I was pleasantly surprised by the contents of his speech, especially considering he's a Goldman-Sachs alumni.
I've left out the section which is specific to Canada's challenges since it's not as important as the rest. The full text of the speech complete with graphs can be found at the link below.
http://www.bankofcanada.ca/wp-content/u ... 121211.pdf
Of particular interest is the section on managing the deleveraging process; austerity is necessary, inflation won't work, and growth is unlikely. The implication is that debt restructuring, in other words, defaults, are likely to take place. And his thoughts on defaults mirror my own, if nations are going to default, they should do so as soon as possible rather than putting it off.Growth in the Age of Deleveraging
Introduction
These are trying times.
In our largest trading partner, households are undergoing a long process of balance-sheet repair. Partly as a consequence, American demand for Canadian exports is $30 billion lower than normal.
In Europe, a renewed crisis is underway. An increasing number of countries are being forced to pay unsustainable rates on their borrowings. With a vicious deleveraging process taking hold in its banking sector, the euro area is sinking into recession. Given ties of trade, finance and confidence, the rest of the world is beginning to feel the effects.
Most fundamentally, current events mark a rupture. Advanced economies have steadily increased leverage for decades. That era is now decisively over. The direction may be clear, but the magnitude and abruptness of the process are not. It could be long and orderly or it could be sharp and chaotic. How we manage it will do much to determine our relative prosperity.
This is my subject today: how Canada can grow in this environment of global deleveraging.
How We Got Here: The Debt Super Cycle
First, it is important to get a sense of the scale of the challenge.
Accumulating the mountain of debt now weighing on advanced economies has been the work of a generation. Across G-7 countries, total non-financial debt has doubled since 1980 to 300 per cent of GDP. Global public debt to global GDP is almost at 80 per cent, equivalent to levels that have historically been associated with widespread sovereign defaults.1
The debt super cycle has manifested itself in different ways in different countries. In Japan and Italy, for example, increases in government borrowing have led the way. In the United States and United Kingdom, increases in household debt have been more significant, at least until recently. For the most part, increases in non-financial corporate debt have been modest to negative over the past thirty years.
In general, the more that households and governments drive leverage, the less the productive capacity of the economy expands, and, the less sustainable the overall debt burden ultimately is.
Another general lesson is that excessive private debts usually end up in the public sector one way or another. Private defaults often mean public rescues of banking sectors; recessions fed by deleveraging usually prompt expansionary fiscal policies. This means that the public debt of most advanced economies can be expected to rise above the 90 per cent threshold historically associated with slower economic growth.2
The cases of Europe and the United States are instructive.
Today, American aggregate non-financial debt is at levels similar to those last seen in the midst of the Great Depression. At 250 per cent of GDP, that debt burden is equivalent to almost US$120,000 for every American (Chart 1).3
Several factors drove a massive increase in American household leverage. Demographics have played a role, with the shape of the debt cycle tracking the progression of baby boomers through the workforce.
The stagnation of middle-class real wages (itself the product of technology and globalisation) meant households had to borrow if they wanted to maintain consumption growth.4
Financial innovation made it easier to do so. And the ready supply of foreign capital from the global savings glut made it cheaper.
Most importantly, complacency among individuals and institutions, fed by a long period of macroeconomic stability and rising asset prices, made this remorseless borrowing seem sensible.
From an aggregate perspective, the euro area’s debt metrics do not look as daunting. Its aggregate public debt burden is lower than that of the United States and Japan. The euro area’s current account with the rest of the world is roughly balanced, as it has been for some time. But these aggregate measures mask large internal imbalances. As so often with debt, distribution matters (Chart 2).
Europe’s problems are partly a product of the initial success of the single currency. After its launch, cross-border lending exploded. Easy money fed booms, which flattered government fiscal positions and supported bank balance sheets.
Over time, competitiveness eroded. Euro-wide price stability masked large differences in national inflation rates. Unit labour costs in peripheral countries shot up relative to the core economies, particularly Germany. The resulting deterioration in competitiveness has made the continuation of past trends unsustainable (Chart 3). Growth models across Europe must radically change.
It’s the Balance of Payments, Stupid!
For years, central bankers have talked of surplus and deficit countries, of creditors and debtors. We were usually ignored. Indeed, during a boom, the debtor economy usually feels more vibrant and robust than its creditors. In an era of freely flowing capital, some even thought current account deficits did not matter, particularly if they were the product of private choices rather than public profligacy.
When the leverage cycle turns, the meaning and implications of these labels become tangible. Creditors examine more closely how their loans were spent. Foreign financing constraints suddenly bind. And to repay, debtors must quickly restore competitiveness.5
Financial globalisation has provided even greater scope for external imbalances to build (Chart 4). And its continuation could permit larger debt burdens to persist for longer than historically was the case. However, experience teaches that sustained large cross-border flows usually presage liquidity crunches.6
The Global Minsky Moment Has Arrived
Debt tolerance has decisively turned. The initially well-founded optimism that launched the decades-long credit boom has given way to a belated pessimism that seeks to reverse it.
Excesses of leverage are dangerous, in part because debt is a particularly inflexible form of financing. Unlike equity, it is unforgiving of miscalculations or shocks. It must be repaid on time and in full.
While debt can fuel asset bubbles, it endures long after they have popped. It has to be rolled over, although markets are not always there. It can be spun into webs within the financial sector, to be unravelled during panics by their thinnest threads. In short, the central relationship between debt and financial stability means that too much of the former can result abruptly in too little of the latter.
Hard experience has made it clear that financial markets are inherently subject to cycles of boom and bust and cannot always be relied upon to get debt levels right.7 This is part of the rationale for micro- and macroprudential regulation.
It follows that backsliding on financial reform is not a solution to current problems. The challenge for the crisis economies is the paucity of credit demand rather than the scarcity of its supply. Relaxing prudential regulations would run the risk of maintaining dangerously high leverage—the situation that got us into this mess in the first place.
The Implications of Deleveraging
As a result of deleveraging, the global economy risks entering a prolonged period of deficient demand. If mishandled, it could lead to debt deflation and disorderly defaults, potentially triggering large transfers of wealth and social unrest.
History suggests that recessions involving financial crises tend to be deeper and have recoveries that take twice as long.8 The current U.S. recovery is proving no exception (Chart 5). Indeed, it is only with justified comparisons to the Great Depression that the success of the U.S. policy response is apparent.
Such counterfactuals—it could have been worse—are of cold comfort to American households. Their net worth has fallen from 6 ½ times income pre-crisis to about 5 at present (Chart 6). These losses can only be recovered through a combination of increased savings and, eventually, rising prices for houses and financial assets. Each will clearly take time.
In Europe, a tough combination of necessary fiscal austerity and structural adjustment will mean falling wages, high unemployment and tight credit conditions for firms. Europe is unlikely to return to its pre-crisis level of GDP until a full five years after the start of its last recession (Chart 7).
Managing the Deleveraging Process
Austerity is a necessary condition for rebalancing, but it is seldom sufficient. There are really only three options to reduce debt: restructuring, inflation and growth.
Whether we like it or not, debt restructuring may happen. If it is to be done, it is best done quickly. Policy-makers need to be careful about delaying the inevitable and merely funding the private exit. Historically, as an alternative to restructuring, financial repression has been used to achieve negative real interest rates and gradual sovereign deleveraging.
Some have suggested that higher inflation may be a way out from the burden of excessive debt.9
This is a siren call. Moving opportunistically to a higher inflation target would risk unmooring inflation expectations and destroying the hard-won gains of price stability. Similarly, strategies such as nominal GDP level targeting would fail unless they are well understood by the public and the central bank is highly credible.10,11
With no easy way out, the basic challenge for central banks is to maintain price stability in order to help sustain nominal aggregate demand during the period of real adjustment. In the Bank’s view, that is best accomplished through a flexible inflation-targeting framework, applied symmetrically, to guard against both higher inflation and the possibility of deflation.
The most palatable strategy to reduce debt is to increase growth. In today’s reality, the hurdles are significant.
Once leverage is high in one sector or region, it is very hard to reduce it without at least temporarily increasing it elsewhere.
In recent years, large fiscal expansions in the crisis economies have helped to sustain aggregate demand in the face of private deleveraging (Chart 8 ). However, the window for such Augustinian policy is rapidly closing. Few except the United States, by dint of its reserve currency status, can maintain it for much longer.
In most of Europe today, further stimulus is no longer an option, with the bond markets demanding the contrary.
There are no effective mechanisms that can produce the needed adjustment in the short term. Devaluation is impossible within the single-currency area; fiscal transfers and labour mobility are currently insufficient; and structural reforms will take time.
Actions by central banks, the International Monetary Fund and the European Financial Stability Facility can only create time for adjustment. They are not substitutes for it.
To repay the creditors in the core, the debtors of the periphery must regain competitiveness. This will not be easy. Most members of the euro area cannot depreciate against their major trading partners since they are also part of the euro.
Large shifts in relative inflation rates between debtor and creditor countries could result in real exchange rate depreciations between euro-area countries. However, it is not clear that ongoing deflation in the periphery and higher inflation in the core would prove any more tolerable than it did between the United Kingdom and the United States under the postwar gold standard of the 1920s and 1930s.
The route to restoring competitiveness is through fiscal and structural reforms. These real adjustments are the responsibility of citizens, firms and governments within the affected countries, not central banks. A sustained process of relative wage adjustment will be necessary, implying large declines in living standards for a period in up to one-third of the euro area.
We welcome the measures announced last week by European authorities, which go some way to addressing these issues.
With deleveraging economies under pressure, global growth will require global rebalancing. Creditor nations, mainly emerging markets that have benefited from the debt-fuelled demand boom in advanced economies, must now pick up the baton.
This will be hard to accomplish without co-operation. Major advanced economies with deficient demand cannot consolidate their fiscal positions and boost household savings without support from increased foreign demand. Meanwhile, emerging markets, seeing their growth decelerate because of sagging demand in advanced countries, are reluctant to abandon a strategy that has served them so well in the past, and are refusing to let their exchange rates materially adjust.
Both sides are doubling down on losing strategies. As the Bank has outlined before, relative to a co-operative solution embodied in the G-20’s Action Plan, the foregone output could be enormous: lower world GDP by more than US$7 trillion within five years (Chart 9). Canada has a big stake in avoiding this outcome.
To Summarize Thus Far
The market cannot be solely relied upon to discipline leverage.
It is not just the stock of debt that matters, but rather, who holds it. Heavy reliance on cross-border flows, particularly when they fund consumption, usually proves unsustainable.
As a consequence of these errors, advanced economies are entering a prolonged period of deleveraging.
Central bank policy should be guided by a symmetric commitment to the inflation target. Central banks can only bridge real adjustments; they can’t make the adjustments themselves.
Rebalancing global growth is the best option to smooth deleveraging, but its prospects seem distant.
There's a lot to digest in Mr. Carney's speech, if any of you have questions I'll try to answer them as best I can.
