The world economy is suffocating under record debt

by Michael Collins, Investment Commentator at Fidelity International

May 2016

Banking is lucrative because commercial banks create money that makes them money. They fashion money by making largely unbacked loans that become someone’s income. When these people bank these earnings, banks have more assets on which to make more loans that are only partially backed by deposits.[1] Under the fractional-reserve banking system that has operated over the past 350 years, the amount of money banks create is measured by the money multiplier. This ratio divides the amount of money banks create by the sum a central bank injects into the banking system to ignite this process (the monetary base).

It can be said that these money multipliers have gone berserk since the 1980s, when financial systems were liberalised and inflation stifled (which allowed for low interest rates). The world is now staggering under a record amount of debt. Household, corporate and government debt are at unmatched levels in absolute and relative (to GDP) terms.

This unrivalled debt poses an unprecedented threat to the world economy. At some point the debt accumulation must stop, which would mark the juncture at which the debt-fuelled economic model of the developed world is spent. Unmatched debt levels call into question long-term financial stability, for surely not all amounts outstanding will be repaid. Most probably, vast sums will be written off and these actions could trigger systemic banking failures. The lack of a global mechanism for dealing with sovereign default means that any government bankruptcies will be messy, as the saga of Greece shows. Think what would happen if, say, Japan defaulted, an event some warn is inevitable.[2] Excessive bank lending to households is behind the housing bubbles that have wreaked so much damage on economies and threaten to do likewise in other countries. Emerging countries are, as always, at risk; of late, many of their companies, rather than just their governments, have over-borrowed too, often in foreign currencies.[3]

Mega debt is an even more potent threat when populations are ageing and shrinking. Record debt means authorities have limited ammunition to fight the next economic downturn. Stretched government-debt ratios hamper more fiscal stimulus while unmatched debt makes it harder for central banks to boost interest rates to levels from where they could cut to make a difference in a recession. Even if debt is paid down in an orderly fashion, economic prosperity will be curtailed because it would mean consumers, companies and governments were trimming the consumption and investment that propel economies.

How these threats are diffused, or how policymakers manage the damage if they are ignored to the point of crisis, will hold much sway over living standards and political stability in coming decades. While officials are pondering these issues, the worry is that few solutions are at hand. 

Debt is the lifeblood of capitalism and has helped lift living standards for decades so borrowing is not a bad thing in itself. At a micro level, debt enables people, companies and governments to manage cash flows over time. Sovereign debt in most cases provides investors with haven investments. Governments can safely borrow unceasingly if their fiscal deficits as a percentage of GDP are below the rate of economic growth. Thus the UK government has carried debt since 1693 and the US administration since 1836 without much fuss.[4] Too little debt can hamper economies, as India’s lack of development proves. Some parts of the global economy are reducing debt.[5] There is no definitive point where debt is too high. The world has coped with excessive debt before – namely after the two world wars – and thrived over time. But only governments were awash in debt then. After World War II, consumers, especially veterans with years of savings and pent-up demand, drove the economic growth that allowed governments to repay debt. So these episodes shouldn’t reassure policymakers that such an escape is possible nowadays. Officials need to come up with new solutions to tackle the threat from too much debt, especially since much of the collateral people and companies have used to borrow against are assets priced at values that appear unsustainably high. Officials would be well aware that few things disrupt economies and politics more than systemic financial crises.[6]   

Ever climbing

McKinsey Global Institute studied debt levels in 47 countries and its report released in 2015 estimates that global debt soared from US$142 trillion (A$187 trillion) in 2007 to US$199 trillion in 2014.[7] Over these seven years, the ratio of debt to global output climbed from 269% of world GDP to 286%, making a mockery of those who called this period “the age of deleveraging”.

Half of the increase in debt was in developing economies. To make this jump more lethal, much of the borrowing was done in US dollars, which is harder to repay if currencies slump. Governments in advanced countries accounted for a third of the increase because many ran fiscal deficits to combat slumps (as they should have). Public debt also increased because governments assumed much of the burden of private debt via bailouts for banks and other companies. The remainder was borrowing by consumers and business, much of it to buy financial assets.

The report found that over the past seven years no major economies and only five emerging countries have reduced relative debt (Argentina, Egypt, Israel, Romania and Saudi Arabia) while 14 countries boosted total debt by more than 50 percentage points. (Australia’s total debt climbed 33 percentage points to 213% of GDP.) The report found that household debt has climbed to concerning levels in Australia (no surprise), Canada, Denmark, Malaysia, the Netherlands, South Korea, Sweden and Thailand, while China is a special case of debt addiction. From 2007, Beijing instructed state banks to commence a lending frenzy that resulted in total debt jumping 82 percentage points to 217% of output (and more recent studies put it at 240% of GDP). While China’s lending spree helped save the world economy, it means China will be of less help to global growth in coming years, at the very least.

The Bank of International Settlement blames excessive debt on the way the international monetary and financial systems exacerbate the dysfunctionalities within domestic policy regimes. The think tank for central banks says financial imbalances occur within countries because perceptions of value and risk are proocyclical (higher house prices encourage more borrowing) and incentives encourage risk-taking during booms – mechanisms that feed on themselves. On top of this, local authorities are more concerned with controlling inflation than the forces boosting systemic risk. The international monetary system amplifies these flaws by encouraging pro-cyclical capital flows and by how monetary and currency regimes – via the use of the US dollar as a reserve currency – spread easy monetary conditions from core economies to the rest of the world. This leads to policies that encourage the types excess that “paradoxically over time heightens the probability of major contractions and stagnation”.[8]

Remedies

So what should authorities do about excessive debt? First of all, authorities shouldn’t panic. Most governments, households and businesses can manage their debt loads provided economies hum. The worst action policymakers could take would be to taint debt as “bad” and encourage excessive repayments. That would only put economies in a downward spiral. As the experience of the eurozone shows, imposing fiscal austerity has the counterintuitive effect of worsening debt ratios because austerity shrinks economies faster than it reduces debt and can entrench deflation, which boosts the real value of debt. Higher inflation would have the opposite effect, so officials should focus on economic growth and let inflation rise, perhaps as high as 5%. If consumers and businesses overreacted and rushed to sell financial assets to reduce debts they could trigger an asset-price crash.

Policymakers can certainly step up efforts to prevent more imbalances. The most powerful way to do this is to use capital controls and regulation to limit lending booms, steps the Australian Prudential Regulation Authority is taking to manage Australia’s housing bubble. Basel III is a step in this direction because it has increased bank capital and liquidity requirements and sought to tackle the pro-cyclical bias of the financial systems. Policymakers in major countries would help others if they made allowance for the international effects of their policies to avoid damage to others. During busts, they need to force banks to deal with bad debts to improve the creditworthiness of overall balance sheets to (paradoxically) encourage enough lending to support the economy. They could consider laws that enshrine the separation between commercial (utility) and investment (casino) banking that implicitly guarantee that governments will protect deposit-taking banks. Such action could defuse the voter backlash against banking that is prompting existential threats to banking such as the proposal to hold a referendum in Switzerland on whether or not to ban the ability of banks to make largely unbacked loans – in other words, to outlaw fractional-reserve lending.[9]

Other areas policymakers can overhaul are the tax incentives that encourage borrowing. The two tax breaks that stand out are, firstly, tax deductions on mortgage repayments (allowed in about half of the western world, especially in Europe, but not Australia, which instead offers “negative gearing” on investment properties). The other is the deductibility of interest on corporate debt that applies just about everywhere. The Economist calculates that in 2007 (when interest rates were higher) the value of tax forgone in Europe was worth 3% of GDP while it was 5% in the US – more than the amount spent on the military.[10] The subsidies not only distort lending towards mortgages, they add to inequality by favouring the haves and reduce the use of equity in financing companies, a less-crisis-prone way to fund investment. There could be, however, be short-term consequences, such as falling housing prices, in removing these subsidies. The vested interests opposing change are formidable, if not unsurmountable. The higher interest rates are, the harder it is to curtail tax perks favouring debt. Now, therefore, would be the best time to take these steps.

Excessive government debt can be curbed in various ways. Officials could even resort to tricks to do this. One would be to mint, say, a trillion dollar coin. If the law allows, the treasury department could mint such a coin, deposit it with the central bank and receives the corresponding amount in cash, a sum that would wipe out the equivalent in government debt. Another way would be to write off bonds held by central banks – do this, and some calculate that Japan’s government debt-to-GDP ratio would fall from a world-high 235% to about 95%. More credible steps would be to allow a modest rise in inflation to erode the real value of debt. Governments could sell assets or boost taxes and other charges. More sneakily, governments could use their legal might to squeeze money from their citizens, be they savers, investors or creditors, via what is known as “financial repression”. Underhand ways to reduce government debt are laws capping interest rates or laws that force citizens or managed funds to buy sovereign bonds. Or governments could default.  

As some governments will lose the capacity to repay their debts, the world needs a global rules-based system for managing such crises. At the moment, government defaults are managed by the parties involved. They thrash out an agreement among themselves that may involve maturity extensions, rate reductions, grace periods and debt write-offs, even if the talks are under the supervision of the IMF, which is often conflicted by being a creditor too. This system favours wealthy countries over poorer ones and rarely sets a country on a sustainable footing; the usual result is endless crises. Greece is but one such example, while Argentina’s just-ended 15-year feud with minority shareholders, who opposed a restructuring accepted by the majority of creditors, is another. A proper global rule-based system would bind all creditors and would prevent creditors using national legal systems to sabotage agreements.

But such solutions are only tinkering. More comprehensive ones must be found, especially if global interest rates move higher. Until resolutions are found, the huge build-up in debt that fanned economic growth over the past four decades will linger as a deadweight on economies and the world would have done well if it were to avoid more systemic crises. Amid slow growth and debt-fueled emergencies, future generations will wonder how policymakers in the past could have let money multipliers twirl so fast.

Debt information comes from McKinsey Global Institute (Debt and (not much) deleveraging.” February 2015. http://www.mckinsey.com/insights/economic_studies/debt_and_not_much_deleveraging). Total debt excludes financial companies. Other information comes from Bloomberg unless stated otherwise.