Sudip Bandyopadhyay’s Blog

The attitude of investors has changed dramatically during the course of the credit crisis. In its early stages, they denied the crunch was a serious matter. Even after the demise of Bear Stearns, most were still hopeful that it would be a short-lived affair.  However, since Lehman’s collapse and the subsequent economic implosion there has been less wishful thinking in evidence. Investors now accept it will take a long haul before our credit-bloated economies recover from earlier excesses. The question is how long?

A study of the aftermath of previous credit bubbles is instructive. In general, after a bust all the abnormal growth in credit is reversed. Credit as a proportion of gross domestic product tends to shrink back to its level of a decade earlier. Furthermore, past experience suggests the greater the boom, the longer it takes to unwind. For instance, Japanese private credit expanded by about 60 per cent of GDP in the years before 1990. It took a whole decade for this debt to be paid off.  By contrast, the Scandinavian boom of the late 1980s was less pronounced. In Finland, Sweden and Norway, credit grew by an average of about 25 per cent of GDP. These countries sweated off their excess liabilities in a little more than three years.

The size of the outstanding debt is also a good predictor of how long the deleveraging lasts. Again, the Scandinavians had a relatively low ratio of private sector debt to GDP, when their crisis struck. However, both the US in the 1920s and Japan in the 1980s accumulated corporate and household debt equivalent to more than twice their economic output. In addition, there’s a fairly close relationship between the magnitude of the preceding real estate bubble and the length of the unwind.  It is common for emerging markets to speed up the deleveraging process with a currency devaluation. This allows them to boost exports and use the extra income to pay down outstanding liabilities. For small open economies, a massive currency devaluation is generally accompanied by a surge of inflation. There is no faster way to reduce the real burden of debt than through hyperinflation. Turkey, Indonesia and Mexico have all pursued this path over the past couple of decades. However, Japan’s deleveraging process was so protracted because inflation was low or negative throughout the 1990s.

These historical findings allow us to make some tentative forecasts about the likely length of the debt unwind in the US and Europe in the years to come. Over the past decade, private sector indebtedness has climbed by about 70 per cent of GDP in both the US and UK. Both these countries ended up with a vast stock of debt relative to their national income – US private debt climbed to nearly 250 per cent of GDP. Furthermore, both the UK and US experienced great housing bubbles.

Over the past year, inflation has fallen sharply. The UK has an advantage owing to the sharp devaluation of sterling over recent months. However, given the enfeebled state of the world economy, it’s unlikely a surge in exports will alleviate British woes.  The situation on the peripheries of Europe is even more dire. During the boom, Spain and Ireland grew their debt at twice the rate of the US. Both countries ended up with a stock of debt at roughly the same level as Japan’s in 1990. The housing bubbles in Ireland and Spain were also more pronounced than in the US. Neither country can devalue their currencies since they are members of the European Monetary Union. And given the European Central Bank’s strict monetarist credentials, there is little immediate prospect of inflation eroding the burden of the beleaguered Iberian and Celtic debtors.

If history is a useful guide, it is possible the reduction in private sector debt in the US and UK will last well into the middle of the next decade.  It may take even longer in Spain and Ireland. Governments will slow this process down by running large fiscal deficits. But they can’t arrest the deleveraging.  Deleveraging episodes are generally characterised by rising savings, low levels of investment and weak consumption. Economic growth tends to be both below average and fitful. It is common for initial economic recoveries to be followed by subsequent weakness – the so-called “W-shaped” recovery. Under such dreadful conditions, it is hardly surprising equities are more volatile than normal and valuations become cheap. The good news is that the stock market tends to discount the bad news and bottoms out long before the deleveraging comes to an end. The US stock market reached its nadir in July 1932. However, Americans were still paying down their debts at the end of the decade.