Now we know where the tipping point lies. Debt becomes poisonous once it reaches 80pc to 100pc of GDP for governments, 90pc of GDP for companies, and 85pc of GDP for households. From then on, extra debt chokes growth.
Stephen Cecchetti and his team at the Bank for International Settlements have written the definitive paper rebutting the pied pipers of ever-escalating credit. “The debt problems facing advanced economies are even worse than we thought.”
The basic facts are that combined debt in the rich club has risen from 165pc of GDP thirty years ago to 310pc today, led by Japan at 456pc and Portugal at 363pc.
“Debt is rising to points that are above anything we have seen, except during major wars. Public debt ratios are currently on an explosive path in a number of countries. These countries will need to implement drastic policy changes. Stabilization might not be enough.”
Demographic atrophy and aging costs will make this even nastier. “Rising dependency ratios put further downward pressure on trend growth, over and above the negative effects of debt.”
Why has it happened?
1) Restrictions on credit have been “systematically removed” since the 1970s. (ie Gordon Brown’s 120pc mortgages and other such idiocies)
2) Greenspan’s “Great Moderation” fooled us all into thinking the world was free of risk.
3) The “Asian Savings Glut” pulled down real bond yields. (The BIS is being too kind to its masters — central banks — who also pulled down short rates for fifteen years, catastrophically so in my view).
4) Tax policies favour debt; ie corporate debt in Europe, or mortgages in the US, as well as a host implicit debt subsidies and guarantees (Fannie Mae and Freddie Mac?)
So get rid of all these bad policies (gradually of course).
The professoriat has been a little too cavalier in arguing that debt does not really matter for the world as a whole because we all owe it to ourselves. Debtors are offset by creditors (not always from friendly countries). Common sense suggest that this academic solipsism is preposterous, and so it now proves to be.
“As modern macroeconomics developed over the last half-century, most people either ignored or finessed the issue of debt. Yet, as the mainstream was building and embracing the New Keynesian orthodoxy, there was a nagging concern that something had been missing. On the fringe were theoretical papers in which debt plays a key role.”
“There are intrinsic differences between borrowers and lenders; non-linearities, discontinuities… It is the asymmetry between those who are highly indebted and those who are not that leads to a decline in aggregate demand.”
Creditors do not step up spending to cover the shortfall when debtors are forced to retrench suddenly. So the economy tanks.
My own suspicion is that debt has very powerful “intertemporal effects” that are not factored into the models. It steals growth from tommorow, until there is little left to steal. The BIS does not explore this angle. (Mr Cecchetti said politely that I was talking nonsense when I raised this point with him .. well yes, perhaps, wouldn’t be the first time).
Here is the league table. It is revealing.
As you can see, the US has one of the lower combined debts at 268pc of GDP. Australia is lowest (232), followed by Austria (238) and Germany (241). (I don’t believe the Norway figure in this chart. Norway has no public debt, except for purposes of monetary management).
This is one reason why I hold to my quirky view that the US is in better relative shape than much of OECD bloc — though still dreadful, obviously. It was on a flat line of around 150pc for half a century before exploding).
The US also has much healthier fertility rates and demographics than most. Adjusted for aging effects, America is more credit-worthy than Germany.
By all means strip the US of its AAA rating, but every country with total debt above 240pc of GDP and a fertility rate below 1.9 should also be stripped. All members of currency unions should be capped at AA automatically, since they no longer have sovereign policy instruments and since they switch FX risk into default risk.
It is far from clear what the rich world should do about this mess right now. The BIS does not offer a policy prescription, though the IMF has.
Christine Lagarde says there is an optimum “therapeutic dose” of fiscal tightening. If too violent, it threatens to tip the global economy back into recession and prove self-defeating. Deficits and debt will rise as fast, or even faster.
The IMF view is that calibrated fiscal tightening must be offset by easy monetary policy, perhaps even QE3 if deflation rears its ugly head again and threatens a full-blown Fisherite debt-deflation spiral. That is broadly my view. We are not there yet, though we might be soon.
Let us not demonize all debt. It is the lubricant of progress.
“Used wisely and in moderation, it clearly improves welfare. But, when it is used imprudently and in excess, the result can be disaster.”
And disaster we have. We must prepare for a long hard slog, for the rest of my life and yours.
Do read the report. The BIS has been a rare of voice of good judgement for the last decade.
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