In a new San Francisco Fed Economic Letter , economists Òscar Jordà , Moritz Schularick , and Alan M. Taylor try to settle the debate over whether private credit or public debt was the bigger culprit in the global economic crisis. They award points to each. In short, their research seems to show that private credit booms put economies in difficult positions. And public debt makes it difficult for economies to recover. The narrative of the recent the global financial crisis in advanced economies falls into two camps. One camp emphasizes private-sector overconfidence, overleveraging, and overborrowing; the other highlights public-sector profligacy, especially with regard to countries in the periphery of the euro zone. One camp talks of rescue and reform of the financial sector. The other calls for government austerity, noting that public debt has reached levels last seen following the two world wars. Figure 1 Credit and debt since 1870: 17-country average Credit and debt since 1870: 17-country average Source: Jordà, Schularick, and Taylor (2013). Figure 1 displays the average ratio of bank lending and public debt to GDP for 17 industrialized economies (Australia, Belgium, Canada, Denmark, Finland, France, Germany, Italy, Japan, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, the United Kingdom, and the United States). Although public debt ratios had grown from the 1970s to the mid-1990s, they had declined toward their peacetime average before the 2008 financial crisis. By contrast, private credit maintained a fairly stable relationship with GDP until the 1970s and then surged to unprecedented levels right up to the outbreak of the crisis. Spain provides an example of the woes in the euro zone periphery and the interplay of private credit and public debt. In 2007, Spain had a budget surplus of about 2% of GDP and government debt stood at 40% of GDP (OECD Country Statistical Profile). That was well below the level of debt in Germany, France, and the United States. But by 2012, Spain’s government debt had more than doubled, reaching nearly 90% of GDP, as the public sector assumed large losses from the banking sector and tax revenues collapsed. Thus, what began as a banking crisis driven by the collapse of a real estate bubble quickly turned into a sovereign debt crisis. In June 2012, Spanish 10-year bond rates reached 7% and, even at that rate, Spain had a hard time accessing bond markets. Once sovereign debt comes under attack in financial markets, banks themselves become vulnerable since many of them hold public debt as assets on their balance sheets. The new bout of weakness in the banking system feeds back again into the government’s future liabilities, setting in motion what some have called the “deadly embrace” or “doom loop.” The conundrum facing policymakers is this: Implement too much austerity and you risk choking off the nascent recovery, possibly delaying desired fiscal rebalancing. But, if austerity is delayed, bond markets may impose an even harsher correction by demanding higher interest rates on government debt. Matters are further complicated for countries in a monetary union, such as Spain. Such countries do not directly control monetary policy and therefore cannot offset fiscal policy adjustments through monetary stimulus by lowering domestic interest rates. In addition, central banks in these countries have limited capacity to stave off self-fulfilling panics since their lender-of-last-resort function evaporates. Fluctuations in fiscal balances over the business cycle are natural. As economic activity temporarily stalls, revenues decline and expenditures increase. With the recovery, fiscal balances typically improve. But the debate on what is a country’s appropriate level of public debt in the medium run continues to rage. It is unclear whether high debt is a cause or a consequence of low economic growth. That said, public debt is not a good predictor of financial crises. Read the full letter here .
Filed under: recession, debt, recovery, EU, financial crises, causes of the crisis, San Francisco Fed, austerity measures, public debt, european central bank, federal reserve bank of san francisco, economic letter, ecb, debt crises, Òscar Jordà, Moritz Schularick, Alan M. Taylor, private debt