Project Syndicate – Kenneth Rogoff is Professor of Economics and Public Policy at Harvard University, and was formerly chief economist at the IMF
Doctors have long known that it is not just how much you eat, but what you eat, that contributes to or diminishes your health. Likewise, economists have long noted that for countries gorging on capital inflows, there is a big difference between debt instruments and equity-like investments, including both stocks and foreign direct investment. So, with policymakers and pundits railing against sustained oversized trade imbalances, we need to recognize that the real problems are rooted in excessive concentrations of debt. If G-20 governments stood back and asked themselves how to channel a much larger share of the imbalances into equity-like instruments, the global financial system that emerged just might be a lot more robust than the crisis-prone system that we have now.
Unfortunately, we are very far from the idealized world in which financial markets efficiently share risk. Of the roughly $200 trillion in global financial assets today, almost three-quarters are in some kind of debt instrument, including bank loans, corporate bonds, and government securities. The derivatives market certainly helps spread risk more widely than this superficial calculation implies, but the basic point stands. Certainly, there are some good economic reasons why lenders have such an insatiable appetite for debt. Imperfect information and difficulties in monitoring firms pose significant obstacles to idealized risk-sharing instruments.
But policy-induced distortions also play an enormous role. Many countries’ tax systems hugely favor debt over equity. The housing boom in the United States might never have reached the proportions that it did if homeowners had been unable to treat interest payments on home loans as a tax deduction. Corporations are allowed to deduct interest payments on bonds, but stock dividends are effectively taxed at the both the corporate and the individual level. Central banks and finance ministries are also complicit, since debt gets bailed out far more aggressively than equity does. But, contrary to populist rhetoric, it is not just rich, well-connected bondholders who get bailed out. Many small savers place their savings in so-called money-market funds that pay a premium over ordinary federally insured deposits. Shouldn’t they expect to face risk? Yet a critical moment in the crisis came when, shortly after the mid-September 2008 collapse of Lehman Brothers, a money-market fund “broke the buck” and couldn’t pay 100 cents on the dollar. Of course, it was bailed out along with all the other money-market funds. I am not advocating a return to the early Middle Ages, when Church usury laws forbade interest on loans. Back then, financial-market participants had to devise fantastic schemes and contortions to disguise interest payments.
Yet today the pendulum has arguably swung too far in the opposite direction. Perhaps scholars who argue that Islamic financial systems’ prohibition on interest generates massive inefficiencies ought to be looking at these systems for positive ideas that Western policymakers might adopt. Unfortunately, overcoming the deeply ingrained debt bias in rich-world financial systems will not be easy. In the US, for example, no politician is anxious to say that home-mortgage deductions should be eliminated, or that dividend payments should be tax-free. Likewise, developing countries should accelerate the pace of economic reform, and equity markets in too many emerging economies are like the Wild West, with unclear rules and lax enforcement.
Worse still, even as the G-20 talks about finding a “fix” for global imbalances, some of the policy changes that its members have adopted are arguably exacerbating them. For example, we now have a super-size International Monetary Fund, whose lending capacity has been tripled, to roughly $750 billion. Europe has similarly expanded its regional bailout facility. These funds may prove to be an effective short-term salve, but, over the long run, they will likely fuel moral-hazard problems, and potentially plant the seeds of deeper crises in the future. A better approach would be to create a mechanism for orchestrating orderly sovereign default, both to minimize damage when crises do occur, and to discourage lenders from assuming that taxpayers’ money will solve all major problems. The IMF proposed exactly such a mechanism in 2001, and a similar idea has been discussed more recently for the eurozone. Unfortunately, however, ideas for debt-restructuring mechanisms remain just that: purely theoretical constructs.
In the meantime, the IMF and the G-20 can help by finding better ways to assess the vulnerability of each country’s financial structure – no easy task, given governments’ immense cleverness when it comes to cooking their books. Policymakers can also help find ways to reduce barriers to the development of stock markets, and to advance ideas for new kinds of state-contingent bonds, such as the GDP-linked bonds that Yale’s Robert Shiller has proposed. (Shiller bonds, in theory, pay more when a country’s economy is growing and less when it is in recession.)
Of course, even if the composition of international capital flows can be changed, there are still many good reasons to try to reduce global imbalances. An asset diet rich in equities and direct investment and low in debt cannot substitute for other elements of fiscal and financial health. But our current unwholesome asset diet is an important component of risk, one that has received far too little attention in the policy debate.