"The prudent will have to pay for the profligate"

Martin Wolf takes a discursive route to make a fairly straightforward observation: no matter how the US deals with its debt hangover, the consequences are likely to be contractionary. But a rapid move to a sustainable savings rate (6%? 10%?) would produce tremendous dislocations. Hence, the public sector will throw sand in the gears, which inevitable means more expenditures, so the responsible will pay for the reckless.

But as we go down this road in America, we are likely to encounter a great deal of resistance. Remember, even in Japan, a society that has tremendous respect for authority, it was difficult to sell the public on bailing out the banking system. And here, a generation of free market ideology may backfire. That line of thinking led to a backlash against regulation which helped make the credit crisis possible (yes, there might have been some speculative froth even with tougher rules, but not to this degree). Now this may well have been cant on the part of business interests who will tack with the wind. But to the extent that they created true believers in their faith, they will have created a cohort of libertarians and conservatives who will be deeply opposed to rescuing the imprudent.

The next few months may reveal some of the fault lines.

From the Financial Times:

You have enjoyed a debt-financed spending spree. But times are now harder: you find it impossible to roll over your debt; you have to pay much higher interest rates than before; or you find that the value of the assets you pledged as collateral is now less than your loan. What can you do? Provided enough of you are in trouble, you call for help from the fairy government-mother.

Over-indebted individuals have just three choices: reduce spending below income, sell assets they own to somebody else or, if the worst comes to the worst, default. But one person’s debt is another person’s asset, one person’s expenditure is another person’s income; one person’s sale is another person’s purchase and one person’s default is another person’s loss.

If very many individuals reduce their spending, in order to pay down their debt, the economy slumps. If many try to sell assets they own, their prices crash. If many default on their debts, financial intermediaries implode. The economics of an entire economy are not the same as the economics of a single household. That was perhaps the most important point John Maynard Keynes made.

Thus, argues Mr Magnus, “there is a quite serious risk that the de-leveraging downturn could run amok: credit contraction causes economic contraction, which causes further write-downs and capital destruction, which leads to more credit contraction and so on”. On the upside, the fairy government-mother stood on the sidelines, applauding the enthusiasm of her charges. On the downside, she is dragged in, as risk-addiction turns into risk-aversion.

Between its low in the first quarter of 1982 and its high in the second quarter of 2007, the share of the financial sector’s profits in US gross domestic product rose more than six-fold. Behind this boom was an economy-wide rise in leverage (see chart). Leverage was the philosopher’s stone that turned economic lead into financial gold. Attempts to reduce it now risk turning the gold back into lead again.

Hélène Rey of the London Business School has demonstrated this process for the financial sector.** She describes three ways in which markets have malfunctioned: via the originate-to-distribute model, with its weak incentives to assess loan quality and wide diffusion of assets of unknown quality; via the vicious spiral in credit default swaps, with rising prices forcing a higher cost of funds on banks, so worse credit standing and so forth; and, finally, via tumbling market valuation of assets, with distressed sales in thin markets lowering solvency and forcing further sales.

Each drowning institution drags others down with it. The solution they all desire is for the government to act as lender of last resort against illiquid instruments and buyer of last resort of impaired ones. While the former activity has been known since the days of Walter Bagehot’s Lombard Street, the latter is an overt bail-out. But for the sector as a whole, any other way of reducing excessive liabilities is far too slow, collectively ruinous, or both.

Now consider a second crucial sector: US households. They have been spending more than their income for a decade. Indeed, this spending has been the single most important counterpart of the persistent US surplus on the capital account (or deficit on the current account). In the process, households have accumulated ever more debt.

How might households seek to reduce their indebtedness, collectively? They can try to sell assets. But they can sell houses only to one another, which would not, in aggregate, help. They can sell equities to the rest of the world, but their prices might crash first. They can default. Indeed, many seem likely to do so. But that would damage the financial sector’s solvency and, through that, either the government’s balance sheet, via bail-outs, or the balance sheet of other households, via losses on financial assets.

Finally, they can cut back on spending. But that would guarantee a recession, if not a slump. In the fourth quarter of 2007, household savings were still as low as ever, at 2 per cent of GDP. Imagine that they rose swiftly back to where they were in the early 1990s. That would be an increase of 4 percentage points of GDP. The result would be a deep recession. It is no surprise, therefore, that politicians are trying to rescue the housing market, while the Federal Reserve has been slashing interest rates with vigour.

In such predicaments, the government always emerges as the lender, borrower and spender of last resort. It will act by bailing out insolvent people and institutions, by either replacing or guaranteeing the lending activities of the private financial sector and, not least, by running larger fiscal deficits, as private-sector financial deficits shrink.

It should be no surprise, therefore, that the principal balance-sheet effect of Japan’s long crisis was a rise in the government’s gross debt from 70 per cent of GDP in 1990 to 180 per cent at the end of last year. Leverage did not so much disappear as become socialised.

Similarly, a rise in the indebtedness of the US government is an almost inevitable consequence of any prolonged financial crisis. A jump in public debt is an invisible increase in long-term private obligations. But this is socialised private debt: the prudent pay for the profligate.

An escape from the public sector’s debt trap exists: the mass default known as inflation. By destroying the purchasing power of money, the government can engineer a speedy reduction in indebtedness across the economy, at the expense of creditors, principally the elderly and foreigners. Inflation is a magic tax on creditors whose proceeds are directly transferred to debtors.

The bottom line is simple. Neither households nor the financial sector, as a whole, can de-leverage swiftly, other than via a calamitous mass default or by shifting their debt elsewhere, usually on to the government. For an entire economy, particularly a huge one, to recover from debt-addiction is hard. However much one may loathe the idea, a private-sector financial mania will finish up as public-sector pain.

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  1. a

    I just don’t understand the conclusion, “However much one may loathe the idea, a private-sector financial mania will finish up as public-sector pain.” It may finish up, but it doesn’t have to. What one needs is a bit of courage, to just say no.

  2. S

    ADP report unreal. -58K but ADP rep gets on TV and almost embarrassingly says financial employment was flat in the month? Is it me…

  3. The Epicurean Dealmaker

    In addition to matters of personal taste and morals, the principle motivating factor behind aversion to bailing out the profligate in any such situation is the belief that they alone have profited from their profligacy. However, given the scale and duration of leveraging across all sectors of the economy, it is ludicrous to assert that the prudent did not also share in the benefits of the asset inflation bubble credit profligacy helped created.

    Are the prudent not also homeowners, taxpayers, investors, and 401K owners? If so, their personal wealth and income was boosted by the over-spending of their neighbors and government officials as well. Perhaps they did not actively seek such benefits, and personally abhorred them (I doubt it), but they benefited nonetheless from increases in the value of their real estate and investments, and the reduction in the taxes they otherwise should have paid to support the government expenditures they likewise enjoyed.

    Whether they liked it or not, the prudent ended up borrowing from the future just as much as the profligate, simply because neither prudent nor profligate can insulate themselves from the behavior of their fellow citizens. Now the future has arrived, and we all have to pay the bill.

  4. insurance guy

    If Martin Wolf is right and the Government will end up spending heavily to resolve this mess, the money should be spent on upgrading infrastucture (including education), and not on bailing out equity and debt investors in financial institutions.

    Yves is right. Nationalize the banks if and when they become insolvent. Protect depositors of banks and clients and counterparties of IBanks. Watch the savings rate climb. Stimulate economic activity through public infrastucture investment.

    We may suffer a recession, but if infrastructure spending is strong enough, a recession is all it will be… and the economy will be more productive from the investment going forward.

  5. Zeke

    Epicurian, you wrote: “Whether they liked it or not, the prudent ended up borrowing from the future just as much as the profligate, simply because neither prudent nor profligate can insulate themselves from the behavior of their fellow citizens. Now the future has arrived, and we all have to pay the bill.”

    I disagree. Some people made out like bandits and others very much went about their lives as normal. I bought a house before the boom and continued to live in it and pay off my fixed mortagage. Sure it went up in paper value, and now it’s gone back down.

    Meanwhile my friend Raoul took out a series of ARM loans planning to roll them over and lived on the teaser rate for 5 years. By virtue of paying only 2% for money he was able to buy a McMansion. At some point even with the loans his McMansion had appreciated on paper so much he took equity out and used it for fancy furniture and trips to Asia.

    Now he’s upside down and owes lots of money.

    We didn’t benefit in anywhere near equal amounts from the boom. I had the pleasant experience of noting my house was worth more (for a bit, before it wasn’t again). Raoul has had the pleasure of living in a 10,000 square foor mansion with swimming pool and tennis court for 5 years, and all those luxury vacations I didn’t take.

    If we bail out the profilgate we are creating the ulitimate moral hazard, in my opinion. In so far as possible chips should fall where they may. It may, indeed, be the case that entities like Bear Stearns are “too big to fail” but even then we should work hard to let them, or punish them, if we can. The $2 stock price was better than the $10 stock price for this reason, in my opinion.

  6. S

    truckers causing major diruptions and talking about slowing deliveries. I thought this only happend in France.

  7. Anonymous

    Speaking as one of the prudent, it wasn’t fun to try to buy a house in the inflated market. We snagged a good deal because we are prudent, but if housing prices fall far enough we could go upside-down through no fault of our own.

  8. Anonymous

    Why just bail it out? Let’s take some lasting action and get things going again in a sane, productive manner. The Fed is the source iof the problem, not the solution. It is the banking system, under the Fed’s watchful eyes and support that created the subprime crisis to create paper to feed the derivatives monster.


  9. eh

    But as we go down this road in America, we are likely to encounter a great deal of resistance.

    Something sort of like an ‘immovable object’ is what I have in mind.

  10. Anonymous

    Far from “tacking with the wind”, I believe business interests were either running or reaching with the prevailing winds, however far this may have pushed them off-course. When one tacks to port or starboard, it is with the intention of making headway against the prevailing winds. When doing so it is possible – through mishandling, misjudgement, or simple misattention – to wind up in irons, and one can easily find that the craft has completely stalled or is even moving backwards.

  11. Anonymous


    I rather disagree with your statement that the prudent have benefited significantly.

    I hold a fairly good but not spectacular job (IT for a bank), have worked since 1998, never participated much in the dot-com madness, have invested a bit here and there but mostly in fixed income. Didn’t buy any real estate (not much money when it was reasonable, and by the time I saved around $500,000, it got just way too expensive for my tastes).

    Now, with a lot of sadness I watch my savings being wiped out by the government through USD inflation.

    So, who was supporting whom?

    Apart from a reasonably good job market (not forgetting being laid off post-dot-com crash), I have not benefited in this much at all.


  12. Anonymous

    You said inflation was a possibility. to transfer burden to creditors. That already is happening as foreign holders of US financial assets, bonds and stock (such as China, etc) lost 30% of their wealth as the dollar depreciated…

  13. Anonymous

    “But as we go down this road in America, we are likely to encounter a great deal of resistance.”

    Maybe once upon a time that would have been true. But given that Americans have looked on like drugged sheep as our leaders launched a trillion-dollar unprovoked war on another country, tapped all our phones and email without warrants, and handed over billions in taxpayer dollars to the people who ran Bear Stearns into the ground, I doubt that there will be much resistance.

  14. Moopheus

    “”I doubt that there will be much resistance.”

    All of that is true, but when you threaten an American’s wallet, then they sit up and notice.

  15. foesskewered

    Perhaps, the silent solution (combining public indebtedness and inflation) has already began. Perhaps, US consumers haven’t noticed it much but the rest of the world, particularly Asia is seeing alarming interest rates. No one wants a recession, but if it means that ultimately, the US economy can regain some real health, it should be preferrable to unhealthy doses of bailout morphine

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