave, which began in the mid-1990s, asset bubbles tempted households to borrow more heavily as first their shares and then their homes rose in value. It was only after the value of their property holdings plunged from 2006 onwards that their debts became so onerous. The first wave of borrowing, then, was a rational response to a liberalising policy. The second was a regrettable response to an unsustainable bubble.Consumer spending, according to a model laid out by Christopher Carroll, now on Ms Romer’s Council of Economic Advisors, reflects the push and pull of impatience and anxiety. Impatience pushes households to spend. Anxiety leads them to build up a “buffer stock” of wealth, which will be some multiple of their normal income, as a hedge against misfortune. The crisis has depleted that buffer. Households’ net worth now amounts to 487% of their disposable income, down from a peak of 639% in 2006 and a historical average of about 500% (see chart 2). To restore their wealth to this long-run average, households would have to repay about $1.4 trillion of debt. At their present rate of saving, these balance-sheet repairs will not be finished until 2012.


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