In the lead-up to 2007-2008, there was a rapid build-up in debt in developed economies. Between 2000 and 2009, total global credit grew from $57 trillion to $109 trillion, equating to a growth of 7.5 per cent each year, around double the growth in economic activity.
Debt was used to drive economic growth, allowing immediate consumption or investment against the promise of paying back the borrowing in the future. Spending that would have taken place normally over a period of years was accelerated because of the availability of debt.
The use of debt can be beneficial, where the economic activity generated is sufficient to repay the borrowing with interest. But the build-up of debt over the past quarter of a century has been excessive, beyond repayment capacity. In many countries, debt reached three to four times GDP levels not normally reached other than in wartime (1914-1918 and 1939-1945), when the result was losses for creditors of the losing states. Increasing debt at a more rapid rate than income is not sustainable indefinitely.
Echoing former US Vice President Dick Cheney’s view that “budget deficits don’t matter”, it is now fashionable in certain economic circles to downplay the problems of debt and its claims on future income and wealth.
Debt, the argument goes, cannot increase aggregate demand. The reduced spending resulting from one person’s saving is offset by increased spending by another, who borrows the funds, leaving expenditure unchanged.
As for every debtor there is a creditor, one party merely sacrifices their current purchasing power to another, with the transaction being reversed when the loan is repaid with interest. If money represents a claim on income or resources, then borrowed money is merely a transfer of claims to future resources. In addition, debtors need not repay, simply borrowing more in the future to cover maturing debt. The rules can also be changed with debt forgiveness, defaults or inflation being used to deal with the problems.
The argument is flawed. The irrelevance of borrowing on demand ignores the effects of fractional banking and leverage, which can multiply the process rapidly.
Borrowing is also assumed to finance assets or investments that generate income or value to repay principal and interest. A significant proportion of current debt does not meet this test.
Only around 15-20 per cent of total financial flows went into investment projects with the remaining 80-85 per cent being used to finance existing corporate assets, real estate or unsecured personal finance to “facilitate lifecycle consumption smoothing”. Borrowings were frequently used to finance pre-existing assets where anticipated price rises were to be the source of repayment.
Under these conditions, a slowdown in the ability to borrow ever increasing amounts can lead to a sharp fall in asset prices to levels below the outstanding debt creating repayment difficulties. This is precisely what happened in many housing markets.
In the US, Ireland, Spain or Portugal, construction and GDP was boosted by debt-fuelled housing investment for which there was no demand. As Lorenzo Bini Smaghi, a former member of the European Central Bank (ECB) observed: “[Many countries] accumulated an excess of public and private debt before the crisis to try to sustain their standards of living and their welfare systems, which turned out to be unsustainable and required a sharp adjustment when the crisis broke out.”
Debt has a fixed maturity. Deteriorating asset values or creditworthiness can reduce the ability to refinance, triggering financial crises as illustrated by recent European sovereign debt problems.
Debt is also intermediated by banks, which by design are leveraged with each dollar of capital supporting anywhere (up to) $30 in loans. Losses can rapidly threaten the solvency of financial institutions. This in turn increases the risk of failure of the payment system crucial to the functioning of modern economies. Banking system weakness can reduce the supply of credit to successful businesses, hampering economic activity.
The argument that every debtor has a corresponding creditor ignores the fact that the lenders may be foreign. Where the borrowings are sourced offshore there is net outflow of cash to the lender, which can affect domestic wealth and activity as well as increase financial risk.
Reducing debt through debt forgiveness, defaults or inflation is not without consequences. Savings designed to finance future needs, such as retirement, are lost. This in turn results in additional claims on the state to cover the shortfall or reduce future expenditure, which crimps economic activity.
Debt irrelevance assumes a Ponzi scheme where nations need to borrow ever-increasing amounts to both repay existing borrowing but also to maintain economic growth. By 2007-2008, the US needed $4 to $5 of debt to create $1 of economic growth, compared with an additional $1 to $2 of debt per additional $1 of GDP in the 1950s. Currently, China needs $6 to $8 of debt to create $1 growth, compared with $1 to $2 as recently as 10 to 20 years ago. Such a rapid increase in debt levels is unsustainable given constraints of an ageing population and slower growth overall.
In One Lesson: The Shortest and Surest Way to Understand Basic Economics, Henry Hazlitt summarised the problem: “Everything we get, outside of the free gifts of nature, must in some way be paid for. The world is full of so-called economists who in turn are full of schemes for getting something for nothing. They tell us that the government can spend and spend without taxing at all; that it can continue to pile up debt without ever paying it off, because ‘we owe it to ourselves’."
Some five years after the commencement of the crisis, debt levels have not decreased significantly. There has only been a transfer of debt from corporate and individual balance sheets to sovereign states. The slow deleveraging has relied on a mixture of asset sales, modest debt write-downs and increased saving.
Reducing debt to the required levels at the needed pace is increasingly difficult. The real options such as default or large scale debt write-offs are economically and politically difficult. For example, significant write-downs on sovereign debt would trigger major crises for banks and pension funds. The resulting losses to savers would trigger a sharp contraction of economic activity. National governments would need to step in to inject capital into banks to maintain the payment and financial system’s integrity.
But in the absence of strong growth and high inflation, unsustainable debt levels cannot be artificially maintained. If and when the problems re-emerge, the ability of the sovereigns to intervene will be constrained. The financial strength of many sovereigns are now impaired by increasing levels of borrowing incurred in the lead-up to and following the GFC, reducing their ability to act in case of financial crisis.
Satyajit Das is a former banker. His latest book is ‘A Banquet of Consequences’ (published in North America as 'The Age of Stagnation' ). He is also the author of ‘Extreme Money and Traders, Guns & Money’