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Tackling the Ongoing Problem of Too Much Debt


A certain amount of debt can help an economy grow. But there's a point at which too much of it becomes harmful.


But anyone who thinks this is a prescription for more government spending to deal with our GDP problem needs to understand this: Correlations are not static. Correlations are constantly being built up and broken down. So relationships that hold true today may not tomorrow. To me, the positive correlation government debt has to GDP reflects the relatively lower levels of government debt in the data. If the data was made up completely of countries comparable to Japan (with 456% debt to GDP), the results are bound to look different.

I'm throwing in this next table because it elucidates debt's "double-edgedness" clearer than anything else I can think of; it shows the relationship between debt growth and the volatility of annual GDP per capital growth, and the most significant sector is corporate debt. The positive correlation here implies simply this: Adding debt makes GDP growth more volatile; GDP can go higher, or decline farther, faster with debt than without it:

The paper goes on to discuss thresholds for debt; like trying to map out at which debt level you cross over into Mordor and GDP growth actually declines. Relax, no equations will be drawn out and explained here. If you want that level of detail, go read the paper. The thresholds they found were 85% of GDP for governments, 90% of GDP for corporates, and 85% for households. If you add them up, that is about a total debt to GDP burden of 250%. After which debt servicing costs are bound to take their toll on aggregate growth.

If you take a look at the table again, you'll see Germany already has a non-financial debt to GDP level of 241%. If the threshold for where debt becomes a drag on GDP is around 250%, there is no way Germany can bail anyone out. Spain is at 355%. Italy is at 310%. France is at 321%. These are the biggest economies in the eurozone and their debt levels are already creating drags on GDP growth for themselves. So there is no way they can take on more debt or guarantee anything else without putting their own GDP growth on a longer, deeper freeze. And in case you haven't noticed, it's not like eurozone GDP growth is going to be all that robust as it is.

There is a very good passage on debt's uses from the paper, which should be leading all of us to ask a very serious question. First, here's the passage (emphasis, mine):

As for its uses, borrowing allows individuals to smooth their consumption in the face of a variable income. It allows corporations to smooth investment and production in the face of variable sales. It allows governments to smooth taxes in the face of variable expenditures. And it improves the efficiency of capital allocation across its various possible uses in the economy. At least in principle, it should also shift risk to those most able to bear it.

And public debt, in particular, can help smooth consumption not only through the lifetime of individuals who are currently alive, but also across generations. To the extent that future generations will be richer than the current ones – because they will have a combination of more human capital and more productive technology – a transfer from future to current generations can raise society's intertemporal welfare.

A mighty pair of assumptions, in that last paragraph. Future generations will be richer because there will be more people and more productive technology than in the present. The paper touches on the developed world's demographic problem (older populations and declining birth rates), and our current employment situation shows the problem with the second part: Job growth is arriving in some sectors but there's a shortage of people that can apply or use that "productive technology." While there are more people, there's a shortage of knowledge-based capital to go around.

But I digress. The question that needs to be asked is the one of wealth transfer across time. Debt allows us to enjoy higher standards of living today by borrowing because we assume standards of living will be better tomorrow. One of the biggest arguments I hear these days is that we're faced with an aggregate demand problem. "There's too little aggregate demand," they say. Well, here's a question to make your head spin:

What if our problem is not a question of too little aggregate demand or aggregate supply? What if we've consumed too much already? What if our own inter-temporal welfare was raised too far, too fast?

If you turn the question around in that context, it paints a much different picture for the road ahead. It's a picture of "muddling through"; a picture of stagnation. We've pulled too much consumption forward and there may not be enough money to pay for it all. Is it right? Is it wrong? I don't know. All I can tell you is I don't see a lot of people asking the question.

But let's suppose it is true. In that case, what comes next? Either more debt gets defaulted on and we continue washing, rinsing and repeating the credit cycles of the past, or we take our chances on a more amenable debt jubilee. I don't know which one eventually happens, I'm not that smart. But the one thing I can tell you is that social mood will be in the driver's seat.
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