Broken balance sheets and the depletion of equity

Broken balance sheets - The case of Cyprus

More often than not debt is presented as the evil of our times. To a large extent this is true but debt is only the symptom of the real problem. As it is argued, it is the use of debt that matters and what unproductive loans on a massive scale do to people’s and businesses’ balance sheets and their ability to actively participate in the recovery of the economy once it sinks itself into a balance sheet recession [1]. The case of Cyprus is cited as an example.

The total debt for Cyprus (private and public) in 2020 as reported by Eurostat (Table) is 375.8% of Gross Domestic Product (GDP) currently about €21.7 billion [2]. If one also adds the “investments” of the Social Security Fund in Government securities (and not even accounting for the “invisible” unfunded Government debt such as for pensions and social insurance) the total public and private debt would be closer to 420% of the GDP. That is a total debt of over €90 billion. Divided by the number of households (330,000) and active companies (estimated to be 120,000[1]) then at 450,000 economic agents on average each owes a staggering amount of more than €200,000.

The problem however is not so much the amount of debt but rather whether what we owe is depleting equity and therefore creates broken balance sheets (balance sheets with negative or close to negative net worth). This happens where excessive borrowing, as expected, creates a liability on the balance sheets of households and companies but which however, because the lending is unproductive and/or is used on consumption it does not create a counterbalancing offsetting asset on their balance sheets. This depletes equity and creates conditions of what Richard Koo [3] has termed as “balance sheet recession”.

A balance sheet recession arises where the economy because of excessive and wasteful debt is put onto a downward spiral whereby there are not many remaining credit-worthy potential borrowers but which also dampens consumer demand as highly indebted borrowers find themselves struggling to service their existing loans. The latter in turn means that opportunities for new and viable capital investments become rare and far between. This is surely the dire-straits Cyprus finds itself in after the huge wasteful and non-productive lending that took place prior and after the bail-in of 2013.

Flawed neo-liberal economic thinking

This is what neo-liberal Economic thinking ignores in my opinion and which, either by omission or design, it is assumed away. In other words, that private debt does not matter or that it does not affect economic welfare because “we owe it to ourselves” and that the market will somehow take care of it. The thinking is correct if indeed we all owe to each other about the same amount of money. In such circumstances, our balance sheets will show the loan as a liability but because someone else also owes the same to us it will be “cancelled out” and have no effect on our equity position (our net worth) as an offsetting debt owed to us is also created on the Asset side of our balance sheet. The logic is that we can then simply just “pay up what we owe to each other” and no one owes anything to anyone anymore. The private debt disappears.

Furthermore, neo-classical thinking by what is generally known as the “Third postulate of welfare economics” assumes away who may gain or lose in free market exchanges. To quote Harberger [4]:

“When evaluating the net benefits or costs of a given action (project, program, or policy), the costs and benefits accruing to each member of the relevant group (e.g., a nation) should normally be added without regard to the individual(s) to whom they accrue”.

Although the postulate has its uses (especially in cost-benefit analysis) it is a rather a heroic assumption which, intentionally or not, covers up the creation of extreme inequalities that emanate from the pile up of debt on the economic agents of a country. In other words, who gains and who loses is important. When the many owe enormous amounts of debt which is backed by collaterals and guarantees to the very few the free market does not cancel out private debt. It creates conditions of neo-feudalism in a country when banks call on the collaterals or sell the loans to funds.

The depletion of equity is the real problem

The real issue is whether the additional debt taken over by the people and corporations has been used productively to create corresponding assets. As is the case in Cyprus, the uncontrolled amounts of debt, mostly from using foreign deposits, was directed through the local banks towards consumption and capital investments with negative return (non-viable projects). If these loans were properly assessed by the banks, as it was their duty, most would not pass the repayment capability criterion and therefore should not have been granted. As a result, the country now finds itself trapped and confronting a huge and widespread problem of broken balance sheets.

Private debt cannot be assumed away because in reality what happens is that very few “too big to fail” banks load up households and corporations with massive and often unbearable amounts of unproductive debt in order to gain an income on deposits. Inevitably, this depletes borrower equity through losses as no corresponding asset of the same or higher value is created. It also hampers the borrower’s ability to service or restructure his loans.

The problem therefore is not the debt itself but rather if it was employed productively funding viable projects [3]. If, as was the case in Cyprus however, excessive borrowing has gone into consumption and non-productive investments that have become non-repayable, the country falls into a balance sheet recession that may take decades to escape from, as Richard Koo [1] eloquently explains with regard to what happened to Japan in the 1990ies.

A failing banking system facilitates wealth transfer

Banks have a duty of care to carefully assess the repayment capability of a loan application and only approve it if a proper credit risk appraisal is done. When banks, as it is customary nowadays, engage instead in collateral only lending, they are guilty of fraudulent conveyance[2] as the only way to repay the loan is from the use of the recourse. But even more importantly it sets the economy on a downward path towards a recession. In such circumstances as argued by Michael Hudson there is no other way out for an economy to recover but debt forgiveness [6].

The redistribution of existing wealth that ensues from such bad lending practices also has a negative impact on the ability of an economy to create new wealth as the risk profile of the rich who buy this debt seeks and pursues asset-backed and relative risk-free investments rather than risky ventures in the real economy. Such investments are more often than not sought and found in the transfer of assets mostly through a failing and misfunctioning banking system that accommodates them [7]. The granting of non-viable loans and the selling off of such debt to Funds inevitably leads to extraction of existing rather than the creation of new wealth.

In conclusion, neo-liberal thinking assumes away a real problem in over-indebted economies. The damage that extreme and unproductive private debt creates which is the depletion of equity. This causes widespread broken balance sheets that inevitably hold hostage the economy and hamper its ability to recover from an ensuing recession. In addition, it derails the real economy and extends further the concentration of money in the hands of the few. And this happens amidst a loose financial system which caters for their risk-avert profile preferences of the very rich which are sought to be satisfied through the transfer of existing assets rather than indulging in often risky capital investments in the real economy. This sanctuary is provided and facilitated by a failing banking system which is focusing merely on collateral lending rather than in a proper assessment of repayment capability.

Bibliography and References

1. Koo, Richard (2015) The Escape from Balance Sheet Recession and the Q.E. Trap, Wiley.

2. Microeconomic Imbalance Procedure Scoreboard 2020, Eurostat (Europa.eu), https://ec.europa.eu/eurostat/en/web/products-eurostat-news/-/edn-20211124-2

3. Kavvadia Helen and Savvides Savvakis (2019) "Funding Economic Development and the Role of National Development Banks-The Case of Cyprus", World Economics Journal, Vol. 21, No. 3, July–September

4. Harberger, Arnold (1971) “Three basic postulates for applied welfare economics,” Journal of Economic Literature IX, No. 3, September: pp. 785-797

5. Savvides, Savvakis C., (2021) “The disconnect of funding from wealth creation” (August 1, 2020). John Deutsch International Development Discussion Paper, Queen's University, DDP 2019-10.

6. Hudson, Michael (2012) Finance Capitalism and its discontents. ISLET-Verlag.

7. Hudson, Michael (2018) “’Creating Wealth’ Through Debt: The West’s Finance-Capitalist Road”, May, https://www.counterpunch.org/2018/05/04/creating-wealth-through-debt-the-wests-finance-capitalist-road/

Savvakis C. Savvides is an economist, specialising in economic development and project financing. He is a former senior manager at the Cyprus Development Bank and has been a regular visiting lecturer at Harvard University and currently at Queen’s University. Author page: http://ssrn.com/author=262460.