We typically think of the economy as consisting of four sectors: the external sector, households, businesses, and the government. In China however it is more practical to subdivide these further into the following:
- Creditors. Creditors are forced to absorb the losses associated with writing down the debt when the borrower defaults on its debt and restructures it with a principle or interest reduction. Much of China’s debt burden has been extended through the banking sector, however, and because the debt that must be written down exceeds the banking industry’s capital base, ultimately the cost will be passed on to some other economic sector – for example Chinese households ultimately absorbed the cost of the banking sector losses generated in the late 1990s.
- The external sector. To pass on costs to foreigners requires that they have significantly larger exposure to China than they actually do, and would also probably require defaulting on external debt, a path Beijing is unlikely to choose to follow.
- Ordinary households. Most banking crises, like the recent US and European crises and the Chinese banking crisis at the end of the 1990s, are resolved by hidden transfer mechanisms that pass the cost of writing down debt to households. China today however must increase household wealth, not reduce it, if consumption is to rise fast enough to allow investment to decelerate, which means ordinary households cannot be allowed to absorb the cost.
- Wealthy households. Given high levels of income inequality, and the low propensity to consume of the wealthy, forcing them to absorb the costs of writing down debt – in the form of highly progressive income taxes, for example – is likely to be among the less costly ways economically for Beijing to pass on the costs of paying down debt. As their income or wealth is reduced, the wealthy are likely to convert most of that reduction into lower savings and very little of it into lower consumption, thus minimizing its adverse impact on domestic demand.
- Small and medium enterprises. Chinese SMEs are among the most efficient economic entities in China and are likely to be the main source of innovation and value creation in the future. Their long-term success is vital to China’s long-term growth. Like ordinary households they should be protected from absorbing the costs of Beijing’s debt-management policies.
- Local and provincial governments. These have amassed a considerable amount of assets whose liquidation would most efficiently absorb debt write-down costs and would entail the lowest medium and long-term economic costs, although not perhaps the lowest political costs. As their assets are liquidated, total Chinese savings will decline and Chinese consumption will remain largely unchanged, thus minimizing the adverse impact on domestic demand.
- The central government. Beijing too could pay for the cost of writing down debt by liquidating central government assets, although this may conflict with other economic policy objectives, including overcoming vested-interest opposition to the reforms.
That simple observation holds the key to explaining the post-79 era in British politics. How do you win an election? Inflate the property market. How do you mimic economic growth? Encourage housing equity withdrawal.
In savvier parts of the establishment, that relationship is now tacitly accepted. The latest Economist has a discussion on household debt in the UK that concludes: “It remains unsustainable for household debt to rise relative to incomes indefinitely … But for the time being rising debt may not be a bad thing … The British economy may be somewhat unbalanced, but at least it is growing.” This is the house journal of the departure-lounge capitalist class admitting that the British economy may be tapped out, but at least we can keep borrowing.
Figure 7: Acceleration of private debt and change in unemployment (Correlation coefficient -0.82)
On capital, debt and the future of capitalism.
Heather Stewart, “UK credit binge pushes debt above 500% of GDP,” The Guardian, 19 January 2012
An international study found Britain had the highest level of debt after Japan, that the debt had risen over the past three years to more than 500% of national output, and that on current trends it would take until 2020 for UK households to return debt levels to the pre-bubble trend. …