Many economists, including Janet Yellen, view global economic troubles since 2008 largely as a story about “deleveraging” — a simultaneous attempt by debtors almost everywhere to reduce their liabilities. Why is deleveraging a problem? Because my spending is your income, and your spending is my income, so if everyone slashes spending at the same time, incomes go down around the world.
Or as Yellen put it in 2009, “Precautions that may be smart for individuals and firms — and indeed essential to return the economy to a normal state — nevertheless magnify the distress of the economy as a whole.”
So how much progress have we made in returning the economy to that “normal state”? None at all. You see, policymakers have been basing their actions on a false view of what debt is all about, and their attempts to reduce the problem have actually made it worse.
First, the facts: Last week, the McKinsey Global Institute issued a report titled “Debt and (Not Much) Deleveraging,” which found, basically, that no nation has reduced its ratio of total debt to GDP. Household debt is down in some countries, especially in the United States. But it’s up in others, and even where there has been significant private deleveraging, government debt has risen by more than private debt has fallen.
You might think our failure to reduce debt ratios shows that we aren’t trying hard enough — that families and governments haven’t been making a serious effort to tighten their belts, and that what the world needs is, yes, more austerity. But we have, in fact, had unprecedented austerity. As the International Monetary Fund has pointed out, real government spending excluding interest has fallen across wealthy nations — there have been deep cuts by the troubled debtors of Southern Europe, but there have also been cuts in countries, like Germany and the United States, that can borrow at some of the lowest interest rates in history.
All this austerity has, however, only made things worse — and predictably so, because demands that everyone tighten their belts were based on a misunderstanding of the role debt plays in the economy.
You can see that misunderstanding at work every time someone rails against deficits with slogans like “Stop stealing from our kids.” It sounds right, if you don’t think about it: Families who run up debts make themselves poorer, so isn’t that true when we look at overall national debt?
No, it isn’t. An indebted family owes money to other people; the world economy as a whole owes money to itself. And while it’s true that countries can borrow from other countries, America has actually been borrowing less from abroad since 2008 than it did before, and Europe is a net lender to the rest of the world.
Because debt is money we owe to ourselves, it does not directly make the economy poorer (and paying it off doesn’t make us richer). True, debt can pose a threat to financial stability — but the situation is not improved if efforts to reduce debt end up pushing the economy into deflation and depression.
Which brings us to current events, for there is a direct connection between the overall failure to deleverage and the emerging political crisis in Europe.
European leaders completely bought into the notion that the economic crisis was brought on by too much spending, by nations living beyond their means. The way forward, Chancellor Angela Merkel of Germany insisted, was a return to frugality. Europe, she declared, should emulate the famously thrifty Swabian housewife.
This was a prescription for slow-motion disaster. European debtors did, in fact, need to tighten their belts — but the austerity they were actually forced to impose was incredibly savage. Meanwhile, Germany and other core economies — which needed to spend more, to offset belt-tightening in the periphery — also tried to spend less. The result was to create an environment in which reducing debt ratios was impossible: Real growth slowed to a crawl, inflation fell to almost nothing and outright deflation has taken hold in the worst-hit nations.
Suffering voters put up with this policy disaster for a remarkably long time, believing in the promises of the elite that they would soon see their sacrifices rewarded. But as the pain went on and on, with no visible progress, radicalization was inevitable. Anyone surprised by the left’s victory in Greece, or the surge of anti-establishment forces in Spain, hasn’t been paying attention.
Nobody knows what happens next, although bookmakers are now giving better than even odds that Greece will exit the euro. Maybe the damage would stop there, but I don’t believe it — a Greek exit is all too likely to threaten the whole currency project. And if the euro does fail, here’s what should be written on its tombstone: “Died of a bad analogy.”