ECB's Trichet: No-BS Talk to Yankee Debt Lovers

ECB President Jean-Claude Trichet should be most familiar to readers as the anti-Bernanke. Although his institution has certainly taken some unconventional measures to help put out fires in Europe, their magnitude pales in comparison to those taken by the self-described Yankee helicopter pilot. Unsurprisingly, Bernanke has gone on talking about policy options for further easing.

A few weeks ago, Trichet wrote an op-ed in the Financial Times that developed economies should stimulate no more. Only yesterday, Trichet attended the central banker jamboree in Jackson Hole, Wyoming, where he took the opportunity to warn his easy money American colleagues about the perils of their actions. While his entire speech is a tour de force that requires close reading, below is an excerpt concerning what the US has most likely in mind. That is, the Yanks think that living with the debt is not particularly harmful. Trichet, however, would like to disagree with this misdiagnosis:

What about the option of “living with the debt”? Some have suggested to ignore existing financial imbalances “for the time being” and focus only on the short term. Rather than pressing on with the deleveraging process, more spending could be encouraged to sustain growth in the short term.

I believe that adopting this view would be very dangerous for our economies. There is a very clear example of the consequences of choosing to live with the debt: Japan in the 1990s. The “lost decade” in that country was the result of allowing the banking system to remain fragile over many years.

Banks appear to have contributed to economic weakness by rolling over the bad debts of inefficient firms. Banks’ inadequate capitalisation implied that they were unwilling to take losses. Low productivity growth in those inefficient firms and the locking in of capital and labour put a drag on potential output. Only a healthy financial system is able to provide funding for good projects that spur productivity and innovation.

The lesson from past history is that dealing with the legacy of accumulated imbalances is not simply a duty to be fulfilled after the economic recovery, but rather an important precondition for sustaining a durable recovery. The primary macroeconomic challenge for the next 10 years is to ensure that they do not turn into another “lost decade”.

This lesson is consistent with economic theory and evidence. Since the time of Irving Fisher, economists have explored the impact of a legacy of indebtedness for growth. In various ways, these analyses suggest that an excessive debt burden – whether emanating from the corporate, household or public sector – constitute a drag on spending, thereby dampening growth.

For firms, for example, high indebtedness reduces their net worth and the ability to borrow for new projects. Consequently, firms will postpone investments until they are able to restore sound balance sheets. Similarly, households’ precautionary saving could remain high until their wealth-to-income ratios return to more normal levels, following the collapse in asset values at the peak of the crisis.

Economic growth can also be threatened by high public indebtedness, which, without a credible fiscal retrenchment plan, can generate substantial uncertainty. Firms and households know that ultimately they will have to bear the consequences of the painful measures needed to reduce debt. As long as it is unclear when the adjustment will occur and who will bear what fraction of the costs of adjustment, firms and households may delay their investment and consumption decisions, slowing down the economic recovery. In the data, evidence points to the existence of a negative association between the level of public debt and subsequent GDP growth, which is particularly marked at high debt levels.

Finally, the debt overhang can make it attractive for governments to adopt regulatory measures that compel the financial and/or household sectors to hold government debt at low or even negative real interest rates – measures referred to as “financial repression”. Forced investment in government bonds distorts the role of the financial system in channelling resources to the most efficient firms and slows down economic growth. While the effects of financial repression on growth are particularly severe, these effects may also occur through excessive financial regulation.

So the option of ‘living with the debt’ indefinitely is not a solution to the challenges currently facing policy-makers, nor is it a means to ensure sustainable economic recovery. We must focus on policies to address the debt overhang.

Ricardian equivalence, baby; don't leave home without thinking about it. On America's current trajectory, perhaps folks won't be talking about Jackson Hole but the Bernanke Hole.