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.
Debt has been compared to a double-edged sword. A certain amount is constructive. But once you reach a certain threshold, a tipping point if you will, debt is no longer helpful; it's harmful. Kind of like bacon. Yes, bacon makes everything tastes better and it may seem like you can never get enough. But everybody knows if you're eating a pound or two at a time, you better keep the crash cards charged and close by. You're going to need them.
We've seen the effects of debt this year all around us. In fact, if I were going to vote for a Person of the Year, I would vote for debtors everywhere. From sovereign nations dancing on the knife's edge with default to Occupy Wall Street protestors calling for the expungement of debt, the effects of debt's vise-like grip was all around us this year. Debt matters, and dealing with this issue is not over. In fact, I would argue we have not made as much progress in dealing with the debt hangover as many would like to think.
Why does it matter? It's simple. Debt has fueled our economy for several decades now.
The question is, has debt provided too much fuel? Has it given our economy a sugar rush as a cheap substitute for an economy that runs on the leaner, more efficient, protein and antioxidant-rich fuels of savings and investment? Dietary analogies aside, this is an important question to frame and answer because doing so will determine the solution to the quagmire we still find ourselves in.
I actually started thinking about this a lot more when Kevin Depew shared an email with me not too long ago. In it was a reference to a paper from the Bank of International Settlements, "The real effects of debt" by Cecchetti, Mohanty and Zampolli. The paper examined data from 18 OECD countries between 1980 and 2010. They looked at debt's impact to economic growth and tried to estimate levels of debt that would be considered excessive and harmful to an economy.
But first, a high-level overview of the data. This first chart shows that the authors were able to segment data into three sectors: household, non-financial corporate, and government. While the Fed's Flow of Funds data does this and has a rich time series, not all countries treat this data the same way. At any rate, the chart shows that three decades ago, the total stock of debt for the three sectors was 167% of GDP. Now, it is 314%.
That translates into an annual growth rate in excess of 5% per year, which is roughly the same GDP growth rate the US has seen over the same period of time. But also, note who has been doing the borrowing; it hasn't been governments, but households and corporates. Governments have been relatively thrifty.
This next table looks at some of the countries included in the data the paper was based on. Note the debt levels of Germany and Greece. They're surprisingly close:
But, OK. Debt has ballooned in all of these countries over the past 30 years. What does that mean for GDP growth? Funny you should ask because the next table delves into that topic. It turns out debt has a negative impact on annual GDP per capita growth:
Government debt is shown to have a positive correlation with annual GDP per capita growth, but let's review the first chart: Government debt showed the lowest amount of growth over the past three decades, despite the political wrangling you and I hear day in and day out about it. The Bible verse of taking out the plank in your own eye before removing the speck from the eye of your neighbor comes to mind.
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):
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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