What happens when we come to the place where we have to deal with all that debt?
Fortunately, my favorite central banker, Bill White -- who was the Bank for International Settlements' chief economist -- did a brilliant interview with my friend Mark Dittli in Switzerland in November that gives us some answers.
Today, the Canadian criticizes the central banks: “They have pursued the wrong policies over the past three decades, which have caused ever higher debt and ever greater instability in the financial system.”
He suggests that the current crisis should be used to rethink in order to build a more stable economic system, one in which fiscal policy plays a greater role and that relies more on productive investment.
In this in-depth conversation, White says what should be done – and he demands more humility from decision makers: “We know much less about the economy than we think we do.”
Bill is not calling for austerity at this time. He recognizes we are in a recession/potential depression. But he does want more emphasis on the fiscal policy and not central banks.
We’re on a slope where monetary policy has become increasingly ineffective in promoting real economic growth. Every crisis was met with monetary easing that caused debt and other imbalances to accumulate over time, and that caused the next crisis to be bigger than the previous one. The next crisis then needed more punch from central banks. But since interest rates were never raised as much in upturns as they were lowered in downturns, the capacity to deliver that punch was decreasing.
[The recent March, 2020] episode perfectly encapsulates my view of what’s wrong with our monetary policy of the past decades. True, the Fed had no choice but to step in to prevent a financial meltdown. But this meltdown only happened because of the monetary policy followed over previous years.
… my point is: Central banks create the instabilities, then they have to save the system during the crisis, and by that they create even more instabilities. They keep shooting themselves in the foot.
William Dudley and other US central bankers are beginning to admit that they have come to the end of their effective ability to manage their respective economies. Governments have to step in with fiscal policy that is actually targeted and productive.
Then Bill lists four ways that we can deal with the debt, not all of them palatable:
There is no return back to any form of normalcy without dealing with the debt overhang. This is the elephant in the room. If we agree that the policy of the past 30 years has created an ever-growing mountain of debt and ever rising instabilities in the system, then we need to deal with that.
In theory, there are four ways to get rid of an overhang of bad debt.
One: Households, corporations and governments try to save more to repay their debt. But we know that this gets you into the Keynesian Paradox of Thrift, where the economy collapses. So this way leads to disaster.
Two: You can try to grow your way out of a debt overhang, through stronger real economic growth. But we know that a debt overhang impedes real economic growth. Of course, we should try to increase potential growth through structural reforms, but this is unlikely to be the silver bullet that saves us.
This leaves the two remaining ways: higher nominal growth -- i.e., higher inflation -- or try to get rid of the bad debt by restructuring and writing it off.
When later asked about write-offs, Bill said this:
That’s the one I would strongly advise. Approach the problem, try to identify the bad debts, and restructure them in as orderly a fashion that you can. But we know how extremely difficult it is to get creditors and debtors together to sort this out cooperatively. Our current procedures are completely inadequate.
How long can this go on? Longer than you might think. From David Rosenberg, Chief economist and strategist at Gluskin Sheff & Associates:
We had core CPI data out of Japan and the YoY trend went further into deflation to -0.7% in October from -0.3% in September. The is the sharpest move into deflation terrain since March 2011.
A country with a 700% total debt-to-GDP ratio, two decades of zero interest rates, and a central bank balance sheet that is 130% of GDP. Nice to see how all the credit creation has managed to spur on a reflationary backdrop. Shades of what’s to come in the U.S.
I agree the US could turn Japanese.
While I think we will see inflation in the short term (2 to 3 years), the debt overhang and growth of central bank reserves will lead us directly into the same problem Japan is facing. That is, a deflationary economic cycle with no growth.
It will be a strange new world that will have no resemblance to the last decade’s “normal.”
We will stumble through and some of us will do extraordinarily well, because we position ourselves to take advantage of this cycle. New technology (especially biotechnology) will make our lives better all the while, so that's a good place to start looking for opportunity.
The Great Reset: The Collapse of the Biggest Bubble in History
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