Tuesday, 25 October 2011

Is Debt Jubilee Necessary?

Some political pressure groups, especially the Organised Interest Group of Households, are calling for a partial debt jubilee on households' debt in Iceland. At least one political party, the Progressive Party, has also put forward an economic plan where they propose a faster "reorganisation" of household debt. Right after the collapse, they proposed writing down the debt of household by 20%. It's a flammable subject, to say the least.

It's an undeniable fact that households in Iceland are too indebted and it's increasing the financial instability of the economy. In comparison to other households, their debts are nearly double of those in the Euro Zone (EZ). The graph below shows the comparison (data from CBI's Financial Stability 2011 report).

Household debt, % of GDP

But levels of household debt are only half of the story. The cost of debt is the other part of it. And using long term interest rates as a proxy for the cost of household debt, one can get the data behind this graph - a simple multiple of annual interest rates (OECD quarterly figures) and household debt. Take note that this is not representative for cash flows.

Estimated annual cost of household debt as % of GDP

Now blatantly, this is madness! Absolute and utter madness! Annual cost of debt for household in Iceland was 4-8 times higher than in the countries used here for comparison. And in them, the economy came down crashing because of high debt levels. And the cost of debt maintenance is still too high. That is the real problem in Iceland.

But the theory says...
What has to be done in Iceland is simple: lower the debt burden. This means either to lower long term interest rates and/or lower the debt levels. One way of lowering the debt burden is debt jubilee of some kind. But that's not easy. There is considerable political pressure against debt jubilee because it would harm the (domestic) owners of the debt. And the major owners are: the pension funds. Other big owners are banks and Housing Financing Fund (a GSE).

Now, according to economic theory, that shouldn't matter then. The argument goes that one's debt is another's asset and so in the macro economy, the macro effects of debt cancel out, given that the creditor and the debtor are domestic parties - only foreign debt matters. And when the creditor and the debtor is the same as in the case of large part of Icelandic household debt, the debt levels should certainly not matter at all. The cash flows due to debt are simply going from the left pocket of the households to the right one, making the households, in macro economic perspective, indifferent on whether the debt is partially cancelled. And since this would represent a transfer of wealth from old people to young - the irresponsible young - the political atmosphere is certainly not leaning towards debt jubilee.

In the case of banks and the Housing Financing Fund, demanding some sort of debt jubilee would harm their balance sheet. That, the theory goes, could introduce lack of credit supply (zombie banks) and harm the economy through a credit crunch. An extreme case would be where the banks would collapse and the State would have to refinance them. This applies especially in the case of HFF which is in fact as good as bankrupt already. The State is essentially the households so debt jubilee would be a boomerang, shooting down households through increased taxes on its way back from cutting down the debt levels.

So the arguments against debt jubilee is that it would harm the households themselves through the pension system. Further danger would be through increased fragility of the banking system, harming the economy and the households themselves through higher taxes. Furthermore, some (mad) theory says that private debt levels don't matter anyway: one's debt is another's asset and the net effects are none, given that the creditor and the debtor are both domestic.

...and it's all wrong
All this isn't true. The theory is wrong: gross debt levels do matter! And once spiced up with astronomical interest rates, the soup becomes poisonous for financial stability and with it macroeconomic welfare.

There are many reasons for why the gross debt levels really matter. One is the fact that assets and debts of households are not homogeneously distributed. Even though households in aggregate may well be netted out of the whole sum (unlikely anyway), the fact is that intra-household distribution of debt and assets is not homogeneous. This means, in short, that one household may be the owner of the debt of 10 others. Because of this uneven distribution of debt and assets, the cash flows are not even between the households: they are concentrated towards a certain attractor. And if the gross debt of those 10 households is too high, they go under, thereby harming the economy as their consumption levels drop and bankruptcies increase.

Another reason for why the gross debt levels matter is that even though the debts and assets were evenly distributed between households, which they are not, the fact alone that there is maturity mismatch between assets and debts makes debt non-neutral. As an example, in Iceland the households must pay back their debts today but they won't get anything paid out of the pension system until the individuals are old enough. So what are they going to do about the debt until then? Assuming that gross debt and gross assets don't matter, even though they are evenly spread out between households, is saying the time stands still.

Other arguments for the non-neutrality of gross debt include psychological and behavioural factors such as irrationality, non-neutrality of money, the endowment effects, procrastination and many more. None of them support the theory that gross debt is neutral.

Is debt jubilee the answer then?
So gross debt matters and Icelandic households are drowning in it. Naturally then, the question "is debt jubilee the answer?" pops up.

It isn't. Yes, debt jubilee would help and I have changed my view from before: Icelanders should go for a partial debt jubilee. But it matters how it's done. Debt jubilee is a serious nuclear-option: there will be collateral damage and it's as politically inflammable as one can imagine. Beside obvious questions such as the moral hazard question (does debt jubilee increase the will to get indebted later, trusting that you'll be cut down from the snare just in time?) and what is a "fair" debt forgiveness, a debt jubilee has to be carried out in such a way that in few years time the same problem won't be back. If we go for the "red button", we better make sure that households and economic units in general cannot en masse get themselves into such a hopeless financial situation that debt jubilee is the only way out.

Debt jubilee is not the answer but it's a part of it. Icelanders have leveraged the assumed assets they think they have in the banks and the pension system to such a degree that today's households are being pulled down into the abyss by a massive debt stone. As the households get sucked into the deep, so does the macro economy. It's time to cut the rope - decrease the leverage - but make sure the rope doesn't hook onto another debt-stone in a few years time. How that should be done is another matter and will be discussed later.

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