Ending Over-Lending


Frequently Asked Questions

The following provide a representation of frequently asked questions about Ending Over-Lending and the Debt-to-Cash Flow approach:


Author’s Responses & Comments

Why hasn’t this been done before?

The main reason is lack of data. Finding the data for the total debt for a country is very difficult, as Reinhart and Rogoff repeatedly indicated in their book This Time Is Different.  Government debt data can be located, but the private portion of total debt is “elusive” (to use their word).  The OECD, Eurostat and a growing number of central banks are now providing the debt data through flow of funds tables and integrated accounts, but these are generally only for industrialized countries, and don’t go back many years.  Nevertheless, it is now possible to do the calculations at least for recent years (approximately 15 depending on the country).  On the savings side, ‘cash flow’ is often puzzling for people, so this approach has likely not been obvious.  Additionally, for whatever reason, economic theory has not addressed the relationship between the stock of debt versus the flow of savings.  One notable exception to this void is HP Minsky’s Financial Instability Hypothesis which does speak to comparison of debt obligations to underlying cash flows. Minsky’s work however does not provide examples nor the means to implement the hypothesis.

Where is the data for prior crises? Can you not demonstrate the Debt/CF for prior crises? This would help validate the approach.

As noted in the above comment, the necessary data is just becoming available for recent years, and is not available for older crises (as of yet).  Examples such as the various South American collapses of the 80s and 90s or the Scandinavian banking crisis of the early 1990s could be studied, but the data is apparently not available.  The author is searching for appropriate older data.  The data for the US for the depression years is available and was included as Figure 12 in the October 2011 published Ending Over-Lending.  Accessing the data for prior crises would be expected to show a spike in Debt/Cash Flow up to a crisis level with a subsequent reversion toward a long term mean of optimum leverage (this pattern is evident in the US case).

How are the financial stability zones set? That is, how did you determine Optimum, Warning and Crisis Zones relative to the corresponding level of the ratio?

The Four Zone Framework was established as initial estimates based on  a mix of ‘science’ and ‘art'. The “science part” of setting the zones was by way of a study of the utility industry, including a study of the Debt/CF data for the 10 years prior, and the 10 years after Chapter 11 insolvency events. The details of this approach are set out in Figure 8 of the original October 2011 paper. Simplistically, the utility industry was deemed to be an acceptable peer to a nation given the industry’s stable cash flows (this peer grouping is the ”art” part).  Similarly, nations have diversity in their cash flows (different industries, sectors) which provide stability to their cash flow (gross saving). Granted, the assignment of zones is preliminary and subject to further research. As cited in the original paper, the delimits between the zones are intended as indicative grey areas of overlap – not definitive divisions. The Zones have already been refined in more recent presentations at conferences but to emphasize, refining the stratification of financial instability is a central effort for further research.

Why not just use Debt/GDP?

Debt/GDP is the most pervasive means of measuring a nation’s debt, but this metric is flawed. First, the metric only accounts for government debt, while ignoring Household, Corporate and Banking sector debt. More importantly, GDP measures the total output of a nation and as such is akin to its aggregate revenue. In financial and credit analysis, debts are not normally compared to revenue, and very little literature pursues this approach. Debts are normally compared to another accounting measure--cash flow--which more directly affects an entity’s ability to source and service debt. Cash Flow statistics, including the Debt/CF ratio, have been shown in numerous academic studies to be effective predictors of corporate loan covenant violations, bankruptcy, and Chapter 11 events. Simplistically, the Debt/CF ratio measures the number of years of cash flow required to retire an entity’s outstanding debt. The higher the ratio, the more ‘levered’ the entity.

Is Gross Savings really the same as Cash Flow?

Yes. Gross Saving is just a broader measure of savings.  A depreciation amount is added to the more commonly used Net Saving.  This is entirely consistent with ‘cash flow’ accounting for corporations.

So can this indicator be used to predict financial crises in advance of their occurrence?

Yes. The idea is that nations should manage their affairs so that the nation’s Debt/Cash Flow position remains within a range of optimal leverage, providing financial stability. If the nation’s leverage starts to escalate (as indicated by a rising ratio), a warning is evident.  Nations on a track of continually rising leverage (as measured by the ratio) face increasing financial instability, which sooner or later, will result in a financial crisis. The ratio provides a direct measure of leverage and financial instability, but numerous other factors will come into play in determining when a crisis will occur (maturity schedule of outstanding debt for example). Work is underway formally testing the statistical predictive capability of the metric.

What about crisis management? Can this tool be used to get out of a crisis?

The initial and pri mary objective of Ending Over-Lending is to provide insight to avoid getting into a crisis in the first place.  But yes the Debt/CF approach can be used to assist in sorting out problems if a crisis is already underway.  The most obvious means is to estimate the amount of debt that can feasibly be borne or carried.

If Debt/CF were to be used for macro-prudential policies, what would be some sample policies?

As an example, in the case of an over-heated Household sector, changes could be made to increase mortgage down payment requirements and shorten the allowed amortization periods.  In the case of the financial industry, specified debt-to-cash flow requirements would be included as an ongoing component of regulatory frameworks. In times of over-heating credit markets, relevant policies include those that encourage saving and discourage borrowing.

Aren’t you setting up a self-fulfilling prophecy?

Nations with escalating leverage have the same choices a company management would have in a similar situation: either proactively manage affairs in order to control leverage and return to an optimum level, or, carry on as is and have the creditors impose the solutions.  Nations, which allow their leverage to escalate, end up in the hands of the IMF.

Have you looked at the economic policies of the countries, and then link those to the instability zones? Have you looked at the effects of wealth distribution?

No, but good idea.