Stephen King: Debt levels could leave us with post-bubble hangover

When central banks have attempted to regulate the supply of money, they have all too often failed

No central banker in his or her right mind would admit to impotence, at least of the economic kind. Unsurprisingly, then, few within the central banking fraternity have expressed any serious doubts about the efficacy of monetary policy. Even when interest rates get close to zero without generating a convincing recovery – a problem in many parts of the world today – there appears to be no real concern. After all, central bankers have other weapons up their sleeves. And the one that offers the most power, apparently, is the printing press.

The zero rate bound on nominal interest rates is, in reality, only infrequently encountered. In recent history, the only major country to have experienced this unusual state of affairs is Japan. The problem with the zero rate bound is straightforward: if expected returns on capital are very low or, possibly, negative – more than likely in a deflationary environment – interest rates may simply not be able to fall far enough to ensure a recovery in economic activity. After all, why borrow at zero or 1 per cent if your prices, wages and profits are likely to fall by 2 or 3 per cent over the coming year?

Under these circumstances, the printing press appears to be the obvious remedy. Double the amount of money in the economy and its price should halve. Put another way, double the amount of money in the economy and people will simply have too much: they'll want to get rid of it and the only way to do that is to buy something – an equity, a corporate bond, a work of art, a house, a new kitchen or maybe a new factory.

The argument is simple, beautifully logical and probably wrong. It assumes that central bankers are in complete control of the money supply and can raise or lower the level of money flowing through the economy at will. The evidence over the past 20 years, however, suggests rather the opposite. When central banks have attempted to regulate the supply of money, they have all too often failed. Two examples spring to mind. The first is the experiment with monetary targeting that took place in many parts of the world in the late 1970s and early 1980s. The second is the more recent Japanese experience where, despite valiant efforts to the contrary by the Bank of Japan, broad money supply growth has remained stubbornly depressed.

The common factor in these two episodes is debt. More specifically, in both cases a gap opened up between actual debt levels and desired debt levels. In the mid to late-1970s, when monetary targeting came into vogue, most credit markets were tightly regulated. This basically meant that, at a given interest rate, not all those who wanted to borrow were able to borrow. Back then, getting a mortgage was a major headache and many applicants would be rejected even if they appeared to be reasonably creditworthy. Actual levels of debt were, as a result, lower than the debt levels that would have "cleared" the market at prevailing interest rates.

With the advent of financial liberalisation in the 1980s, suddenly a whole host of new competitors was able to enter the market. For a given interest rate, many more people were able to borrow and many more suppliers of credit were able to meet their needs. Suddenly, money supply started to grow rather too quickly. Central banks and governments began to overshoot their money supply targets for the simple reason that they had failed to detect the hidden, or suppressed, demand for credit that suddenly began to reveal itself in the 1980s. Policy makers may have thought that they were in control of the printing press but, ultimately, it was the private sector that determined its output. And the key determinant of money supply growth became the speed with which actual debt levels were able to rise to desired debt levels.

Now take a look at Japan. The collapse in Japanese asset prices through the 1990s, in effect, implied a collapse in expectations about future income growth. This, in turn, created a problem for debtors. Those that had borrowed in the heady days of the late-1980s, when asset prices roared ahead and everyone thought that Japan was going to rule the world, began to regret their decisions. Debts that, in a past life, would have easily been repaid in just a few years became a lot more problematic. Put simply, with asset prices having fallen and with income growth a lot weaker than expected, debt repayment became sheer hard work. And with everyone hell-bent on debt repayment, there was no money left for growth: the economy slumped, deflation arrived and debt levels turned out to be persistently too high.

In other words, the Japanese situation is exactly the opposite of the 1970s and 1980s experience. Then, debt levels were lower than people wanted them to be. In Japan, debt levels were higher than people wanted them to be. So what did this imply for the printing press? Well, for a few years, the Bank of Japan wasn't terribly happy about the whole idea of printing money and chose to keep the secret weapon hidden away. But over the past 18 months, the Bank of Japan has been printing money with a vengeance. Growth in so-called "narrow" money has been running at more than 20 per cent annually, no mean achievement by anybody's standards.

There is, however, a catch. The printing press may be churning away but there's no one around that wants to take the money away. The Japanese banking system has a lot of problems in itself but the bigger problem appears to be a lack of appetite from either companies or households to borrow. Even if you can make the banking system itself awash with money, the economy itself isn't going to benefit unless people actually have the appetite to use the money. Of course, if the private sector doesn't want to, you can get the public sector to do the job for you. But, even here, there may be limits. Money will eventually end up in the pockets of companies and households and they may again choose to repay debts than to spend. If debt levels are too high, money may simply not be able to swish around the economy. In Japan's case, broad money supply growth has remained remarkably weak in recent years.

What relevance does all of this have for today? My charts show that debt levels have risen in absolute terms very quickly in the US and the eurozone over the past few years. They also show that, as a share of income, household debt in the US has also risen dramatically. Is this a re-run of the 1970s and 1980s – where actual debt levels rose to desired debt levels as a result of financial liberalisation – or, instead, do these debt levels raise the risk of Japan all over again where actual debt levels are too high relative to desired debt levels?

Sadly, I suspect it's the latter. Debt levels that, a few years ago, were no big deal, are increasingly becoming a constraint on growth, undermined at first by falls in equity prices and, perhaps over coming months, by falls in house prices. The printing press may give comfort to central bankers but excessive debt levels in the private sector may leave us suffering from a post-bubble hangover for a lot longer than policy makers would have us believe.

Stephen King is managing director of economics at HSBC.

stephen.king@hsbcib.com