The great reprieve ends as the great credit contraction continues

In his Telegraph column, Ambrose Evans-Pritchard described the end of the "Great Reprieve" that policymakers bought for western economies at the start of the credit crisis.  As Ken Rogoff pointed out in Thomas Friedman's NY Time column, while this economic reprieve was going on, the "Great Credit Contraction" continued.

According to Professor Rogoff,

[T]he real problem is that the global economy is badly over-leveraged, and there is no quick escape without a scheme to transfer wealth from creditors to debtors, either through defaults, financial repression, or inflation. ... 

It is not a wealth transfer when a debtor defaults.  It is a realization of an investment loss from granting credit in excess of what the borrower could repay.  Both the creditor and the debtor lose.

For example, think of the investor in a mortgage and the individual who used the mortgage proceeds to buy a house.  When the individual defaults, the borrower loses the house and any money the borrower invested in the house.  The creditor loses the difference between the outstanding balance of the mortgage and what the house can be sold for in foreclosure.

“The aftermath of a typical deep financial crisis is something completely different [from a recession] ... It typically takes an economy more than four years just to reach the same per capita income level that it had attained at its pre-crisis peak. ... Many commentators have argued that fiscal stimulus has largely failed not because it was misguided, but because it was not large enough to fight a ‘Great Recession.’ But, in a ‘Great Contraction,’ problem No. 1 is too much debt.” 

Until we find ways to restructure and forgive some of these debts from consumers, firms, banks and governments, spending to drive growth is not going to come back at the scale we need. 

This raises the question of what exactly did we do during the Great Reprieve to address the issue of over-leverage and its related issue of solvency.

Primarily, policymakers kicked the can down the road and prayed for a miracle.

I say this because of the failure by policymakers to put in place the necessary and sufficient condition for addressing the issue of over-leverage.  This condition is disclosure of all the useful, relevant information in an appropriate, timely manner.

For financial institutions, this would be disclosure of their current asset and liability-level data.  For structured finance securities, this would be disclosure of the performance of their underlying collateral.

With disclosure, market participants could know who is holding the losses and it would be possible to choose a path forward for the global economy.

Our challenge now, therefore, is to deleverage the economy as fast as possible, while, at the same time, getting back to investing as much as possible in our real pillars of growth so our recovery is built on sustainable businesses and real jobs and not just on another round of credit injections.

It is only with disclosure that we can reduce the leverage in the economy as fast as possible while also investing for growth.  Disclosure is necessary so investors know whether their investment in financial institutions is filling the black hole of insolvency or is supporting lending needs of sustainable businesses.