Interconnectedness Is Blocking the Way

It is becoming evident that there is too much debt in the system (remember, it is total debt that is important — not government debt alone), and that the deleveraging process is holding back growth and demand. It is necessary to restore balance sheets, though. To deleverage, there are not a lot of options — either you pay off your debt without taking more on, or you default (or if you’re a country — grow faster than debt accumulation). The default route is the quickest, but can have unintended consequences. In Europe (and the world, really), this is complicated by too big to fail institutions, which cannot be allowed to fail. The following chart is from the ECB’s January bulletin and shows cross-sector balance sheet exposure in the euro area. Picture 51 Interconnectedness Is Blocking the WayJust think about it. The blue-parts show known counterparties, the red unknowns. That’s a lot of known unknowns. What’s really interesting is how many unknown unknowns there are, especially what’s going to happen if a big eurozone bank blows up and the effect on non-financial corporations.

The cross-sector exposure is making it harder to go through the deleveraging process. It is also why some decisions that indeed seem weird (think Greece) might have explanations, namely that there are some unknowns involved.