Remarks by Mark Carney Governor of the Bank of Canada Empire Club of Canada / Canadian Club of Toronto 12 December 2011

Toronto, Ontario

Growth in the Age of Deleveraging

Introduction
These are trying times. In our largest trading partner, households are undergoing a long process of balance-sheet repair. Partly as a consequence, American demand for Canadian exports is $30 billion lower than normal. In Europe, a renewed crisis is underway. An increasing number of countries are being forced to pay unsustainable rates on their borrowings. With a vicious deleveraging process taking hold in its banking sector, the euro area is sinking into recession. Given ties of trade, finance and confidence, the rest of the world is beginning to feel the effects. Most fundamentally, current events mark a rupture. Advanced economies have steadily increased leverage for decades. That era is now decisively over. The direction may be clear, but the magnitude and abruptness of the process are not. It could be long and orderly or it could be sharp and chaotic. How we manage it will do much to determine our relative prosperity. This is my subject today: how Canada can grow in this environment of global deleveraging.

How We Got Here: The Debt Super Cycle

First, it is important to get a sense of the scale of the challenge. Accumulating the mountain of debt now weighing on advanced economies has been the work of a generation. Across G-7 countries, total non-financial debt has doubled since 1980 to 300 per cent of GDP. Global public debt to global GDP is almost at 80 per cent, equivalent to levels that have historically been associated with widespread sovereign defaults.1 The debt super cycle has manifested itself in different ways in different countries. In Japan and Italy, for example, increases in government borrowing have led the way. In the United States and United Kingdom, increases in household debt have been more significant, at least until recently. For the most part, increases in nonfinancial corporate debt have been modest to negative over the past thirty years. In general, the more that households and governments drive leverage, the less the productive capacity of the economy expands, and, the less sustainable the overall debt burden ultimately is.
Not for publication before 12 December 2011 12:55 Eastern Time

-2Another general lesson is that excessive private debts usually end up in the public sector one way or another. Private defaults often mean public rescues of banking sectors; recessions fed by deleveraging usually prompt expansionary fiscal policies. This means that the public debt of most advanced economies can be expected to rise above the 90 per cent threshold historically associated with slower economic growth.2 The cases of Europe and the United States are instructive. Today, American aggregate non-financial debt is at levels similar to those last seen in the midst of the Great Depression. At 250 per cent of GDP, that debt burden is equivalent to almost US$120,000 for every American (Chart 1).3 Chart 1: U.S. non-financial debt near levels of the Great Depression
U.S. non-financial debt to GDP ratio
Percent of GDP

% 300 250 200 150 100

Sources: U.S. Census Bureau data from 1916 to 1953, U.S. Flow of Funds data from 1954 to 2011, Bureau of Economic Analysis

Last observation: 2011Q3

Several factors drove a massive increase in American household leverage. Demographics have played a role, with the shape of the debt cycle tracking the progression of baby boomers through the workforce. The stagnation of middle-class real wages (itself the product of technology and globalisation) meant households had to borrow if they wanted to maintain consumption growth.4 Financial innovation made it easier to do so. And the ready supply of foreign capital from the global savings glut made it cheaper. Most importantly, complacency among individuals and institutions, fed by a long period of macroeconomic stability and rising asset prices, made this remorseless borrowing seem sensible. From an aggregate perspective, the euro areas debt metrics do not look as daunting. Its aggregate public debt burden is lower than that of the United States and Japan. The euro areas current account with the rest of the world is roughly balanced, as it has been for some time. But these aggregate measures mask large internal imbalances. As so often with debt, distribution matters (Chart 2).

-3Chart 2: Euro-area imbalances have widened

Net international investment positions in 2002 and 2010, percentages of GDP % 150 100 50 0 -50 -100 -150

2002
Sources: International Monetary Fund International Financial Statistics, International Monetary Fund World Economic Outlook

2010
Last observation: 2010

Europes problems are partly a product of the initial success of the single currency. After its launch, cross-border lending exploded. Easy money fed booms, which flattered government fiscal positions and supported bank balance sheets. Over time, competitiveness eroded. Euro-wide price stability masked large differences in national inflation rates. Unit labour costs in peripheral countries shot up relative to the core economies, particularly Germany. The resulting deterioration in competitiveness has made the continuation of past trends unsustainable (Chart 3). Growth models across Europe must radically change. Chart 3: Unit labour costs in peripheral countries up, relative to core
Unit labour costs relative to Germany, annual data, 2000=100 Index 155 145 135 125 115 105 95 2000 2001 France 2002 2003 Portugal 2004 2005 Ireland 2006 2007 2008 Spain 2009 2010 Greece
Last observation: 2010

Italy

Sources: Deutsche Bundesbank, national statistics agencies

Its the Balance of Payments, Stupid!

For years, central bankers have talked of surplus and deficit countries, of creditors and debtors. We were usually ignored. Indeed, during a boom, the debtor economy usually feels more vibrant and robust than its creditors. In an era

-4of freely flowing capital, some even thought current account deficits did not matter, particularly if they were the product of private choices rather than public profligacy. When the leverage cycle turns, the meaning and implications of these labels become tangible. Creditors examine more closely how their loans were spent. Foreign financing constraints suddenly bind. And to repay, debtors must quickly restore competitiveness.5 Financial globalisation has provided even greater scope for external imbalances to build (Chart 4). And its continuation could permit larger debt burdens to persist for longer than historically was the case. However, experience teaches that sustained large cross-border flows usually presage liquidity crunches.6 Chart 4: Capital flows have expanded rapidly
Gross foreign assets and liabilities as percentages of GDP, annual data % 1,400 1,200 1,000 800 600 400 200 0 % 600 500 400 300 200 100 0

United Kingdom (LHS) Germany United States

Canada Italy

France Japan
Last observation: 2010

Source: International Monetary Fund International Financial Statistics, International Monetary Fund World Economic Outlook

The Global Minsky Moment Has Arrived

Debt tolerance has decisively turned. The initially well-founded optimism that launched the decades-long credit boom has given way to a belated pessimism that seeks to reverse it. Excesses of leverage are dangerous, in part because debt is a particularly inflexible form of financing. Unlike equity, it is unforgiving of miscalculations or shocks. It must be repaid on time and in full. While debt can fuel asset bubbles, it endures long after they have popped. It has to be rolled over, although markets are not always there. It can be spun into webs within the financial sector, to be unravelled during panics by their thinnest threads. In short, the central relationship between debt and financial stability means that too much of the former can result abruptly in too little of the latter. Hard experience has made it clear that financial markets are inherently subject to cycles of boom and bust and cannot always be relied upon to get debt levels right.7 This is part of the rationale for micro- and macroprudential regulation. It follows that backsliding on financial reform is not a solution to current problems. The challenge for the crisis economies is the paucity of credit demand rather

-5than the scarcity of its supply. Relaxing prudential regulations would run the risk of maintaining dangerously high leveragethe situation that got us into this mess in the first place.

The Implications of Deleveraging

As a result of deleveraging, the global economy risks entering a prolonged period of deficient demand. If mishandled, it could lead to debt deflation and disorderly defaults, potentially triggering large transfers of wealth and social unrest. History suggests that recessions involving financial crises tend to be deeper and have recoveries that take twice as long.8 The current U.S. recovery is proving no exception (Chart 5). Indeed, it is only with justified comparisons to the Great Depression that the success of the U.S. policy response is apparent. Chart 5: Weakest U.S. recovery since Great Depression
U.S. real GDP across economic cycles; start of recession = 100, quarterly data
Start of the recession

Index 135 125 115 105 95 85

Years before the start of the recession

Years after the start of the recession

75 65 3 4 5 6

-2

-1

Range of past U.S. recessions (1948 onward) U.S. current cycle Great Depression

The Big Five modern financial crises Base-case projection

Note: The Big Five modern financial crises include Spain (1977), Norway (1987), Finland (1991), Sweden (1991) and Japan (1992). Sources: U.S. Bureau of Economic Analysis and Organisation for Economic Co-Operation and Development

Such counterfactualsit could have been worseare of cold comfort to American households. Their net worth has fallen from 6 times income precrisis to about 5 at present (Chart 6). These losses can only be recovered through a combination of increased savings and, eventually, rising prices for houses and financial assets. Each will clearly take time. In Europe, a tough combination of necessary fiscal austerity and structural adjustment will mean falling wages, high unemployment and tight credit conditions for firms. Europe is unlikely to return to its pre-crisis level of GDP until a full five years after the start of its last recession (Chart 7).

Managing the Deleveraging Process

Austerity is a necessary condition for rebalancing, but it is seldom sufficient. There are really only three options to reduce debt: restructuring, inflation and growth. Whether we like it or not, debt restructuring may happen. If it is to be done, it is best done quickly. Policy-makers need to be careful about delaying the inevitable and merely funding the private exit. Historically, as an alternative to restructuring,

-6Chart 6: Large drop in U.S. household wealth

U.S. net worth to disposable income Ratio 6.5 6.3 6.1 5.9 5.7 5.5 5.3 5.1 4.9 4.7 4.5

Sources: U.S. Federal Reserve, Bureau of Economic Analysis, and Bank of Canada calculations

Last observation: 2011Q3

Chart 7: Euro-area recovery was weak, is over

Euro-area real GDP across economic cycles; start of recession = 100, quarterly data
Start of the recession

Index 115 110

Years before the start of the recession

105 100
Years after the start of the recession

95 90 5 6

-2

-1

1 2 3 4 Range of past recessions (1980 onward) The Big Five modern financial crises Current cycle Base-case projection

Note: The Big Five modern financial crises include Spain (1977), Norway (1987), Finland (1991), Sweden (1991) and Japan (1992) Sources: Eurostat and Organisation for Economic Co-Operation and Development

financial repression has been used to achieve negative real interest rates and gradual sovereign deleveraging. Some have suggested that higher inflation may be a way out from the burden of excessive debt.9 This is a siren call. Moving opportunistically to a higher inflation target would risk unmooring inflation expectations and destroying the hard-won gains of price stability. Similarly, strategies such as nominal GDP level targeting would fail unless they are well understood by the public and the central bank is highly credible.10, 11 With no easy way out, the basic challenge for central banks is to maintain price stability in order to help sustain nominal aggregate demand during the period of real adjustment. In the Banks view, that is best accomplished through a flexible

-7inflation-targeting framework, applied symmetrically, to guard against both higher inflation and the possibility of deflation. The most palatable strategy to reduce debt is to increase growth. In todays reality, the hurdles are significant. Once leverage is high in one sector or region, it is very hard to reduce it without at least temporarily increasing it elsewhere. In recent years, large fiscal expansions in the crisis economies have helped to sustain aggregate demand in the face of private deleveraging (Chart 8). However, the window for such Augustinian policy is rapidly closing. Few except the United States, by dint of its reserve currency status, can maintain it for much longer. Chart 8: Private deleveraging, public leveraging
Household and government debt Percentage point change, 2007 to 2010 40 30 20 10 0 -10 -20 Spain United Kingdom United States Household leverage (debt/disposable income) General government gross debt (%GDP)
Sources: Bank for International Settlements, IMF World Economic Outlook September 2011

In most of Europe today, further stimulus is no longer an option, with the bond markets demanding the contrary. There are no effective mechanisms that can produce the needed adjustment in the short term. Devaluation is impossible within the single-currency area; fiscal transfers and labour mobility are currently insufficient; and structural reforms will take time. Actions by central banks, the International Monetary Fund and the European Financial Stability Facility can only create time for adjustment. They are not substitutes for it. To repay the creditors in the core, the debtors of the periphery must regain competitiveness. This will not be easy. Most members of the euro area cannot depreciate against their major trading partners since they are also part of the euro. Large shifts in relative inflation rates between debtor and creditor countries could result in real exchange rate depreciations between euro-area countries. However, it is not clear that ongoing deflation in the periphery and higher inflation in the core would prove any more tolerable than it did between the United

-8Kingdom and the United States under the postwar gold standard of the 1920s and 1930s. The route to restoring competitiveness is through fiscal and structural reforms. These real adjustments are the responsibility of citizens, firms and governments within the affected countries, not central banks. A sustained process of relative wage adjustment will be necessary, implying large declines in living standards for a period in up to one-third of the euro area. We welcome the measures announced last week by European authorities, which go some way to addressing these issues. With deleveraging economies under pressure, global growth will require global rebalancing. Creditor nations, mainly emerging markets that have benefited from the debt-fuelled demand boom in advanced economies, must now pick up the baton. This will be hard to accomplish without co-operation. Major advanced economies with deficient demand cannot consolidate their fiscal positions and boost household savings without support from increased foreign demand. Meanwhile, emerging markets, seeing their growth decelerate because of sagging demand in advanced countries, are reluctant to abandon a strategy that has served them so well in the past, and are refusing to let their exchange rates materially adjust. Both sides are doubling down on losing strategies. As the Bank has outlined before, relative to a co-operative solution embodied in the G-20s Action Plan, the foregone output could be enormous: lower world GDP by more than US$7 trillion within five years (Chart 9). Canada has a big stake in avoiding this outcome. Chart 9: The $7-trillion question
Global output Constant 2000 US$ trillions 55
Approximately $7 trillion* in 2017

50 45 40 35

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

Deficient global demand

G20 framework

*This estimate is a rough approximation. Depending on the assumptions, it could range from $6 trillion to $9 trillion. Sources: Bank of Canada, World Bank

To Summarize Thus Far

The market cannot be solely relied upon to discipline leverage. It is not just the stock of debt that matters, but rather, who holds it. Heavy reliance on cross-border flows, particularly when they fund consumption, usually proves unsustainable.

-9As a consequence of these errors, advanced economies are entering a prolonged period of deleveraging. Central bank policy should be guided by a symmetric commitment to the inflation target. Central banks can only bridge real adjustments; they cant make the adjustments themselves. Rebalancing global growth is the best option to smooth deleveraging, but its prospects seem distant.

What It Means for Canada

Canada has distinguished itself through the debt super cycle (Chart 10), though there are some recent trends that bear watching. Over the past twenty years, our non-financial debt increased less than any other G-7 country. In particular, government indebtedness fell sharply, and corporate leverage is currently at a record low (Chart 11). Chart 10: Canadian debt has risen less than its G-7 peers
Changes in household, corporate and net government debt as percentages of nominal GDP from 1990 to 2010 Percentage points 140 120 100 80 60 40 20 0 Canada Japan United States Germany Italy France United Kingdom
Last observation: 2010

Note: German data prior to 1991 reflects West Germany. Sources: Cecchetti, Mohanty and Zampolli 2011, Organisation for Economic Co-operation and Development, and Bank of Canada calculations

Chart 11: Corporate leverage at a record low

Financial position of the non-financial corporate sector Ratio 1.35 1.30 1.25 1.20 1.15 1.10 1.05 1.00 0.95 0.90 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Debt-to-equity ratio
Source: Statistics Canada, Quarterly Financial Statistics for Enterprises Last observation: 2011Q3

- 10 In the run-up to the crisis, Canadas historically large reliance on foreign financing was also reduced to such an extent that our net external indebtedness was virtually eliminated. Over the same period, Canadian households increased their borrowing significantly. Canadians have now collectively run a net financial deficit for more than a decade, in effect, demanding funds from the rest of the economy, rather than providing them, as had been the case since the Leafs last won the Cup. Developments since 2008 have reduced our margin of manoeuvre. In an environment of low interest rates and a well functioning financial system, household debt has risen by another 13 percentage points, relative to income. Canadians are now more indebted than the Americans or the British. Our current account has also returned to deficit, meaning that foreign debt has begun to creep back up. The funding for these current account deficits has been coming largely from foreign purchases of Canadian portfolio securities, particularly bonds. Moreover, much of the proceeds of these capital inflows seem to be largely, on net, going to fund Canadian household expenditures, rather than to build productive capacity in the real economy. If we can take one lesson from the crisis, it is the reminder that channelling cheap and easy capital into unsustainable increases in consumption is at best unwise. Canadas relative virtue throughout the debt super cycle affords us a privileged position now that the cycle has turned. Unlike many others, we still have a riskfree rate and a well-functioning financial system to support our economy. It is imperative that we maintain these advantages. Fortunately, this means largely doing what we have been doingindividuals and institutions acting responsibly and policy-makers executing against sound fiscal, monetary and regulatory frameworks. It cannot entirely be business as usual. Our strong position gives us a window of opportunity to make the adjustments needed to continue to prosper in a deleveraging world. But opportunities are only valuable if seized. First and foremost, that means reducing our economys reliance on debt-fuelled household expenditures. To this end, since 2008, the federal government has taken a series of prudent and timely measures to tighten mortgage insurance requirements in order to support the long-term stability of the Canadian housing market. Banks are also raising capital to comply with new regulations. Canadian authorities are co-operating closely and will continue to monitor the financial situation of the household sector. To eliminate the household sectors net financial deficit would leave a noticeable gap in the economy. Canadian households would need to reduce their net financing needs by about $37 billion per year, in aggregate. To compensate for such a reduction over two years could require an additional 3 percentage points of export growth, 4 percentage points of government spending growth or 7 percentage points of business investment growth. Any of these, in isolation, would be a tall order. Export markets will remain challenging. Government cannot be expected to fill the gap on a sustained basis.

- 11 But Canadian companies, with their balance sheets in historically rude health, have the means to actand the incentives. Canadian firms should recognize four realities: they are not as productive as they could be; they are underexposed to fast-growing emerging markets; those in the commodity sector can expect relatively elevated prices for some time; and they can all benefit from one of the most resilient financial systems in the world. In a world where deleveraging holds back demand in our traditional foreign markets, the imperative is for Canadian companies to invest in improving their productivity and to access fastgrowing emerging markets. This would be good for Canadian companies and good for Canada. Indeed, it is the only sustainable option available. A virtuous circle of increased investment and increased productivity would increase the debt-carrying capacity of all, through higher wages, greater profits and higher government revenues. This should be our common focus. The Bank of Canada is doing its part by fulfilling its mandate to keep inflation low, stable and predictable so that Canadian households and firms can invest and plan for the future with confidence. It is also assisting the federal government in ensuring that Canadas world-leading financial system will be there for Canadians in bad times as well as good and in pushing the G-20 Action Plan because it is in Canadas interests.

Conclusion
It makes sense to step back and consider current challenges through the longer arc of financial history. Todays venue is an appropriate place to do so. A century ago, when the Empire Club and the Canadian Club of Toronto would meet, the first great leveraging of the Canadian economy was well under way. During the three decades before the First World War, Canada ran current account deficits averaging 7 per cent of GDP. These deficits were largely for investment and were principally financed by long-term debt and foreign direct investment. On the eve of the Great War, our net foreign liabilities reached 140 per cent of GDP, but our productive capacity built over the decades helped to pay them off over time. Our obligations would again swell in the Great Depression. But in the ensuing boom, we were again able to shrink our net liabilities. When we found ourselves in fiscal trouble in the 1990s, Canadians made tough decisions, so that on the eve of Lehmans demise, Canada was in the best fiscal shape in the G-7. We must be careful, however, not to take too much comfort from these experiences. Past is not always prologue. In the past, demographics and productivity trends were more favourable than they are today. In the past, we deleveraged during times of strong global growth. In the past, our exchange rate acted as a valuable shock absorber, helping to smooth the rebuilding of competitiveness that can only sustainably be attained through productivity growth. Today, our demographics have turned, our productivity growth has slowed and the world is undergoing a competitive deleveraging.

- 12 We might appear to prosper for a while by consuming beyond our means. Markets may let us do so for longer than we should. But if we yield to this temptation, eventually we, too, will face painful adjustments. It is better to rebalance now from a position of strength; to build the competitiveness and prosperity worthy of our nation.

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Endnotes
C. M. Reinhart and K. S. Rogoff, A Decade of Debt, National Bureau of Economic Research Working Paper No. 16827, Cambridge, 2011.
2 1

C. M. Reinhart and K. S. Rogoff, Growth in a Time of Debt, American Economic Review 100, no. 2 (May 2010): 57378.

These figures, daunting as they are, actually understate the extent of the problem. They do not include the liabilities stemming from the pension and health care promises made by governments but not yet funded, which some estimate to be even larger than the current explicit stock of debt. R. G. Rajan, Fault Lines: How Hidden Fractures Still Threaten the World Economy (Princeton: Princeton University Press, 2010). Japan illustrates the importance of whether ones creditors are domestic or foreign. The public and total non-financial debt burdens in Japan have risen well beyond levels that have proved unsustainable in other countries, owing largely to the fact that the preponderance of that debt is owed domestically. From an external perspective, Japan is the largest net creditor in the world. See M. Carney, Global Liquidity, a speech delivered to the Canada-United Kingdom Chamber of Commerce in London, United Kingdom, 8 November 2011. See A. Turner, Debt and Deleveraging: Long Term and Short Term Challenges, a speech delivered to the Centre for Financial Studies, Frankfurt, Germany, 21 November 2011. Turner argues, in fact, that the current situation is the result of decades of cumulative, massive policy errors, particularly the over reliance on free markets, (p.6). See C. M. Reinhart and V. R. Reinhart, After the Fall, Macroeconomic Challenges: The Decade Ahead, Federal Reserve Bank of Kansas City 2010 Economic Policy Symposium. Available at: <http://www.kansascityfed.org/publicat/sympos/2010/reinhart-paper.pdf>.
9 8 7 6 5 4

K. Rogoff, Inflation Is Now the Lesser Evil, Project Syndicate, December 2008.

10

See J. Hatzius, Z. Pandl, A. Phillips, and S. J. Stehn, A. Tilton, S. Wu, and M. Acosta-Cruz, The Case for a Nominal GDP Level Target, US Economics Analyst, No: 11/41; Goldman Sachs Global ECS Research, 2011; and C. Romer, Dear Ben: Its Time for Your Volcker Moment, New York Times, 29 October 2011.

Indeed, if inflation is both higher and more uncertain, a higher inflation risk premium might result, prompting an increase in real interest rates that would exacerbate unfavourable debt dynamics.

11