Deleveraging Redfined - Part 2: Martin Wolf on the Least-Bad Alternative


“You can’t get out of debt by adding more debt.”

This is the myth that Martin Wolf takes aim at in his third blog post on deleveraging, one of the most significant economic issues of our time.

In an earlier post INET explored his initial op-ed and the two other pieces it inspired on deleveraging and balance sheet recessions (to be linked). Today, we will look at the remaining stories in Wolf’s series, which debunk old economic thinking on deleveraging and how to get out of debt.

So how to get out of debt? Wolf suggests that the idea of getting out of debt via austerity is “the reverse of the truth, which is that that the only way to get out of debt is to add more debt. What matters is who adds the debt and in what form.”

Wolf says that in a big financial crisis and with large-scale deleveraging like we are seeing now, the proper response is to shift debt from those who can’t afford to pay to those who can. “The crisis is because the wrong people (and institutions) are indebted,” he writes. “The obvious way to change this is for the debt to be paid down. But the impact of that is to depress the economy. Some other entity must start to borrow, instead.”

And in the current case, when the private sector is over indebted, “There are only two other sectors,” he writes, “the government and the rest of the world. So, if the household and corporate sectors are to go into surplus, as the over-indebted seek, or are forced, to pay down their debt, the other two must go into deficit.”

And this, he says, is exactly what’s happened since 2008. “The government has gone massively into deficit, not because of active policy decisions, but as a result of declines in revenue and rising government spending triggered by the post-crisis recession.”

The usual claims against government deficits – specifically burdening future generations – are also only half the story, Wolf suggests. Why? Because they don’t take into account the counterfactual of a lower economic trajectory if the public sector doesn’t help the economy grow. “The present is not simply bequeathing larger debts to the future,” he writes. “It is bequeathing both larger debts and larger financial claims in order to sustain a larger economy, now and in future.”

The question is whether the benefit is greater than the cost. When a country is facing a balance sheet recession like the U.S. is now, the answer would seem to be a clear yes.

In the fourth part Wolf tackles “objections to providing fiscal support for deleveraging.” Wolf suggests that countries facing deleveraging that are lucky enough to have their own currency – like the U.S. and U.K. – are fortunate that they face low borrowing costs in real terms.

“So why not borrow?” he asks.

The most prominent objection comes from Carmen Reinhart and Kenneth Rogoff, whose famous work concluded that in periods where public debt exceeded 90 percent of GDP economies grew more slowly. But, Wolf suggests, “The conclusion one cannot draw is that public debt must be kept below 90 percent, whatever the cost. Struggling to keep debt below 90 per cent of GDP might be far more costly than letting debt rise above that threshold. As in almost everything in economics, it is all about choosing the best (or, in this case, least unpleasant) alternative.”

What the best option is depends on why public debt would be accumulated. It also depends on the causality of Reinhart and Rogoff’s assertion. “Does higher debt lower growth or low growth raise debt?” Wolf asks.

Wolf goes on to further challenge Reinhart and Rogoff’s ideas. “Again, let us accept that very high public debt ratios may create problems,” he writes. “None the less, the period after the Napoleonic War was when the U.K. began its industrial revolution and the post-war period was one of good economic performance, in both the U.S. and U.K. The conclusion is that high debt can be perfectly manageable in countries that know how to manage it.”

“Context does matter,” Wolf concludes, and in cases like the present, it’s a matter of taking “the least bad alternative.”

In the final part of Wolf’s deleveraging series, he addresses the “ways to accelerate private-sector deleveraging.”

There are two ways to achieve this, Wolf suggests, “capital transactions and default.” But due to the nature of the current housing bust, few people with capital will want to buy the assets (houses) at a time when prices are falling. So, “while the sale of assets owned by over-indebted people is part of the solution, it is likely only to be a part.”

The other option, then, is organized default. Wolf stresses that there are two big problems with this approach: “First, mass default can be difficult to organize; and, second, it can be destructive.”

But Wolf has another alternative for “delivering the equivalent of mass default.” Inflation. Inflation can create negative real interest rates that lower the value of debt relative to the price of the assets and can encourage investment. There are also downsides to this approach, however, as it would “damage the prudent saver.” Furthermore, Wolf notes, “In countries with deep slumps, inflation is not easy to deliver. Conventional quantitative easing does not seem to do the trick. Something more radical would be needed.”

All of these approaches have costs and benefits. There is no magic bullet. “All such policies should be regarded as complements to, not substitutes for, resort to the government’s balance sheet as a cushion for adjustment,” Wolf suggests. “In brief, we should accept large, temporary fiscal deficits as part of the price of returning the economy to health after the crisis.”

This may not be an ideal choice. But it’s the best of a bad bunch.

Click here to read INET’s first post on Wolf’s deleveraging series
Click here to read part 3: Getting out of debt by adding debt
Click here to read part 4: Objections to providing fiscal support for deleveraging
Click here to read part 5: Ways to accelerate private-sector deleveraging