How deleveraging weighs on economic growth

Nikolaj Schmidt, chief international economist at T. Rowe Price

Chronically weak demand and low interest rates are more the result of deleveraging than symptoms of long-term stagnation, says Nikolaj Schmidt of T. Rowe Price. As a result, the global economy is arguably in much better shape than many believe.

Consistently low and even negative interest rates have raised fears that the global economy has entered a period of chronically weak demand, which former U.S. Treasury Secretary Larry Summers called "long-term stagnation" described. Why people are concerned is obvious: Since the global financial crisis of 2007 to 2008, monetary policy has been loosened more and more to support growth, with disappointing results. With policy rates so close to the floor, there is little room for monetary policy to maneuver if there is a negative demand shock. It's a serious headache for central banks.

Four phases of deleveraging

"I do not believe that the main cause of weak growth over the past decade is long-term stagnation", says Nikolaj Schmidt, chief international economist at T. Rowe Price "Rather, the unprecedentedly low interest rates of recent years are, in my view, the result of a protracted deleveraging process, but one that is likely to end eventually. Therefore, I believe that the global economy is probably in better shape than the supporters of the long-term stagnation thesis would have us believe.", he explains in his latest market commentary.

The economist points out the phases into which this deleveraging process has been divided since the global financial crisis:

  1. The "hot" Phase of the crisis that provided the impetus to reduce debt on U.S. balance sheets,
  2. the sovereign debt crisis in the eurozone, which set in motion the deleveraging process in Europe,
  3. the "Taper Tantrum", that primarily affected emerging markets (excluding China), and
  4. The deleveraging of the Chinese economy.

These phases of deleveraging have severely slowed the global economy, one after the other, over the past eleven years. Schmidt says: "Typically, deleveraging phases after a crisis take a few years; the fact that this process is already quite long and taking place in so many areas shows how large the macroeconomic imbalances were that were created before and during the global financial crisis."

Debt reduction with different directions

Debt reduction has taken different directions in different regions. "In the U.S., while households have been rapidly reducing their debt, the nonfinancial corporate sector has been massively increasing borrowing. Used mainly for financial engineering – i.e., share buybacks, dividend payments, takeovers – which does not contribute to growth", explains Schmidt. In Europe and Japan, he said, deleveraging has taken place in many different ways. Nevertheless, there is a strong impetus to reduce budget deficits that ballooned during the global financial and European sovereign debt crises, the expert says. The deleveraging process in China has been accompanied by a determined reorientation of policy priorities away from growth and toward financial stability, focusing on sectors away from households.

If everyone wants to reduce their debt at the same time, too little final demand will dampen growth. Moreover, the surplus of lendable funds is depressing interest rates. Schmidt warns, however: "It would be a mistake, however, to believe that long-term, protracted debt reduction is something 'natural' or 'logical. In economies with growing populations, household debt should be an increasingly large share of total income. Because as the number of households grows, the stock of available housing must also grow. This in turn means that someone has to take out a mortgage – either the household or the owner of the housing or. Landlord."

Low interest rates are not symptoms of stagnation

The expert from T. Rowe Price wonders whether economists are taking too lightly the rising debt in the nonfinancial corporate sector in the U.S. Financially, he said, this is clearly a factor of uncertainty that will play an important role in the next recession. But since this debt would not have found its way into the real economy – say, in the form of an investment boom – no major distortions are likely to have occurred at the macroeconomic level either.

What will it take for consumers and businesses to start borrowing again to spur growth? "This question is more difficult to answer. A prerequisite for borrowing, in addition to ending the stock-flow correction in construction and housing, is a degree of confidence in the future, which in turn requires policy stability. However, the last few years have brought us the back-and-forth of the trade conflict between the U.S. and China, the seemingly never-ending story of Brexit and the rise of populist anti-establishment parties in many countries", explains Schmidt. Some degree of political stability may need to return before households and businesses start spending again.

Nikolaj Schmidt reiterates: "The chronically weak demand and low interest rates of the past decade are more the result of deleveraging triggered by the sharp increase in macroeconomic imbalances before the global financial crisis than symptoms of long-term stagnation. As a result, the global economy is probably in much better shape than proponents of the long-term stagnation thesis claim."

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