Thursday, October 13, 2011

Who pays for the debt overhang?

High levels of debt by governments and households are a constraint on how fast demand can grow today. Even if the economic fundamentals (productivity, labor market) were unaffected by the crisis, an environment where everyone wants to save cannot be conducive to growth. Production needs to be sold and for that you need customers. Even those who are not very sympathetic to economic models where demand drives growth understand the difficulties of growing in an environment of debt overhang (here is Martin Feldstein today on the New York Times).

Default, reduction in mortgage payments are all proposals to alleviate the problem but they come at a cost: your debt is someone else's asset. There are, of course, circumstances where debt reduction is not a zero-sum game, where this is the only way to avoid a spiral of less spending, lower income and even higher debt as a percentage of income. This is what is called the paradox of thrift. There are other circumstances where everyone can benefit from debt reductions. As Martin Feldstein argues, reducing the value of a mortgage can be beneficial to both the individual and the bank:

This plan is fair because both borrowers and creditors would make sacrifices. The bank would accept the cost of the principal write-down because the resulting loan — with its lower loan-to-value ratio and its full recourse feature — would be much less likely to result in default. The borrowers would accept full recourse to get the mortgage reduction.

Of course, the bank would love to get back the full amount of the loan but given that in many cases individuals can walk away from an underwater home, a reduction in debt is the best the bank can get. In this case we can argue that it is even in the interest of the individual bank to strike this deal, so there is no need for co-ordination.

A similar story applies to the debate about default in Greece but the solution is less obvious. Banks do not like the idea of default; they want to be paid back but they also understand that a compromise might be better than fighting to a point where default is even bigger. This is the logic behind the current negotiations between the Greek government, the holders of the bonds and governments (who are behind the potential tax payer money that could go into the deal). And this becomes a very difficult discussion where co-ordination is key. As an example, European banks are likely to find themselves under pressure to raise more capital to absorb potential losses from an orderly default of the Greek debt. But it is costly to raise capital. The negotiations start and you need to get enough public support for your position. Josef Ackermann is quoted today as saying that recapitalization is a bad idea because the cost will ultimately be paid by customers (those asking for a loan). Or worse, the capital will not come from private investors but from public sources, making the government debt problem even worse. Here is the quote from the Financial Times:

On the one hand it [the debate] sends the signal that a [debt] haircut is more likely, and on the other because the resources for recapitalisation will surely not come from private investors, but rather states would ultimately have to raise the funds themselves, thereby worsening their debt levels.
So here we are, in the middle of the negotiation phase. I am sure there is some consensus on why dealing with the debt overhang is good for the economy, now the question is who pays for it. And no one wants to pay for it, so unfortunately there is no consensus there.

Antonio Fatás
on October 13, 2011 |   Edit