Friday, January 22, 2010

Reinhart and Rogoff Again (Deleveraging)

I uttered a few dismissive words about Reinhart and Rogoff's much-praised This Time is Different (though not, be it noted, the formidable dataset that underlies it). Comes now two commentators who has read it more comprehendingly than I did:

We glean five important factors from this work that pertain to our present situation. First, financial imbalances occur when aggregate domestic debt is excessive relative to income, regardless of whether the government or private sector is accumulating the debt. Once debt becomes excessive, countries do not grow their way out of the problem; they must go through the time consuming and often painful processes of debt repayment and increased saving.

Second, whether the domestic debt is externally or internally owed is not as critical as the excessiveness of the debt.

Third, government actions, even involving sizeable sums of money, are far less helpful than they appear. As the book states, "Infusions of cash can make a government look like it is providing greater growth to its economy than it really is."

Fourth, Reinhart and Rogoff cover countries in debt crisis with a host of different conditions, such as growth and age of population, political regimes, technology status, education, and other idiosyncratic features. Nevertheless, economic damage as a result of extreme over-leverage has remarkably similar results, whether the barometer of performance is economic output, the labor markets, or asset prices.

Fifth, further increasing leverage to solve the problem only leads to greater systemic risk and general economic underperformance.

The real question for financial participants is whether all these influences result in inflation or deflation, and the authors' research details both outcomes. As is widely feared here in the U.S., they outline that many countries have had the right circumstances and mechanisms to inflate away their debt overhang, and, in fact, have done so by debasing their currency. Those particular circumstances are not currently present in the United States.

According to Reinhart and Rogoff the norm is that major economic contractions lead to deflation. Importantly, they call our present economic circumstances the "second great contraction."

Thus, not only has the historical "qualitative" research on the subject of deflation chronicled the deflationary impulses emanating from overindebtedness (Fisher's 1933 "Debt-Deflation Theory of Great Depressions"), but also modern "quantitative" methods have now essentially confirmed this conclusion. Over-indebtedness and major contractions lead to deflation.

That's Van Hoisington and Dr. Lacy Hunt, writing in the weekly newsletter of John Mauldin.* They also say that "At $3.70 of debt for every dollar of GDP, U.S. debt is excessive."

*Prescribed Mauldin blurb:
John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to: http://www.frontlinethoughts.com/learnmore.]

1 comment:

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