Repent at leisure A report on debt June 26th 2010

Debt.26.06.10.indd 1 15/06/2010 15:45 The Economist June 26th 2010 A special report on debt 1

Repent at leisure Also in this section Paradise foreclosed The boom has left Florida with an excess of houses, shops and debt. Page 3

The morning after A $3 trillion consumer hangover. Page 4

Betting the balance•sheet Why managers loaded their companies with debt. Page 6

A better bust? Bankruptcy is becoming less calamitous. Page 8

The unkindest cuts Many countries face the diˆcult choice of upsetting the markets or upsetting their voters. Page 9

Judging the judges Borrowing has been the answer to all economic troubles in the past 25 The travails of the rating agencies. Page 11 years. Now debt itself has become the problem, says Philip Coggan AN is born free but is everywhere in duce euphoria. Traders and investors saw In a hole Mdebt. In the rich world, getting hold the asset•price rises it brought with it as Stagnation, default or in‡ation await. The of your †rst credit card is a rite of passage proof of their brilliance; central banks and only way out is growth. Page 12 far more important for your daily life than governments thought that rising markets casting your †rst vote. Buying your †rst and higher tax revenues attested to the home normally requires taking on a debt soundness of their policies. several times the size of your annual in• The answer to all problems seemed to come. And even if you shun the tempta• be more debt. Depressed? Use your credit tion of borrowing to indulge yourself, you card for a shopping spree Œbecause you’re are still saddled with your portion of the worth it. Want to get rich quick? Work for national debt. a private•equity or hedge•fund †rm, using Throughout the 1980s and 1990s a rise borrowed money to enhance returns. in debt levels accompanied what econo• Looking for faster growth for your com• mists called the Œgreat moderation, when pany? Borrow money and make an acqui• growth was steady and unemployment sition. And if the economy is in recession, and in‡ation remained low. No longer did let the government go into de†cit to bolster Western banks have to raise rates to halt spending. When the European Union consumer booms. By the early 2000s a countries met in May to deal with the Acknowledgments vast international scheme of vendor †• Greek crisis, they proposed a ¤750 billion Apart from those quoted in the text, special thanks go to nancing had been created. China and the ($900 billion) rescue programme largely Mark Adelson, Thorhallur Arason, Wayne Archer, Amy Baker, Ken Baird, Jon Baldvin, Joe Carson, George Cooper, oil exporters amassed current•account sur• consisting of even more borrowed money. Richard Duncan, Sebastien Eisinger, Kathleen Gallagher pluses and then lent the money back to the Debt increased at every level, from con• McIver, Sigurdur Gudjonsson, Alan Hudson, Jon Jonsson, developed world so it could keep buying sumers to companies to banks to whole Matt King, Gyl† Magnusson, Arnaud Mares, Richard McGuire, Brian Peters, John Psaropolous, William their goods. countries. The e ect varied from country Rizzetta, James Russell, Je rey Sacks, Maarten Those who cautioned against rising to country, but a survey by the McKinsey Slenderbroek, Peter Spratt, Jon Taylor, Richard Tett, debt levels were dismissed as doom•mon• Global Institute found that average total Loukas Tsoukalis, Arsaeli Valfells, Barrie Wilkinson, Martin Winn and Mike Zelouf. gers; after all, asset prices were rising even debt (private and public sector combined) faster, so balance•sheets looked healthy. in ten mature economies rose from 200% A range of additional charts and a list of sources are at And with the economy buoyant, debtors of GDP in 1995 to 300% in 2008 (see chart 1, Economist.com/specialreports could a ord to meet their interest pay• next page, for a breakdown by country). ments without defaulting. In short, it paid There were even more startling rises in Ice• An audio interview with the author is at to borrow and it paid to lend. land and Ireland, where debt•to•GDP ra• Economist.com/audiovideo/specialreports Like alcohol, a debt boom tends to in• tios reached 1,200% and 700% respectively. 1 2 A special report on debt The Economist June 26th 2010

2 The burdens proved too much for those only way they can maintain their desired two countries, plunging them into †nan• level of spending. Another reason is opti• It’s a drag 2 cial crisis. Such turmoil is a sign that debt is mism; they believe the return on the bor• US GDP growth in $ per additional $ of debt* not the instant solution it was made out to rowed money will be greater than the cost be. The market cheer that greeted the EU of servicing the debt. Crucially, creditors 1.0 package for Greece lasted just one day be• must believe that debtors’ incomes will 0.8 fore the doubts resurfaced. rise; otherwise how would they be able to From early 2007 onwards there were pay the interest and repay the capital? 0.6 signs that economies were reaching the But in parts of the rich world such opti• 0.4 limit of their ability to absorb more bor• mism may now be misplaced. With ageing rowing. The growth•boosting potential of populations and shrinking workforces, 0.2 debt seemed to peter out. According to their economies may grow more slowly 0 Leigh Skene of Lombard Street Research, than they have done in the past. They may 1956 70 80 90 2000 10 each additional dollar of debt was associ• have borrowed from the future, using debt Sources: Bureau of Economic *All domestic ated with less and less growth (see chart 2) to enjoy a standard of living that is unsus• Analysis; Federal Reserve; non-financial debt The Economist 3-year moving average tainable. Greece provides a stark example. Stopping the debt supercycle Standard & Poor’s, a rating agency, esti• The big question is whether this rapid mates that its GDP will not regain its 2008 rather than ŒForgive us our trespasses. build•up of debt‹a phenomenon which level until 2017. The Live 8 campaign in 2005 tried to Martin Barnes of the Bank Credit Analyst, Rising government debt is a Ponzi shame developed nations into forgiving a research group, has dubbed the Œdebt su• scheme that requires an ever•growing pop• the debts of poor countries, particularly in percycle‹has now come to an end. Debt ulation to assume the burden‹unless sub•Saharan Africa. Economists have de• reduction has become a hot political issue. some , such as a techno• veloped the concept of Œodious debt in Rioters on the streets of Athens have been logical breakthrough, can boost growth. As which citizens should not be forced to re• protesting against the Œjunta of the mar• Roland Nash, head of research at Renais• pay money borrowed by tyrannical or kets that is imposing austerity on the sance Capital, an investment bank, puts it: kleptocratic rulers. Interest payments on Greek economy, and tea•party activists in ŒCan the West, with its regulated industry, debt are often regarded as an onerous bur• America, angry about trillion•dollar de†• uncompetitive labour and large govern• den placed on the poor; interest is seen as cits and growing government involvement ment, a ord its borrowing•funded living an unjusti†ed reward for capital, a concept in the economy, have been upsetting the standards and increasingly expensive pub• that goes back to Aristotle and is implicit in calculations of both the Democratic and lic sectors? the Christian idea of usury. Islam forbids it Republican party leaderships. Sovereign default is far from inconceiv• altogether. The book of Deuteronomy sug• To understand why debt may have be• able. Many people are forecasting that gested a debt amnesty every seven years, come a burden rather than a boon, it is nec• Greece, despite its bail•out package from which survived into later Jewish custom. essary to go back to †rst principles. Why the EU and the IMF, will be unable to repay But conventional morality has not al• do people, companies and countries bor• its debts in full and on time. Faced with the ways been on the side of the borrowers. row? One obvious answer is that it is the choice between punishing their popula• Some regard debt as the road to ruin and tions with austerity programmes and let• the failure to repay as a breach of trust. In ting down foreign creditors, countries may the 18th and 19th century debtors in Britain Owe dear 1 †nd it easier to disappoint the foreigners. were often thrown into jail (as in Charles Debt as % of GDP, 2008 Defaults have been common in the past, as Dickens’s ŒLittle Dorrit), though Samuel Financial* Non-financial businesses Carmen Reinhart and Ken Rogo showed Johnson spotted the ‡aws of the practice: Households Government in their book, ŒThis Time is Di erent. ŒWe have now imprisoned one generation Adam Smith, a founding father of econom• of debtors after another, but we do not †nd 0 100 200 300 400 500 ics, noted in ŒThe Wealth of Nations that that their lessen. We have now Japan Œwhen national debts have once been ac• learned that rashness and imprudence † Britain cumulated to a certain degree, there is will not be deterred from taking credit; let Spain scarce, I believe, a single instance of their us try whether fraud and avarice may be South Korea having being fairly and completely paid. more easily restrained from giving it. Switzerland ‡ Governments now face a tricky period France when they have to deal with the debt over• Movable morals Italy hang, decide how quickly to cut their de†• In the past 100 years the moral battle has United States cits (and risk undermining growth), and moved in favour of the debtors. Bankrupt• Germany try to distribute the pain of doing so as eq• cy is no longer stigmatised but simply re• Canada uitably as possible. garded as bad luck. When consumers bor• China Debt is often treated as a moral issue as row beyond their means, the blame is laid Brazil well as an economic one. Margaret At• on lax lending practices rather than irre• India wood, in her book of essays, ŒPayback: sponsible borrowing. Governments have Russia Debt and the Shadow Side of Wealth, encouraged more people to become home• *Asset-backed securities removed because notes that the Aramaic words for debt and owners and thus to take on debt. And de• of double-counting †Adjusted to remove ‡ sin are the same. And some versions of the faulting on one’s debts has become much Source: McKinsey foreign-owned financial debt 2007 Lord’s Prayer say ŒForgive us our debts less cumbersome; in the current housing 1 The Economist June 26th 2010 A special report on debt 3

2 slump many American homeowners have has collapsed as more have acted on the sult of unscrupulous speculation. resorted to Œjingle mail, dropping their theory that a debt•laden balance•sheet is The role of sovereign credit•default keys through the lender’s letterbox and more eˆcient (because interest payments swaps (CDS), a way of betting on the likeli• walking away from their property. are tax•deductible in most countries). hood of a country’s failure to repay the In business, a few failed directorships The recent crisis has also diminished money it has borrowed, has proved partic• are a sign of entrepreneurship rather than belief in the judgment of the †nancial mar• ularly controversial. Southern European incompetence. America’s Chapter 11 pro• kets. The role of banks in the credit crunch nations, which have been at the heart of cess allows the managers of companies to and the cost of the †nancial sector bail•out the recent market turmoil, have been quick remain in place and the business to be pro• has undermined the idea that the markets to blame an Anglo•Saxon conspiracy, tected from its creditors. The number of assess risk fairly and rationally. Instead, brewed up by hedge funds, credit•rating companies with safe AAA credit ratings higher borrowing costs are seen as the re• agencies and even newspapers like this 1

The boom has left Florida with an Paradise foreclosed excess of houses, shops and debt

HE giant iron gates are eerily reminis• ing in double digits until 2012. It will be Tcent of the opening scene of the †lm 2014 before Florida’s payrolls recover to ŒCitizen Kane. Each bears an impressive• pre•recession levels, he predicts. looking crest, CR, with a statue of a rearing Like many other states, before the bust horse standing guard. The view beyond Florida enjoyed a consumer boom that the gates takes in roads, elegant street• may have left it with too many retail out• lights and specially planted trees. The lets. At the Oviedo mall near Orlando plans were for an Œequestrian communi• there are empty shops everywhere. The ty with 11miles of bridleways and stables remaining shopkeepers, led by Jim Pride• for 36 horses. more of Ashton Photography, are mount• But if a modern Orson Welles were to ing a plucky campaign to revive the mall, pan his camera beyond the gates, he complete with family events and ŒWe’re would not †nd a billionaire’s mansion. Here to Stay badges. But they are compet• The gates are padlocked and the roads ing for a share of a smaller consumer pie. lead nowhere. This is the Cordoba Ranch, According to Experian, a credit consultan• a few miles from Tampa in Florida, one of cy, the combined limit for the credit cards the many residential developments that held by each of Florida’s consumers now were when the American averages $20,728, after a high of nearly housing market collapsed. $27,000 in the third quarter of 2008. Florida, with a long history of proper• Florida is not alone in having to shift ty booms, played its full part in the sub• away from consumption and towards in• prime excesses. It has ranked †rst for mort• vestment and exports, but its lack of a big gage fraud among American states in manufacturing base makes the task more three of the past four years. In the fourth diˆcult. Its main hope for growth is quarter of last year more than a quarter of in seven workers, that will mean fewer health care, thanks in part to its large pop• all mortgages there were behind on at jobs and cuts in services across the state. ulation of retired people. least one payment; more than a †fth were Florida’s best•known industry, tou• Given the poor outlook for jobs and at least 90 days behind or already in fore• rism, has also su ered from the recession. the oversupply of housing, Florida’s bad• closure. Estate agents reckon that prices A report by the Themed Entertainment debt problems are likely to linger. In Day• have fallen 40•50% from their peak. Association found that although Walt Dis• tona Beach, an Atlantic resort best known The e ect on the state’s overall econ• ney World in Orlando saw a small rise in for its drag•car racing, estate agents are ad• omy has been huge. In the year to April visitors during 2009, both Universal Stu• vertising lists of foreclosed properties for 2009 Florida’s population fell for the †rst dios and Busch Gardens (in Tampa) suf• sale. These melancholy rosters highlight time in recent memory, by nearly 57,000. fered a substantial decline. the gap between the grand claims of de• In a normal year it would be expected to Sean Snaith, an economist at the Uni• velopers and the cold reality of market grow by 200,000•400,000. Jobs have versity of Central Florida in Orlando, says arithmetic. Who could resist a three•bed• evaporated, particularly in construction, this has been an Œequal•opportunity re• room, two•bathroom house on East Para• property and †nance; the unemployment cession, a ecting professors and plumb• dise Lane, in the subdivision of Shan• rate is 12%. With revenue from property ers. He reckons that Florida’s economy gri•La? The answer, clearly, is lots of taxes down, the state budget is $3.5 billion faces Œa long and protracted climb out of a people. In late April the property could be short. Since the government employs one deep hole, with unemployment remain• snapped up for just under $100,000. 4 A special report on debt The Economist June 26th 2010

2 one, for unfairly pushing up their borrow• will lose money. take on more risk, meaning more debt. Ini• ing costs. The German government moved This is particularly troublesome if the tially such speculation is successful and to ban short•selling of government bonds economy slips into de‡ation, as happened encourages others to follow suit; eventual• and some CDS transactions last month. As globally in the 1930s and in Japan in the ly credit is extended to those who will be Charles Stanley, a stockbroking †rm, cyni• 1990s. Debt levels are †xed in nominal able to repay the debt only if asset prices cally puts it, EU nations are saying: ŒPlease terms whereas asset prices can go up or keep rising (a succinct description of the fund our lifestyles, but don’t hold us to any down. So falling prices create a spiral in subprime•lending boom). In the commitments. which assets are sold o to repay debts, pyramid collapses. triggering further price falls and further In the aftermath of the latest collapse it Why it matters sales. Irving Fisher, an economist who is clear that the distinction between debt in If a husband borrows money from his worked in the †rst half of the 20th century, the private and public sector has become wife, the family is no worse o . By exten• called this the debt de‡ation trap. blurred. If the private sector su ers, the sion, just as every debt is a liability for the Another reason why debt matters is to public sector may be forced to step in and borrower, it is an asset for the creditor. do with the role of banks in the economy. assume, or guarantee, the debt, as hap• Since Earth is not borrowing money from By their nature, banks borrow short (from pened in 2008. Otherwise the economy Mars, does the debt explosion really mat• depositors or the wholesale markets) and may su er a deep recession which will cut ter, or is it just an accounting device? lend long. The business depends on con†• the tax revenues governments need to ser• During the credit boom of the early dence; no bank can survive if its depositors vice their own debt. 1990s and 2000s the conventional view (or its wholesale lenders) all want their If the Western world faces an era of aus• was that it did not matter. Not only were money back at once. If banks struggle to terity as debts are paid down, how will asset prices rising even faster than debt but meet their own debts, they have no choice that a ect day•to•day life? Clearly a society the use of derivatives was spreading risk but to reduce their lending. If this happens built on consumption will have to pay across the system and, in particular, away on a large scale, as it did in the 1930s, the more attention to saving. The idea that us• from the banks, which had capital ratios ripple e ect for the economy as a whole ing borrowed money to buy assets is the well above the regulatory minimum. can be devastating. smart road to riches might lose currency, The problem with debt, though, is the Both of these e ects were seen in the changing attitudes to home ownership as need to repay it. Not for nothing does the debt crisis of 2007•08. Falling property well as to parts of the †nance sector such word credit have its roots in the Latin word prices caused defaults and a liquidity crisis as private equity. credere, to believe. If creditors lose faith in in the banking system so severe that the This special report will argue that, for their borrowers, they will demand the re• authorities feared the cash machines the developed world, the debt•†nanced payment of existing debt or refuse to re• would stop working. Hence the unprece• model has reached its limit. Most of the op• new old loans. If the debt is secured dented largesse of the bank bail•out. tions for dealing with the debt overhang against assets, then the borrower may be Hyman Minsky, an American econo• are unpalatable. As has already been seen forced to sell. A lot of forced sales will mist who has become more fashionable in Greece and Ireland, each government cause asset prices to fall and make credi• since his death in 1996, argued that these will have to †nd its own way of reducing tors even less willing to extend loans. If the debt crises were both inherent in the capi• the burden. The battle between borrowers asset price falls below the value of the talist system and cyclical. Prosperous times and creditors may be the de†ning struggle loan, then both creditors and borrowers encourage individuals and companies to of the next generation. 7 The morning after

A $3 trillion consumer hangover

N THE autumn of 2009 Jonathan Mitch• month to his creditors. If his house rises in credit to those who should never have Iell, a British software developer, realised value over the next †ve years, he will have been granted it. he had a problem. He had been running up to take out a further mortgage to pay back The idea that debt is a shameful state to his credit•card bills for years after his other creditors. But his life is not too con• be avoided has been steadily eroding since partner got sick and was unable to work. strained: he still has a mobile phone and the 1960s, when a generation whose †rst He ended up owing £30,000. ŒYou think if satellite TV. memories were of the Depression was su• they are going to give it to me, I must be Mr Mitchell is one of millions of con• perseded by one brought up during the able to a ord it, he recalls. sumers across the developed world who 1950s consumer boom. People were al• Mr Mitchell tackled his problem before are struggling to deal with their debts in re• ready used to buying houses and motor the baili s arrived. He took advice and ap• duced economic circumstances. By the cars on credit, but suddenly a whole range plied for an IVA (individual voluntary ar• standards of past centuries he has got o of durable goods‹TVs, fridges, washing rangement), a British scheme that allows lightly. A failure to repay debts was once machines‹could be had on easy terms. the borrower to negotiate a plan for deal• seen as a sign of moral laxity. Nowadays it Credit cards and charge cards came into ing with his debts. After allowing for es• is the lender as much as the borrower who widespread use. Buyers no longer had to sential spending, he now pays £280 a is perceived to be at fault for extending scrimp and save to get what they wanted; 1 The Economist June 26th 2010 A special report on debt 5

2 they could have it now. As the range of de• it boom as people remortgaged to release poration, which devised it. The idea goes sirable products grew, from Nintendo Wiis equity and boost their spending. Mortgage back decades, to a time when small retail• to iPhones, the urge to buy †rst and †nd the equity withdrawal rose from less than $20 ers, which needed to o er credit, pooled money later increased. ŒConsumers’ atti• billion a quarter in 1997 to more than $140 information on which customers were tudes have changed incredibly over the billion in some quarters of 2005 and 2006. good and bad payers. These days the bulk past 15 years, says Steve Rees of Vincent After 2007 it slowed abruptly and even of the information is provided by banks Bond, a debt•management agency. ŒThey went negative (homeowners paid down and lenders such as credit•card companies. have gone from aspiring to be just above debt) in 2009. Consumers are also more This is translated into a score ranging from their pay bracket to aiming a long way cautious about borrowing in view of slug• 350 to 800, with the most creditworthy above their pay bracket. gish wage growth and rising unemploy• customers getting the highest rating. All this meant that growth in consumer ment in most of the developed world. credit regularly outstripped growth in GDP In part, too, borrowing has slowed Life’s new essentials in the Anglo•Saxon countries and saving down dramatically because lenders have Andy Jennings of FICO says that custom• ratios fell to historic lows. At the end of the become much more chary about extend• ers’ rankings remain remarkably steady second world war in 1945 consumer credit ing consumer credit. A survey by the Feder• over time; the best payers remain the best in America totalled just under $5.7 billion; al Reserve in October 2008, when the †• payers. What does change is the level of ten years later it had already grown to nancial crisis was at its peak, found that bad debts across all categories when the nearly $43 billion, and the party was just 60% of banks had reduced credit•card lim• economy hits a recession. During the sub• getting started. It reached $100 billion in its for both new and existing customers. prime•lending boom mortgages were of• 1966, $500 billion in 1984 and $1 trillion in Like mortgage lenders, credit•card compa• fered to borrowers with lower FICO scores 1994, or around $4,000 for every man, nies found they had allowed lending stan• than in the past. An updated version of the woman and child. The peak, so far, was al• dards to drop too far. This spring the de• FICO model, to re‡ect the subprime crisis, most $2.6 trillion in July 2008. Household fault rate on American credit cards was a was released last year. debt approached 100% of GDP in 2007, a record 13%, according to Fitch. The crisis has brought about one big level seen only once before, rather omi• How do lenders decide whether con• change in consumer behaviour. The mort• nously in 1929. sumers are creditworthy? In America one gage used to be the last debt people would America was not alone in embarking of the key determinants is an individual’s default on. They did not want to lose their on a debt spree. In Britain household debt FICO score, named after the Fair Isaac Cor• homes or to forfeit the substantial deposit rose from 105% of disposable income in they had had to †nd. But during the sub• 2000 to 160% in 2008, according to the prime boom many borrowers were able to McKinsey Global Institute, and in Spain Feeling poor 3 buy homes without putting down any the ratio rose from 69% to 130% over the America: money, which changed their attitude. In ef• same period. Only in the past couple of Personal bankruptcy Consumer fect, they were renting with an option to † years have consumers paused for breath. filings*, m debt , % pro†t from higher house prices. In America the volume of consumer credit 2.5 15 In the current recession some borrow• in 2009 declined by 4.4%. By March this 2.0 14 ers have given priority to their credit•card year the annual growth rate had crept up 1.5 13 and car loans rather than their mortgages. only to 1%. In Britain credit•card lending fell After all, they can usually †nd a new home in eight of the 16 months between January 1.0 12 to rent. But without a car many of them 2009 and April 2010. 0.5 11 cannot get to work and without a credit In part, this is because consumers in 0 card they †nd it hard to shop. many countries have become more frugal 1980 85 90 95 2000 05 09 Perhaps the housing crash will change in response to the recession and the de• Sources: American *All non-business filings attitudes towards home ownership. For a Bankruptcy Institute; †Debt payments as % of cline in house prices. In America houses Federal Reserve disposable income long time it seemed like a one•way bet, turned into cash machines during the cred• with homeowners able to buy an appreci•1 6 A special report on debt The Economist June 26th 2010

2 ating asset with cheap debt. Having real• who use the facility average nine payday living pay cheque to pay cheque. They’re ised that prices can fall as well as rise and loans annually, so they can end up paying very concerned about their own personal that houses are illiquid assets, many more more in interest than they have borrowed. †nances. Consumers got by because both people may opt for the greater ‡exibility of The outcome is predictable. According husbands and wives went out to work and renting and hold their wealth in more div• to the Centre for Responsible Lending, a they borrowed heavily, as described by ersi†ed forms. That is what happens in quarter to half of all payday borrowers de• Raghuram Rajan, an American economist, Germany, which has a much lower rate of fault every year. Congress has restricted ac• in his book ŒLet Them Eat Credit. home ownership than Britain or America. cess to such loans for the families of mem• Meanwhile, those who have maxed out bers of the armed services. But why do A fate worse than debt their credit cards have been forced to turn consumers choose such an expensive way After the †nancial crisis it brie‡y looked as elsewhere. One very expensive route is of borrowing money? ŒA lot of people opt if consumers were becoming more cau• payday loans. As Jean Ann Fox of the Con• for a payday loan because it’s easy and the tious. Between the †rst quarter of 2008 sumer Federation of America explains, lenders don’t run a credit check, explains and the second quarter of 2009 the saving this involves the borrower writing a Ms Fox. rate surged from 1% to 5% of personal dis• cheque to the lender for the sum bor• For many, debt has become a necessity, posable income. But then it fell back again, rowed, plus the †nancing cost, which the not a choice. In real terms, the median perhaps because people found they sim• lender cashes on payday. Over two weeks wage of American workers has barely ply could not a ord to save. Consumption the cost works out at around $15 of interest shifted since the 1970s. Thomas Schoewe, held up because the Obama stimulus plan for every $100 borrowed, which amounts chief †nancial oˆcer of Wal•Mart, says boosted incomes. But that boost will be to an annual interest rate of 400%. People that Œmore than ever, our customers are strictly temporary. And then what? 7 Betting the balance•sheet

Why managers loaded their companies with debt

OUNTRIES may be desperate to hang ist Œdistressed debt funds emerged that C on to their AAA ratings to keep their looked for undervalued bonds, rather as Heading for junk 4 borrowing costs down, but companies do value investors combed the stockmarket Standard & Poor’s median corporate-credit rating not necessarily share that concern. The for bargains. After the dotcom bubble median rating of the companies assessed burst, actuaries encouraged pension funds AAA by Standard & Poor’s has fallen from A in to diversify their risk so that their portfoli• AA 1981 to BBB• today (see chart 4). That rating os were no longer dominated by equities. A+ is the lowest possible Œinvestment grade At the same time a long period of low inter• A- or, to put it another way, is just one notch est rates and occasional mild recessions BBB above Œjunk bond status. helped fuel the growth of hedge funds and BB+ By itself, this suggests that creditors as private equity, which rely on the use of well as borrowers have had a change of borrowed money to enhance their returns. BB- heart. Traditionally the institutions that The advent of these new investors may B held the bulk of corporate bonds were not have been responsible for some wild 1980 85 90 95 2000 05 10 allowed to buy anything but investment• swings in credit spreads (the excess yields Source: Standard & Poor’s grade securities. Bonds might have be• paid by companies to re‡ect the risk of de• come junk because of a deterioration in fault). At the height of the credit boom in the issuing company’s †nances, but they 2006 spreads had fallen to historic lows. where rather than being frittered away on did not start that way. Jay Ritter of the University of Florida says value•destroying acquisitions. However, in the 1970s and 1980s Mi• the market sometimes underestimates the Standard corporate †nance theory, †rst chael Milken at Drexel Burnham Lambert default risk on junk bonds. Investors tend expounded by Franco Modigliani and realised there was a group of investors to look at recent default rates, which may Merton Miller, states that whether a †rm is who were willing to take the risk of a diver• be misleading. A boom in junk•bond issu• †nanced by debt or equity should make no si†ed portfolio of junk bonds because of ance leaves companies with large pools of di erence to its value; the cash‡ow is sim• the extra yield on o er. And indeed over cash. It takes them a few years to drain ply parcelled out in di erent ways. But the time the extra yield o ered by these bonds these pools and get into trouble. theory leaves out the tax treatment of dif• more than compensated investors for the By pushing down spreads, investors re• ferent kinds of †nance. In most countries risk of default. Mr Milken’s lesson endured duced the cost of capital and encouraged interest payments are tax•deductible but even though Drexel collapsed. companies to take on more debt. At the dividend payments are not. The tax system In the 1990s and early 2000s more and same time the desire for high credit ratings may have encouraged companies to take more people wanted to trade higher risk was going out of fashion. Managements on debt, although Mr Ritter says studies for higher rewards as the returns on cash that hoarded cash were told to return it to have found little relationship between cor• and government bonds dwindled. Special• shareholders so it could be invested else• porate tax rates and debt. 1 The Economist June 26th 2010 A special report on debt 7

2 A stronger motive for borrowing more may have been executive pay. Most incen• tive payments these days come in the form of share options, which if the share price rises rapidly can soon turn executives into multimillionaires. The strongest driver of a company’s share price, in the short term, is the ability to meet quarterly targets for earnings per share. And using spare cash to buy back a company’s equity tends to in• crease earnings per share. Managers should have been deterred from taking on too much debt because a le• veraged balance•sheet is more risky, but that did not seem to worry them. Chief ex• ecutives these days come and go almost as quickly as managers of football clubs. A high•risk strategy may pay o in the short term; higher debt levels may sink the com• nanced. Moody’s reckons that some ¤250 age more attractive. pany only in the longer term, after the ex• billion of LBO debt will need to be rolled Investment and commercial banks be• ecutive has left. Moreover, the value of the over in the next †ve years. came integrated as the old division im• option is related to the volatility of the un• Private•equity loans were just one of posed by the Glass•Steagall act was abol• derlying share price; a riskier strategy many assets (for example, mortgage, car ished. Investment banking was no longer makes that price more volatile and thus in• and credit•card debts) that were bundled just about broking (conducting transac• creases the executive’s putative wealth. together and repackaged into instruments tions in return for commissions) or giving Even if the option expires unexercised, the bought by investors who themselves were advice; it was about using the banks’ bal• executive is no worse o . using borrowed money (banks, hedge ance•sheets to help clients or manage risks. However, the increased use of debt funds and specialist vehicles like con• This generated some fat fees but increased across the corporate sector has not been duits). Such investors were taking advan• the size of the banks’ balance•sheets. uniform. American companies learned tage of the Œcarry trade, borrowing at low In America, the non•†nancial corporate some lessons in 2000•02 when the burst• rates to invest in higher•yielding but riskier sector increased its debt•to•GDP ratio from ing of the dotcom bubble brought down assets. In theory this trade should not be 58% in 1985 to 76% in 2009, whereas the †• giants such as Enron and WorldCom. sustainable in the longer term; the higher nancial sector went from 26% to 108% over Quoted companies were more cautious yields should merely compensate inves• the same period. It was that leverage that about taking on debt in subsequent years. tors for the default risk. In practice, how• made the banks so vulnerable when the A report by the McKinsey Global Institute ever, a long period of economic growth subprime market collapsed in 2008; the as• found that the non•†nancial business sec• and falling interest rates meant that for a sets they ended up owning were illiquid, tor in most countries entered the recent cri• while the trade paid o ‹until the debacle diˆcult to value and even harder to sell. sis with lower leverage (measured as the of 2007•08. Banks such as Bear Stearns and Lehman ratio of debt over book equity) than they made the fatal mistake of assuming that had at the start of the decade. Carry on regardless the markets (often their fellow banks) Instead debt was more concentrated, While those good times lasted, hedge would always be willing to roll over their particularly on those companies that had funds thrived. They found it easier than debts, but they su ered a bank run. The been acquired by private•equity †rms in le• conventional fund managers to play the ar• only di erence was that the charge was led veraged buy•outs (LBOs). In some ways bitrage game because as well as going long by institutions instead of small depositors. private equity is a creature of the Œgreat on cheap securities they could go short In turn, the collapse of the †nance sec• moderation from the mid•1980s to the (bet on a falling price) on expensive ones. tor had a huge impact on the rest of the mid•2000s. Private equity needs willing Sometimes these arbitrage opportunities economy and created a dilemma for gov• investors, access to credit, steady economic were small, so borrowed money was ernments. They want to increase banks’ growth (so that the debt can be repaid) and needed to enhance returns. And hedge capital ratios to avoid future †nancial cri• rising asset markets (so that acquired com• funds could impose higher annual charges ses. But that will cause bank lending to panies can be sold again). than conventional managers, with perfor• grow more slowly or even contract, an out• But conditions are now less favourable. mance fees on top. come they are equally wary of. Economic growth may be sluggish as econ• But many of these strategies were vari• After the crisis struck the banks needed omies work o their debt, and ‡oating ants of the carry trade, which changed the the governments to rescue them, but now companies on the stockmarket may be face of the †nance sector. Banks have al• the governments need the banks to buy harder. Among the biggest debt investors ways borrowed short and lent long. But the their bonds. One reason why EU govern• were the managers of structured products fact that bank deposits were guaranteed by ments eventually rescued Greece was that called collateralised loan obligations the government, allied to the implicit guar• a default would have threatened the mem• (CLOs), but since the credit crunch the mar• antees o ered when central banks cut ber countries’ banking systems. As debtors ket has dried up. And the debts accumulat• rates at times of †nancial crisis, lowered and creditors, banks and governments are ed in the 2006•07 boom have to be re†• the banks’ cost of capital and made lever• locked in a tight embrace. 7 8 A special report on debt The Economist June 26th 2010

A better bust?

Bankruptcy is becoming less calamitous

OING bankrupt used to be the worst friendly approach. tailed, they might have been expected to Gthing that could happen to a company. At the opposite end of the scale is insist on more safeguards upfront. Far from The term stems from the Italian habit of France with its sauvegarde scheme, where it. At the peak of the lending boom in 2006 conducting banking on wooden benches the priority is to save the business and the and 2007, the fashion was for Œcovenant in marketplaces‹banca rupta means bro• employees, with the creditors taking third lite deals which gave creditors fewer safe• ken bench. Traditionally, it spelled ruin. place. Only the debtor can apply for sauve• guards; traditionally, covenants were used Slowly but surely, however, bankrupt• garde. The company has to present a repay• to force debt repayment when the debtor cy law has changed in favour of the cor• ment plan to the court, but the court can re• missed certain †nancial targets. But inves• porate debtor. The main driver has been ject it and impose a plan of its own. The tors were so keen to chase higher yields American law, which has always tended to plan also requires a majority vote, with that they were willing to dispense with favour debtors (farmers in the mid•West large creditors able to vote down small these protections. A lot of this had to do and South) against creditors (eastern mon• ones and unsecured creditors able to out• with the Œshadow †nance industry of ey men). In the 19th century the †nancial vote the secured. Debt repayment can be non•bank institutions and lenders, and the problems of some of the railroad compa• slow; even under a court order, it can take structured products (such as CDOs and nies made lenders more determined to up to ten years. ŒIt looks brutal to creditors CLOs) it created. The industry had such an keep the businesses going; the value of an but this is often the subject of pre•negotia• appetite for debt to feed these beasts that operational railroad was clearly higher tion, says Alan Mason of the Paris oˆce of creditors were inclined to lend †rst and ask than that of the steel rails and wooden ties Fresh†elds Bruckhaus Derringer, a cor• questions afterwards. that made up its physical capital. porate•law †rm. There are signs that †rms, Now that the reckoning has come, sort• In modern America that approach has under pressure from creditors, are reorga• ing out the †nances of troubled companies morphed into Chapter 11, a structure that nising themselves to avoid sauvegarde. has become far more complex. ŒIt used to allows companies to continue operating With lenders in most countries seeing be that a relatively small number of banks and prevents creditors from foreclosing on their rights under bankruptcy law cur• owned a company’s debt, says Matthew 1 the business. Chapter 11has allowed some companies to come back from the dead, al• though in some industries (notably air• lines) at the expense of more pro†table ri• vals. The system has the great bene†t of clarity, with the court ensuring that the creditors are paid in order of seniority, with secured lenders getting †rst cut. Even so, the system struggled to cope with the sheer complexity of Lehman Brothers’ fail• ure. The investment bank became the larg• est ever Chapter 11deal, involving loans of $640 billion. In Europe bankruptcy law is undergo• ing steady reform. ŒIt used to be complete• ly impossible to deal with cross•border failures, says Alan Bloom, head of restruc• turing at Ernst & Young, an accountancy group. That was before Europe•wide insol• vency arrangements for dealing with mul• tinationals were introduced in 2005. But it still leaves the issue of which country’s courts control the process. That depends on which nation is the Œcentre of main in• terest for the company. There is scope for some legal arbitrage: Wind Hellas, a Greek telecoms company with headquarters in Luxembourg, managed to shift its centre of interest to Britain so it could restructure in the British courts. Generally speaking, Brit• ain is deemed to have the most creditor• The Economist June 26th 2010 A special report on debt 9

2 Prest of Moelis, a company that specialises hope that the company’s prospects im• ing the debt, since that would dilute their in debt restructuring. ŒWhen things went prove. The owners of the riskiest tranches stakes. The banks are not keen either, since wrong, the company knew whom to call. often have the most voting power. restructuring would require them to write The banks, for their part, specialised in an• One potential con‡ict, says Andrew down the value of the debt on their bal• alysing credit and had workout teams to Speirs of Hawkpoint, a †rm that advises ance•sheet just as they are struggling to im• deal with trouble. These days companies on corporate †nance, is between dis• prove their capital ratios. Many loans are may have several di erent types of debt, or tressed•debt managers and the original therefore limping towards maturity in a leveraged loans that have been repackaged debt holders. The †rst group has bought process known as Œextend and pretend or and sold round the world. the bonds or loans at a discount and is Œdelay and pray. The interests of the owners of di erent looking for a quick return; the second, hav• Signs of economic recovery and the slices of debt are often at odds with each ing paid the full price, would prefer to hold support schemes organised by central other, a state of a airs known as tranche on in hope of a higher payout. banks have eased this process along. The warfare. Those who own the most senior prices of distressed debt have increased securities in CDOs and CLOs, ranked AAA Delay and pray substantially since the dark days of 2008. or AA, might want to sell the company’s as• In the CLO market, which largely consists But there is still a pile of debt that needs to sets immediately to ensure they get their of loans made to private•equity groups, be re†nanced over the next decade. With money back. But the owners of the more there are special reasons to be patient with the old CDO/CLO machine damaged and risky types of debt would be wiped out by struggling borrowers. The private•equity with banks more cautious about risking that, so they usually want to hang on in the managers have little interest in restructur• their capital, trouble could still lie ahead. 7 The unkindest cuts

Many countries face the diˆcult choice of upsetting the markets or upsetting their voters

ALL it the rich•uncle theory. When the ed in peacetime. The debt•to•GDP ratio of C private sector struggles, governments The worst for decades 5 the G7 group of nations is at its highest lev• often step in to pick up the bill. And when G7 net government debt, % of GDP el for 60 years (see chart 5). individual countries have trouble meeting That has started to raise questions their commitments, they turn to their 150 about whether countries can actually * neighbours, or to the International Mone• 120 meet the bill. Allowing governments to as• tary Fund, for help. sume debt has some obvious advantages. The recent recession, and the †nancial 90 If companies, and in particular banks, go crisis that precipitated it, have led to a bust, they cause a lot of knock•on social sharp increase in government debt in the 60 costs, including jobs and consumer un• developed world, on a scale virtually un• certainty. precedented outside world wars. For some 30 Governments are much less vulnerable states this burden has arisen at a time to credit runs because they can raise taxes when their †nances were already 0 and print money to buy time for the debt 1950 60 70 80 90 2000 12 stretched. And for most countries in the shock to be absorbed. Governments also Source: IMF *Forecast rich world this has happened when they †nd it easier to fund de†cits during reces• are having to face up to a range of pro• sions, when nervous investors are only too blems associated with ageing populations. fault on the debt owed to the classes that happy to shelter behind the safety of gov• Countries have long had a complicated controlled them. ernment bonds. But in the long run de†cit relationship with their national debt. It During the †rst and second world wars †nancing is the equivalent of a private in• was the need to repair its national †nances governments on both sides of the con‡ict dividual getting a new credit card and that forced the ancien regime of Louis XVI exploited the patriotism of their citizens, making the minimum repayment every in France to summon the Estates•General persuading them to buy Œvictory bonds month. For a while it seems like free mon• in 1789, an event that triggered the French and the like. Those same governments ey. The tricky point comes when the credit revolution. In his book, ŒA Free Nation then penalised the patriots by in‡ating limit is reached. Deep in Debt, James Macdonald argues away their debt after the war. From 1945 on• For governments, that credit limit can that the national debt was a source of ward government debt became a tool of vary enormously. One reason why the cri• strength for countries such as Britain and economic management as Keynesian de†• sis has hit the euro zone before other re• the Netherlands, whose governments cit spending was used to cushion econo• gions is that its countries have renounced were †nanced by merchants and bankers. mies during recessions. The booms of the the money•printing and devaluation op• In wartime such countries could easily 1980s and 1990s led to a surge in tax rev• tions by adopting a common currency. In outspend those run by aristocrats, which enues and kept the debt problem under some ways the problems facing euro•zone had a history of default. For Britain and the control. But the recent †nancial crisis members are akin to those facing countries Netherlands there was no incentive to de• caused some of the biggest de†cits record• on the gold standard in the 1930s. They had 1 10 A special report on debt The Economist June 26th 2010

2 to choose between imposing austerity to maintain the standard or repaying credi• tors in devalued currency. The countries that went o gold soonest tended to recov• er fastest. But abolishing the link to gold was far easier than it would be to replace, say, the euro with a new drachma. With luck, today’s government de†cits will be temporary, gradually disappearing as the private sector comes to the fore again. Countries recovered from even big• ger government debt burdens after the sec• ond world war. But at that time the perso• nal, industrial and †nancial sectors of the economy were much less indebted. Economists are still arguing about how quickly to cut government de†cits. Earlier this year the di erent schools sent rival let• ters to the Times, discussing the suitability of early e orts to cut Britain’s budget de†• cit (the new coalition government an• duce demand. Like the Red Queen in Lewis According to Andrew Smithers of Smithers nounced cuts of £6 billion in May). The fear Carroll’s ŒThrough the Looking•Glass, the & Co, a consultancy, a debt•cutting policy is that higher taxes and spending cuts will country has to run as fast as it can just to will make it harder for the government to cause job losses and hit demand at a point stand still. Ireland has been the good boy bail out the private sector in times of need, when the economy is still fragile. of the sovereign•debt markets, taking as well as reducing companies’ cash‡ow The doves contend that the †rst priority quick action to reduce its de†cit through by imposing higher taxes. should be to stimulate growth, since that measures such as cutting public•sector pay. An even bigger problem may be the un• will automatically raise tax revenues and But other countries may not be in a rush to funded liabilities that government face cut expenditure on items such as unem• emulate it: its nominal GDP has fallen by from ageing populations. This is a double ployment bene†ts. The hawks counter that over 16%. burden: bene†ts for growing numbers of there comes a point when further de†cits Third, larger government de†cits imply pensioners will have to be paid for by a are self•defeating. Carmen Reinhart and greater government interference in the shrinking band of workers. These liabil• Kenneth Rogo suggest that the crunch ar• economy and thus a less eˆcient use of re• ities are diˆcult to calculate. Pierre Caille• rives when the debt•to•GDP ratio reaches sources. One study found that each per• teau of Moody’s, a rating agency, says that around 60% in emerging markets and 90% centage•point increase in the share of GDP Œthe state of public•†nance accounting is in developed economies. In rich countries devoted to government spending reduced extremely rudimentary relative to private• median growth rates tend to fall by around growth by 0.12•0.13% a year. sector accounting. one percentage point a year once that limit Last, according to the doctrine of Ricar• A 2009 report by Jagadeesh Gokhale, of is reached. dian equivalence, consumers and busi• the right•wing Cato Institute in Washing• When debt gets too high, a number of nesses see larger de†cits as the precursor to ton, DC, estimated that the average EU problems arise. First, a spiral is set o in higher taxes in future, so they save more of country would need a fund worth 434% of which lower credit ratings for a country their income, meaning that pump•priming its GDP, earning interest at the govern• lead to higher borrowing costs, in turn in• by the government ceases to work. ment’s borrowing rate, to meet such liabil• creasing the de†cit. Markets already seem Even those governments that are ities; alternatively, it would need to save unwilling to fund some countries at sus• tempted to keep stimulating the economy 8.3% of its GDP each year. Neither seems re• tainable rates: by the time Greece turned to may †nd that the markets punish them for alistic. The only answer is to cut future the IMF and its EU partners for help, its it. Once a crisis of con†dence has occurred, bene†ts. But the elderly form a powerful short•term bond yields were nearly 20%. governments †nd it diˆcult to raise the voting block, with a higher turnout than Ramin Toloui of PIMCO, a fund•manage• money they need at an acceptable interest their children, who will pay the bill. ment group, explains the process this way: rate. A report by an economic adviser to ŒWhen government debt reaches extreme the Bank for International Settlements in European extremes levels, concerns about government credit• March noted that Œour projections of pub• Neither Greece nor Iceland has had any worthiness become so severe that addi• lic debt ratios lead us to conclude that the choice about tackling its de†cits. They may tional government spending produces in• path pursued by †scal authorities in a be a long way apart, both geographically creases in long•term interest rates that number of industrial countries is unsus• and culturally, but both are casualties of exacerbate, rather than ameliorate, the tainable. Drastic measures are necessary to the debt crisis. Iceland was the little coun• economic contraction. check the rapid growth of current and fu• try that could. A land with just 300,000 Second, once a country is stuck in this ture liabilities of governments and reduce people, best known for its volcanoes and debt trap, it has to bring in austerity pro• their adverse consequences for long•term its †sh, it privatised its banks and suddenly grammes to reduce the de†cit; but such growth and monetary stability. became an international †nancial power• austerity holds back economic growth be• Countries that decide to embark on def• house. ŒIn the Icelandic system, all the cause higher taxes and lower spending re• icit reduction may face another problem. banks were aggressive broker•dealers like 1 The Economist June 26th 2010 A special report on debt 11

Bear Stearns and Lehman, says Asgeir zens (and particularly its elite) seemed to euro zone in 2001 it reaped an immediate Jonsson, an economist and author of a be doing well out of the boom. Houses dividend in lower interest rates, but it book, ŒWhy Iceland?. doubled in price, the strong krona allowed failed to tackle its underlying problems. A high exchange rate encouraged its its people to go shopping in London and its Dodgy accounting disguised the size of corporate sector to go on an overseas ac• billionaires to buy British retailers and its government debt. Its businesses re• quisition spree. Its housing market football clubs. mained uncompetitive, causing a large boomed as †shermen took out cheap Greece, for its part, was not noted for an trade de†cit. The economy is riddled with loans in euros and yen. The country be• aggressive banking sector or a housing ineˆciencies and restrictive practices. For came an egregious example of the excesses boom. It was traditionally dismissed by in• example, cruise ships are not allowed to of †nancial liberalisation. Its politicians vestors as a country of high in‡ation and take on new passengers at Greek ports, and failed to halt its debt spiral because its citi• repeated devaluations. When it joined the the number of lorry licences is still the sa•1

Judging the judges The travails of the rating agencies

HE rating agencies did not have a good the ECB. (The ECB eventually amended When Standard & Poor’s downgraded Tdebt crisis. They were accused of be• the rules to accept Greece’s bonds, what• Greece to junk status in April, David Beers, ing, at best, naive about the safety of com• ever their rating.) its head of sovereign ratings, put the move plex structured products such as collater• More recently the agencies have been into perspective: ŒWe provide an indepen• alised debt obligations (CDOs) and, at accused of being too harsh, and even of dent view that investors may or may not worst, being less than impartial because being part of an Anglo•Saxon conspiracy choose to consider. Ratings are one of of the fees they got from issuing CDOs. to hold down the southern European na• many inputs that investors look at, and Now companies such as Standard & tions. Countries have been outraged by they are only one of many factors that Poor’s, Moody’s and Fitch are back in the downgrades. There has been talk of set• may a ect movements in the market. limelight. Every time they change the rat• ting up a rival European rating agency. The Mr Beers argues that people may be ing of a sovereign debt they move the agencies put up a vigorous defence, point• paying too much attention to maintaining markets. For a while the rules of the Euro• ing to the good record of their ratings in the top AAA rating: ŒPeople’s perceptions pean Central Bank seemed to give enor• predicting sovereign default rates. No are that a downgrade from AAA means mous power to just one agency, Moody’s. country rated AAA, AA or A has gone on that minutes later you default, but in fact it Had it downgraded Greece, the country’s to default for 15 years. Nearly 98% of coun• means only a slight increase in default government bonds would not have been tries ranked AAA were still ranked either risk. But Pierre Cailleteau of Moody’s eligible for use as collateral for loans from that or AA15 years later. says that Œbecause of the crisis we have to de†ne the boundary between AAA and AA ratings very clearly. The agency uses three concepts: economic and institution• al strength, government †nancial strength and susceptibility to event risk. Mr Cailleteau says the key measure is not the debt•to•GDP ratio but the propor• tion of government revenues devoted to interest payments. Once that proportion exceeds 10%, keeping the AAA rating be• comes more diˆcult. But the agency will not downgrade the country if the govern• ment is committed to decisive action to re• duce the de†cit. But what constitutes decisive action? In judging that, the rating agencies are bound to be drawn further into tricky po• litical territory. For example, they will have to weigh the new British coalition’s plans to deal with its de†cit, and assess how far EU countries are likely to go in bailing out their indebted fellow mem• bers. One thing is certain: the agencies will be shot at from all sides. 12 A special report on debt The Economist June 26th 2010

2 me as in 1990 even though GDP has dou• economist at Kaupthing, a big Icelandic culates that the federal government will bled. Such restrictive practices are keeping bank. ŒThe money supply increased at accumulate a de†cit of $10 trillion be• transport costs too high. According to Yan• 40% a year over a †ve•year period. tween 2011 and 2020, and even that de• nis Stournaras of IOBE, a think•tank, it is Both economies face fundamental diˆ• pends on some fairly optimistic assump• cheaper to transport goods to Athens from culties. For Greece, being a member of the tions about economic growth. Unless Italy than from Thebes, just 32 miles away. euro zone is now a hindrance rather than a policies are changed, total government Greece is an exemplar of the ‡aws in help. Its costs are too high but it cannot de• debt will reach 100% of GDP by 2023. There the European welfare model. The state gets value its currency, and trying to in‡ate its are unfunded liabilities on top of that. remorselessly bigger because political par• way out of its debt would, in e ect, be im• Chris Watling of Longview Economics ties of the right and left have bought votes possible. Iceland, which is not a member reckons that the net present value of by providing supporters with jobs or sub• of the European Union, has been able to spending commitments under the Medi• sidies. Antonis Kamaris of Levant Partners, devalue the krona, but that created a pro• care, Medicaid and Social Security pro• an investment group, says the state must blem for individuals and companies grammes is 276% of GDP. The Democrats Œremove bene†ts that have built up like a which had borrowed in foreign currencies. resist cuts in entitlements and the Republi• ship accumulates barnacles. Public•sec• Its banks had to be nationalised and do• cans resist tax increases, so nothing much tor workers were mollycoddled with pay mestic depositors were favoured over for• gets done. E orts to establish a bipartisan for 13 or 14 months per year and arcane al• eign creditors. de†cit•cutting commission have failed. lowances for things like †rewood or carry• Both countries have had to call in out• ing †les between oˆce ‡oors. side help. The Icelanders have borrowed Advantage America Tax evasion is widespread. A report by from the IMF, with their negotiations But America has two huge advantages the London School of Economics esti• made more complex by a dispute with Brit• over other countries that have allowed it to mates that it reduced Greece’s potential tax ain and the Netherlands over compensa• face its debt with relative equanimity: pos• yield by 26%. It is normal to do deals under tion for foreign depositors in one of its big sessing both the world’s reserve currency the table. On the birth of his baby daughter banks. Iceland is trying to reduce its †scal and its most liquid asset market, in Trea• one parent was asked to hand over ¤2,500 de†cit, which in 2008 reached 13.6% of sury bonds. Even in the midst of the credit in cash to the doctor, in exchange for a re• GDP, via increases in value•added tax, in• crunch, when some of the biggest Wall ceipt for ¤1,500. The Greeks are attempting come tax, and petrol and alcohol duties. Street banks were collapsing, the dollar to tackle this issue. The austerity packages Rising unemployment has prompted rose and Treasury bond yields fell, making introduced over the past 12 months require many Icelanders to emigrate, causing the it easier and cheaper for America to †• higher earners to provide receipts for ex• population to fall for the †rst time since the nance its de†cit. There may come a time penditure before they can qualify for their 19th century. when America is hit by a funding crisis, but tax•free allowance. In Greece spiralling debt costs also it does not look imminent. Market discipline did not work in either forced the government to turn to the IMF America would be more at risk if the country. Greece bene†ted from the im• as well as to its EU partners. But it remains Asian central banks and sovereign•wealth plied credit upgrade provided by joining to be seen whether the population will tol• funds had an obvious alternative. But with the euro zone. Iceland, with its high inter• erate the austerity needed to bring the debt Europe in the midst of its own debt crisis, est rates, got a boost from the Œcarry trade, burden down to a reasonable level. The the euro does not look like an appealing with investors borrowing money in low• most recent package of cuts provoked a option. And there is simply not enough yielding currencies (eg, the yen) and buy• wave of strikes and riots in which three gold in the world to absorb a substantial ing high•yielding ones (eg, the krona). ŒIt bank employees died. portion of central•bank reserves. For the was a classic case of monetary boom and America also faces a huge debt pro• moment, the dollar is the one•eyed curren• bust, says Thordur Palsson, a former chief blem. The Congressional Budget Oˆce cal• cy in the land of the blind. 7 In a hole

Stagnation, default or in‡ation await. The only way out is growth

HERE is an old joke about a stranger porate and †nancial sector that used debt ments’ own balance•sheets have deterio• Twho asks a local for directions and gets to boost its returns and a cultural change rated. In America the amount of govern• the cheerful reply: ŒIf I wanted to go there, I that made it more respectable. ment debt per person has risen from wouldn’t start from here. That advice Central banks and governments im• $16,000 in 2001 to $34,000 now, and sums up the dilemma the developed coun• plicitly guaranteed this debt, riding to the household debt has gone up from $27,000 tries face in dealing with their debt. They rescue whenever a repayment crisis to $44,000. In Britain government debt per have accumulated a mountain of it at ev• loomed. They intervened in a host of small head has almost trebled, from £5,000 in ery level, from the personal to the cor• †nancial †res, using low interest rates to 2001 to nearly £18,000 today, and house• porate and the sovereign. As this special re• put out the ‡ames. But this merely allowed hold debt has jumped from just under port has shown, this was encouraged by a the tinder to build up that set o the huge £14,000 to £24,000. legal system that sheltered debtors, a cor• con‡agration of 2008. Now the govern• Cutting the debt back to more accept•1 The Economist June 26th 2010 A special report on debt 13

2 able levels is both hard and unappealing, younger, fast•growing developing coun• ŒThe leverage•led growth model is dead, since it may involve years of austerity and tries should be borrowing heavily. But in he says. ŒHouseholds and corporates can slow economic growth. It also requires fact it is the other way round. increase borrowing and enhance today’s some tough political decisions. If being This is not unalloyed joy for the creditor consumption and investments but that re• able to borrow makes people feel richer nations. Once the exposure of a creditor to quires that we can assume higher future in• (however illusory the sensation), having to a borrower gets suˆciently large, the two comes and expected returns and/or rising repay the debt makes them feel poorer. sink or swim together. The relationship be• asset values. And this is not certain. They resent the sacri†ces involved, espe• tween China and America has been de• cially if they are imposed by outsiders. scribed as vendor †nancing, in which the Running out of ammunition This is particularly true in democracies. In Chinese lend the Americans the money to The debt burden may also have had a dis• a referendum Icelanders voted over• buy their cheap manufactured goods; a torting e ect on economic policy. In the whelmingly against a debt repayment deal collapse in American demand would 1960s and 1970s governments grappled with Britain and the Netherlands. cause substantial unemployment (and so• with a wage•price spiral in which demands Dani Rodrik, an economist at Harvard, cial unrest) in China. for higher wages forced companies to in• has talked of a Œtrilemma in which coun• The longstanding system of vendor †• crease their prices, which in turn triggered tries aiming for the three goals of deep eco• nancing may have encouraged the rich demands for higher wages. The past two nomic integration with the rest of the world to concentrate on consumption decades have seen a debt•interest rate spi• world, national sovereignty and demo• rather than investment and to enjoy the re• ral. It starts o with the private sector bor• cratic politics can achieve two of them but sulting Œarti†cial growth, like a child on a rowing a lot of money. This is followed by a not all three. Left to themselves, voters will sugar high. Richard Koo, who wrote a book crisis in which the central bank cuts interest resist the sacri†ces needed to remain com• about the Japanese recession, ŒThe Holy rates to help borrowers. That encourages petitive in a system of deep economic inte• the private sector to borrow more, which gration, and nation states are constantly makes it all the more imperative for central erecting barriers to international trade. Mountainous terrain 6 banks to come to the rescue when the next One way of eliminating those barriers US debt as % of GDP crisis comes along. With short•term interest would be to set up some sort of global fed• Financial Non-financial businesses rates now at 1% or less in America, Britain, eral government. Another would be to in• Households Government Japan and the euro zone, this process can• stall a Œfree•market Stalin‹a †gure in the 360 not go any further. mould of Chile’s Augusto Pinochet‹who If the 1960s and 1970s produced con• would force his country’s citizens to accept 300 sumer in‡ation, the debt•interest rate spiral the constraints of the global market, in• 240 created asset in‡ation. In 2000 this pushed cluding debt repayment. Neither option is 180 share prices to unprecedented peaks; in• appealing. deed many stockmarkets have yet to regain The citizens of Europe may now be real• 120 the levels they reached a decade ago. Now ising that debt transfers power from the 60 the support of asset prices has entered a borrower to the creditor. The †rst world 0 new stage, with central banks buying as• war destroyed Britain’s credit position and 1947 60 70 80 90 2000 10 sets (in particular, government and mort• ushered in the era of American †nancial Sources: Bureau of Economic Analysis; gage•backed bonds) directly to boost the †• Federal Reserve; The Economist dominance. Now the debt burden re‡ects nancial sector. the shift in the balance of economic power Indeed, that sector was the biggest ben• from rich countries to developing ones. It is Grail of Macroeconomics, refers to a debt• e†ciary of this spiral. Before the credit striking that on average developed coun• †nanced boom as Œcherry•blossom eco• crunch it generated some 35% of all domes• tries now have a higher debt burden than nomics. He recounts the tale of the two tic pro†ts in America. A highly sophisticat• emerging nations. Investors have certainly brothers who bought a barrel of sake to sell ed society would be expected to spend noticed, and have poured money into to revellers at Japan’s cherry•blossom festi• quite a lot on †nance, but that †gure still emerging•market bonds funds over the val. But instead of taking money from the looked too high. ŒWe have been transfer• past year. Developing countries also have thirsty crowd, each brother charged the ring aggregate income and wealth to the †• more chance of outgrowing their debt bur• other for a cup of sake, then used the pro• nancial•services industry. All this †nancial dens. According to Tony Crescenzi of ceeds to buy a cup for himself, and so on. activity is just a deadweight on the sys• PIMCO, investors are asking themselves, The brothers ended the day drunk and tem, says Mr Grantham. ŒWould I rather lend money to nations empty•handed. During the debt boom the optimists ar• whose debt burden is worsening, or to na• Jeremy Grantham of GMO, a fund•man• gued that the huge growth in derivatives tions where it is improving? agement group, is a detached and cynical did not add to risk in the system because This pattern of debt is the opposite of observer of the †nancial and economic every buyer was matched by a seller. No• what you might expect. At the level of indi• scene. The way he sees it, Œall debt seems to body drew attention to the fact that with vidual consumers, people tend to borrow do is bring growth forward a little. If you get each new instrument the †nance sector when they are young because they are people to spend 1% more than their income took a cut in the form of a fee, or the spread hoping for higher incomes in the future. As every year, after 20 years they are going between buying and selling prices. As de• they reach middle age they start to pay o backwards because interest expense is eat• rivative was piled on derivative, debt on their debts and save for retirement. By ex• ing up more of their salary. debt, the cut got ever larger. tension, rich countries with their greying Robert Bergqvist, chief economist at SEB Financial pro†ts may have arti†cially populations should be saving whereas Group in Sweden, is equally pessimistic. boosted the government’s revenues across 1 14 A special report on debt The Economist June 26th 2010

the IMF and the EU. Ms Reinhart and Mr Rogo argue that the world is due for a wave of sovereign defaults, which are common after serious †nancial crises. Another undesirable model is to in‡ate the debt away, as has often happened in the past. At the extreme, as in Germany in the 1920s, central banks Œmonetise the debt, simply printing the money to allow the government to pay its bills. Some re• gard quantitative easing‹in which central banks create money to buy †nancial as• sets, mainly government bonds‹as mone• tisation by another name. But many coun• tries may †nd this diˆcult, especially if they have a lot of short•term debt. Dhaval Joshi of RAB Capital, a hedge fund, ex• plains that 53% of government debt will 2 a range of items, from corporate pro†ts to bonds, and ageing populations in the rich have to be rolled over by 2012, for example. capital gains and taxes on bonuses. Some world will also want to hold more assets If investors think in‡ation is set to rise, of that revenue may now be lost for good. that produce †xed incomes. they will demand higher yields, increasing Mr Koo points out in his book that whereas Historical factors such as legal, tax and the cost of servicing the debt. in 1990 Japanese tax receipts were ¥60 tril• monetary policy have provided incentives Stagnate, default, in‡ate‹they all seem lion ($416 billion), in 2005 they had come for consumers, companies and (crucially) equally grim. The best solution for rich down to only ¥49 trillion, even though Ja• the †nance sector to pile on debt. The level countries is to work o their debts through pan’s nominal GDP was 13% higher. When of debt has become untenable, but the op• economic growth. That may be harder for revenues were booming, governments tions for reducing it are not enticing. some than for others, given that many thought they would keep coming and in• countries’ workforces are set to level out or creased their spending accordingly. Now it Here’s how not to do it shrink as their populations age. It will be is hard to see how the gap can be closed. One example not to follow is Japan, which all the more important for such countries The vast amount of debt at every level has su ered a long period of stagnation ac• to pursue structural reforms that will in• also raises the question whether the pool companied by ever•rising government• crease productivity. of savings is large enough to absorb it all. In debt•to•GDP ratios. This has proved sus• But outgrowing debt is not easy: the the early 2000s there was no problem. tainable only because of the country’s McKinsey study found that, out of 32 cases Central banks and sovereign•wealth funds strong external position; it owes its debt to of deleveraging following a †nancial crisis in the emerging economies seemed only its own institutions. that it examined, only one was driven by too happy to recycle their current•account For nations that owe money to foreign• growth. America, which has a younger surpluses into the government bonds of ers, a long period of stagnation is likely to workforce than Europe or Japan, might still rich countries. This forced down bond lead to at least partial default. This may be manage it. But for many other countries yields and tempted rich•world investors to the eventual outcome in Greece, despite the hole they have dug for themselves may look for better returns by buying mortgage• the recent rescue package put together by already be too deep. 7 backed and high•yield corporate bonds. All that changed with the credit crunch. O er to readers Suddenly the business sector found it very Future special reports Reprints of this special report are available at a Gambling July 10th diˆcult to borrow. By contrast, govern• price of £3.50 plus postage and packing. Egypt July 17th ments found it easy because their debt was A minimum order of †ve copies is required. Latin America September 11th seen as safe. But once economies start ex• Forests September 25th Corporate o er panding again, business and governments The world economy October 9th Customisation options on corporate orders of 100 Turkey October 23rd may start competing for the same pool of or more are available. Please contact us to discuss savings and the public sector may Œcrowd your requirements. out the private one. As the Greek crisis has Send all orders to: shown, countries which want to dip into that pool would do well to keep their †• The Rights and Syndication Department nances in order. 26 Red Lion Square WC1R 4HQ If attracting international investors is London Tel +44 (0)20 7576 8148 too hard, governments will be tempted to Fax +44 (0)20 7576 8492 lean on their domestic savers. Theo Ze• e•mail: [email protected] mek, who heads the †xed•income division at AXA, a giant insurance company, reck• For more information and to order special reports Previous special reports and a list of ons that a combination of regulatory and and reprints online, please visit our website forthcoming ones can be found online accounting changes will encourage banks Economist.com/rights Economist.com/specialreports and insurance companies to buy more