Friday, January 5, 2018

The narrative of high debt and powerful central banks

In 2017 GDP growth picked up solidifying a global expansion phase that had previously been slow and erratic. The number of countries growing at rates consistent with their potential increased to levels not seen since prior to the global financial crisis. As the expansion gathers pace and, in some cases, becomes long by historical standards, it is time to wonder where the next crisis will come from and how we will deal with it.

Among the many potential reasons why the world might fall into another recession there is one that is repeated very often and it is linked to the narrative we created after the 2008 crisis. We find ourselves again at a point where debt levels are at record high, asset prices are in bubble territory and the only reason why we have growth is because of the artificial support of central banks.

As an example, here is Stephen Roach looking at 2018 and being worried because 
"Real economies have been artificially propped up by these distorted asset prices, and glacial normalization will only prolong this dependency. Yet when central banks’ balance sheets finally start to shrink, asset-dependent economies will once again be in peril. And the risks are likely to be far more serious today than a decade ago, owing not only to the overhang of swollen central bank balance sheets, but also to the overvaluation of assets."

Or from an opinion article at the Financial Times worrying about Global Debt levels: 
"In two respects, the global economy is living on borrowed time. First, global economic growth is so debt-addicted that no big economy can cope with a rapid tightening in monetary conditions. Second, central banks need to reverse their policies, since continuing low rates and excessive leverage may well result in an explosive cocktail of multiple asset price bubbles." 
These are just two examples of the same narrative. One that sees central banks as responsible for generating "artificial" growth that has led to imbalances in the form of overvalued asset prices and excessive debt.

This narrative is not without merit. Many of the past crisis are preceded by excessive credit growth and asset price bubbles. However, there are many nuances that matter in this analysis. Not every debt is bad and judging risk by looking at record-level values of the stock market is not enough. 

Here is a non-exhaustive list of arguments where details matter for this narrative:

1. Central Banks are not that powerful. The notion that a (selected) group of central banks has managed to create artificial global growth and reduced interest rates across all maturities in (almost) all countries in the world without creating any inflation cannot be right (at least I have not seen any economic model that can generate this prediction). The idea that liquidity created in some central banks is traveling across the world and propping asset prices everywhere is not right, that's not what central banks do. Central banks issue liquidity (which becomes an asset for someone else) by removing a different type of asset. For every liability there is an asset. 

The narrative of very powerful central banks sounded reasonable when the US stock market seemed to be driven by the size of the balance sheet of the central bank...

...until the central bank stopped growing its balance sheet and the stock market went up by another 40%.

2. Not all debt is bad. Two obvious points here. First, as much as we like to criticize financial markets for their excesses, we cannot forget that financial development is key to economic development. There is a very strong correlation between GDP per capita and measures of financial development. And a common measure financial development is the ratio of debt to GDP. Higher debt means financial transaction that could not have occurred otherwise. Buying a house with a mortgage means you can own a house today instead of having to save the full value of the house before you can own it. This does not mean excessive spending. In fact, you might not be increasing your expenditures in housing services at all. Instead of renting a house, you own the asset and pay rent to yourself. The risk goes in both directions. If you own it and prices go down you will be unhappy. But if you are renting and prices go up, consider yourself poorer. Second, one cannot forget that the world has no (net) debt. For every liability there is an asset. It cannot be that we (all citizens of the world) are living beyond their means as they bring future consumption to the present. Once again, details matter and we need to look for specific imbalances within parts of the economy, it can be countries or different economic agents (government, private sector, households, a particular set of companies,...) or a combination of both. 

3. Yes, asset prices are high but this does not imply bubbles ready to burst. The difference between this episode and previous bubbles is that this time all asset prices are high. In the run up to the 1990s stock market bubble, stock prices climbed to levels never seen before. But what was worse is that compared to other assets, for example bonds, those prices looked even more out of sync with reality. The implied stock market risk premium in the late 1990s in the US was probably as low as 1%. That makes no sense. In contrast, today stock prices are high (measured against earnings) but so are bond prices. The implied stock premium is likely to be around 4-5%. Slightly below historical averages but not close at all to the bubble levels in the 1990s. These overvalued asset prices across many asset classes fits better with a narrative of a different balance between global saving (high) and global investment (low). As long as those forces do not change, high asset prices and low interest rates are here to stay.

If my arguments are correct, why is it that the simplistic narrative of debt and excesses remains so present in today's economic analysis? I think that it makes for a simple, yet convincing, narrative along the lines of what Robert Shiller describes in this article. Shiller argues that when it comes to economics, storytelling and powerful narratives dominate our perception of reality.

A final thought before we look forward to a great 2018: there are plenty of risks to be worried about for the coming year, there should be no room for complacency. But the emphasis on debt, bubbles and the negative influence of central banks is overemphasized. If we keep looking there for a clue of when the next crisis will come from we might miss it.

Antonio Fatás

on January 05, 2018 |   Edit