Super cheery from BCG - Back to Mesopotamia?

In August, in Stop Kicking the Can Down the Road: The Price of Not Addressing the Root Causes of the Crisis, we argued as follows: “Politicians are trying to solve the problem of too much debt by playing for time. This will fail. Financial repression would have to be significant and requires close political coordination. In addition, it does not address the pressing issues of global imbalances and the adjustments required within the euro zone…. [W]e believe that the failure to act significantly increases the risk of … an unconstrained financial and economic crisis.… Given the empty coffers of governments and their recent heavy use of monetary instruments, there is not much left to stimulate the economy. It will be very hard to stabilize economies and organize a soft landing….” We concluded: “Either the politicians need to organize a systematic debt restructuring for the Western world and/or generate inflation fast, or we run the risk of the situation spinning out of control. In which case, there will be no place to hide.”

We believe that some politicians and central banks—in spite of protestations to the contrary—have been trying to solve the crisis by creating sizable inflation, largely because the alternatives are either not attractive or not feasible:

• Austerity—essentially saving and paying back—is probably a recipe for a long, deep recession and social unrest.

• Higher growth is unachievable because of unfavorable demographic change and an inherent lack of competitiveness in some countries.

• Debt restructuring is out of reach because the banking sectors are not strong enough to absorb losses.

• Financial repression (holding interest rates below nominal GDP growth for many years) would be difficult to implement in a low-growth and low-inflation environment.

Inflation will be the preferred option—in spite of the potential for social unrest and the difficult consequences for middle-class savers should it really take hold. However, boosting inflation has not worked so far because of the pressure to deleverage and because of the low demand for new credit. Moreover, the inflation “solution,” while becoming more tempting, may come to be seen as having economic and social implications that are too unpalatable. So what might the politicians and central banks do?

Since the publication of Stop Kicking the Can Down the Road, a number of readers have asked us what would happen if governments persisted in playing for time. To what measures might they have to resort? In this paper, we describe what might need to happen if the politicians muddle through for too much longer.

It is likely that wiping out the debt overhang will be at the heart of any solution. Such a course of action would not be new. In ancient Mesopotamia, debt was commonplace; individual debts were recorded on clay tablets. Periodically, upon the ascendancy of a new monarch, debts would be forgiven: in other words, the slate would be wiped clean. The challenge facing today’s politicians is how clean to wipe the slates. In considering some of the potential measures likely to be required, the reader may be struck by the essential problem facing politicians: there may be only painful ways out of the crisis.

via www.bcgperspectives.com