A Template for Understanding Big Debt Crises

Classically, a lot of short-term debt cycles (i.e., business cycles) add up to a long-term debt cycle, because each short-term cyclical high and each short-term cyclical low is higher in its debt-to-income ratio than the one before it, until the interest rate reductions that helped fuel the expansion in debt can no longer continue.

Classically, a lot of short-term debt cycles (i.e., business cycles) add up to a long-term debt cycle, because each short-term cyclical high and each short-term cyclical low is higher in its debt-to-income ratio than the one before it, until the interest rate reductions that helped fuel the expansion in debt can no longer continue. Debt fuels growth. When credit is easily available, there's an economic expansion. When credit isn't easily available, there's a recession. Over time, debts rise faster than incomes, creating long-term debt cycles. This process is self-reinforcing: Rising spending generates rising incomes and net worths This raises borrowers' capacities to borrow Which allows more buying and spending, etc. Cycles inevitably reverse. Eventually, debt service requirements become too big relative to incomes. Asset prices fall, debtors struggle with payments, and investors become cautious. This leads to: Decreased spending Falling incomes Credit contraction Falling asset prices Further spending cuts

The key to handling debt crises well lies in policy makers' knowing how to use their levers well and having the authority that they need to do so, knowing at what rate per year the burdens will have to be spread out, and who will benefit and who will suffer and in what degree, so that the political and other consequences are acceptable. Central banks have powerful tools. To manage debt crises, central banks can: Lower interest rates Print money Provide liquidity to markets Guarantee assets/institutions Timing and balance are critical. Central banks must: Act quickly to prevent spiraling deflation But avoid fueling runaway inflation Spread out debt burdens over time Balance interests of debtors and creditors Political constraints often hamper response. Effective crisis management requires: Public support for potentially unpopular measures Legal authority to take bold actions Coordination between monetary and fiscal policy

The two biggest impediments to managing a debt crisis are: a) the failure to know how to handle it well and b) politics or statutory limitations on the powers of policy makers to take the necessary actions. Deflationary deleveraging occurs when: Debts are in domestic currency Central bank can print money freely Focus is on debt reduction/defaults Key features: Asset prices fall Spending and credit contract Unemployment rises Inflationary deleveraging occurs when: Significant debts in foreign currency Limited ability to print money Currency devalues sharply Key features: Rapid currency depreciation High inflation/hyperinflation Debt burdens grow in real terms Policy response determines outcome. The…