Saturday, February 28, 2009

Niall Ferguson calls for Debt Restructuring

The harsh reality that is being repressed is this: the Western world is suffering a crisis of excessive indebtedness. Many governments are too highly leveraged, as are many corporations. More important, households are groaning under unprecedented debt burdens.

Average household sector debt has reached 141per cent of disposable income in the US, 156per cent in Australia and 177 per cent in Britain. Worst of all are the banks in the US and Europe. Some of the best-known names in American and European finance have balance sheets 40, 60 or even 100 times the size of their capital. Average US investment bank leverage was above 25 to 1 at the end of 2008. Eurozone bank leverage was more than 30 to 1. British bank balance sheets are equal to a staggering 440 per cent of gross domestic product.

The delusion that a crisis of excess debt can be solved by creating more debt is at the heart of the Great Repression. Yet that is precisely what most governments propose to do.

With the economy contracting at a rate (excluding inventory accumulation) of minus 5 per cent, we are on the eve of a public debt explosion that the CBO's forecast - $US4 trillion over the next 10 years, but peaking at 54 per cent of GDP - surely understates. The fact that so many other countries are adopting comparable measures means a flood of new issuance is about to hit national and international bond markets.

There is a better way to go, but it is in the opposite direction. The aim must be not to increase debt but to reduce it. In past debt crises - which usually affected emerging market sovereign debt - this tended to happen in one of two ways. If, say, Argentina had an excessively large domestic debt, denominated in Argentine currency, it could be inflated away. If it was an external debt, then the government simply defaulted on payments and forced the creditors to accept a rescheduling of debt and principal payments.

Today, Argentina is us. Former investment banks and German universal banks are Argentina. American households are Argentina. But it will not be so easy for us to inflate away our debts. The deflationary pressures unleashed by the financial crisis are too strong (consumer prices in the US have been falling for three consecutive months; the annualised rate of decline for the last quarter of 2008 was minus 12.7 per cent.)

The solution to the debt crisis is not more debt but less debt. Two things must happen. First, banks that are de facto insolvent need to be restructured, a word that is preferable to the old-fashioned nationalisation. Existing shareholders will have to face that they have lost their money. Too bad; they should have kept a more vigilant eye on the people running their banks. Government will take control in return for a substantial recapitalisation after losses have meaningfully been written down. Bondholders may have to accept either a debt-for-equity swap or a 20 per cent "haircut" - a disappointment, no doubt, but nothing compared with the losses suffered when Lehman Brothers went under.

Glasgow-born Ferguson is Laurence A. Tisch professor of history at Harvard University and William Ziegler professor of business administration at Harvard Business School. He is also a senior research fellow at Jesus College, Oxford University, and a senior fellow at the Hoover Institution, Stanford University. His books include The Ascent of Money: A Financial History of the World.,28124,25115869-643,00.html

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