11 Jul 2012 11:14

A world in debt – where does the money come from?

We hear about the European debt crisis on a daily basis, sovereign states that have too much debt and therefore have problems managing their loans and interest payments. But, it is also about individuals and households that have too much debt and need to pay that off, which makes the economy slow down further.

Are we living in a world where everyone is too heavily in debt, sovereigns, companies and households alike?

“Yes, that is a problem in the Western world. However, it is mostly true for sovereigns and households. Companies generally have strong balance sheets, with little debt,” Bergqvist says.

At the beginning of the millennium, until 2007, indebtedness grew too fast. Bergqvist highlights many reasons: the price of money was too low – central banks kept interest rates down; economies became more international; economic prospects were too rosy; and economist, politicians and central banks talked about the “super cycle” and the “death of economic downturns”. In addition, the birth of the euro induced an exaggerated belief in what the common currency would mean in terms of growth, employment and prosperity.

The right debt level

We read and talk about the “right level” of debt. But, how do we find that level? From the discussion with Bergqvist and Kvist, it is clear that there is no simple answer.

“I do not believe there is an optimal level of indebtedness that is always the right one. It depends on what the money is used for and how quickly debt grows in relation to the overall economy,” Kvist says.

There is a dynamic correlation between credit availability and economic growth, where credit is growing in good times because individuals, companies and governments dare to invest more and therefore lend money for those investments. Similarly, they hold back on investments when times turn for the worse and optimism about the future recedes.

Bergqvist adds: “Often we see credits growing more rapidly than the economy in good times. When that curve rises too steeply and the gap widens compared to the economic growth, we see a bubble building. And those always burst sooner or later.”

Bursting bubbles

Financial bubbles are nothing new; they are a recurring phenomenon through history. They occur when a buyer has unrealistic expectations about what return an asset can provide in terms of future revenue and increased value. Prices rise until the flow of capital ebbs out, since the asset eventually will appear to be overvalued. At that stage more people want to sell than buy.

A bubble can burst very rapidly at that stage, and in the worst-case scenario lead to stock market crashes and recessions. Some examples include the great American depression in the 1930s, the Swedish real estate bubble in the early 1990s and the internet bubble around 2000.

Debt free world not ideal

The discussion also makes it clear that credit availability is important to create growth. A debt-free world is not ideal as it would put a drag on economic development.

“You can easily see that when thinking about student loans. That is when someone borrows money to invest in an education that will generate income in the future. If everyone who wants to study had to save the money first, we would see much slower economic growth,” Kvist says.

Credit is therefore a good thing. It contributes to development and prosperity. It is when credit grows too quickly that bubbles are created that will burst at some stage. Bergqvist and Kvist say this is almost a law of nature that cannot be entirely avoided. We can however counter the effects of economic swings in a number of ways.

“I think the counter-cyclical capital demands placed on banks are good,” Bergqvist says. “Banks must put aside more capital for their lending when the economy is growing quickly.”

Blaming lax credit standards is too simplistic

Kvist says: “In retrospect, it is easy to say that debt grew too fast or too high. But it’s not easy to see that when you are in the middle of an economic upturn. The impression people have is that it is the banks' fault – that the crisis was caused by lax credit standards – this is too simplistic and inaccurate.

“These movements depend on the actions of many players – households, companies and countries that want to invest and borrow, central banks that provide the raw material and politicians who want to stimulate activity. We bankers can’t simply create money, rather we provide the connections between those who want to lend and those who want to borrow.”

Kvist adds that these movements between optimism and pessimism, high and low activity, are part of the natural order, and, when coupled with people’s desire to develop, add to the difficulty of predicting the future.

But, if countries and households in the Western world are highly leveraged, where does the money come from, and who is lending it?

“Primarily it’s through reallocating the savings already in the country. For example, pension companies and industrial companies using household savings and company profits to buy government securities (in other words lending to the state) or buying covered bonds (lending money to banks which then lend the money to mortgage holders).

“If there is still a deficit after reallocation in domestic sectors, countries can raise money from countries that have a financial surplus, in other words a surplus in the current account. This doesn’t have to be in the form of a loan; for instance the country with a surplus can buy real assets (stocks or real estate) or bonds in the country with a deficit.

“Countries which lend money to other countries are, in general terms, the oil producing countries, Asian countries and some others such as Germany and Sweden.”

At the moment enormous rescue packages are put together for countries and banks in Southern Europe with too much debt. And there are efforts to stimulate the economy through cash injections in both the US and Europe. Is this real money or is it a promise to come up with it in the future?

“It’s both money that’s already in the system and new money coming from, for example, the European Central bank (ECB),” Bergqvist says.

But how do you make new money and who can do so?

“It’s central banks in sovereign countries with their own currency that can make money. They don’t have any balance sheet constraints on how much money they can generate and it can happen quickly. At the moment central banks’ balance sheets are growing tremendously, at a rate not seen historically, and they are creating more money than we have ever seen before.”

What are the associated risks?

Bergqvist says: “It creates credibility issues. Printing money means, in practical terms, that the value of money decreases assuming the amount of goods and services stay the same. This in turn leads to a risk of inflation, which erodes purchasing power. It also creates the risk of rising long-term interest rates, which negatively impacts economic activity.

“By adding enormous amounts of money into the system the central banks are trying to get growth going again and prevent the risk that credit will be cut off.

“As long as there is financial and economic uncertainty the effect of the central banks adding money will be limited. Money will not flow as quickly because all the players are more cautious, fewer people want to borrow and invest and fewer people want to lend. What is happening now is essentially a giant experiment where there are no right answers.”