Drowning in debt

At a large investment conference in Edinburgh last week to discuss a range of economic issues, I was surprised that no one formally raised the topic of debt. Additionally surprised, I’d say, because the IMF reminded us on Wednesday that world debt rose last year to a record $152 trillion, twice as high as it was in 2000, and equivalent to an all-time high of 225 per cent of world GDP. Debt clearly isn't the most newsworthy item right now, but it is a big elephant in our proverbial global economic and political room.

Debt is a big issue

The build-up in debt over the last decade or so, analysed across 113 countries that account for 94 per cent of world GDP, has been the largest ever in peacetime. It is important because we know that debt cycles cannot continue forever. Households and companies may find that the value of liabilities outstrips that of their assets, or that they face debt servicing requirements greater than their future repayment capacity. Governments, except for those in the Eurozone, have the option to print currency to sustain debt and debt service obligations for longer but even in this case, they cannot accumulate debts ad nauseam. Sooner or later someone, usually taxpayers, has to pay the bills.

The trouble is, as we saw vividly in and after 2008, that when debt bubbles burst, the consequences can be highly damaging. A large transfer of debt from the private to the public sector has taken place, and the hangover of large debt burdens has placed a strong and enduring drag over economic performance.

The main reasons for the transfer include the use of fiscal resources to shore up the banking system, direct support to non-financial companies that faced financial stress, discretionary fiscal stimulus measures (in 2008-09), and, importantly, the consequences of recession and slow growth in boosting public expenditure and stifling revenues or taxes.

The weak macroeconomic environment has been the single most important driver of the post-2008 build-up in debt, according to the IMF, which has done a sort of volte-face on the issue, having for many years advocated policies that produced just such an outcome. The IMF now estimates that about half of the rise in government or sovereign debt since 2008 is attributable to weak nominal GDP growth. Moreover, this isn’t just a mechanical issue about debt ratios. A zero or low nominal world is a killer for aggregate profits, the viability of pension and insurance funds, and a strong disincentive to savings and investment.

The other major problem has been weak or inadequate deleveraging, especially in the private sector. It is perhaps ironic that the US and the UK, which recorded much faster debt accumulation than Europe before 2008, have both experienced greater deleveraging since. This is partly due to better outcomes with respect to nominal or money GDP growth, but also without doubt to more assertive and early actions to help clean up and capitalise the banking system, as well as more robust bankruptcy and insolvency procedures and institutional arrangements.

The reason it is important to take opportunities to lower debt ratios is because if high debt burdens persist, they become self-perpetuating. They act as a drag over economic growth,  and retard improvement in bank balance sheets, and so stifle lending to new ventures while “zombie” borrowers are kept afloat. Even if low growth and little new lending and investment sustain low interest rates, the burden of debt and debt service and of anticipated future obligations may still rise in a weak macroeconomic environment.

The IMF’s verdict is that private deleveraging, by and large, has been extremely slow since 2008. Looking at the deleveraging experiences of 27 countries between 1980 and 2006, the IMF found that the average duration of deleveraging to be around five years. But since 2008, private debt ratios have fallen by only about a third of what has happened empirically, and so remains very much a work-in-progress.

It’s also become more political

Debt has also become a much greater political issue because the financial crisis marked a crucial point at which the sources of the debt build-up shifted from the private sector to the state. For example, between 2002-08, non-financial debt in advanced economies rose by 35 percentage points of GDP, split roughly 50:50 between households and companies. Yet, between 2008-15, debt rose by a further 35 percentage points of GDP, but this time three-quarters of the rise was accounted for by government entities.

Indeed, in the last few years, private sector debt as a share of GDP has topped out in many advanced countries, and even declined in the US and a handful of other countries. Total debt has continued to rise but more slowly in most countries in Europe and in Japan. The major contributors to the expansion in global debt have been the emerging markets, notably China, but also Brazil, Turkey and several countries in Asia, including Malaysia, South Korea and Thailand.

China’s debt has quadrupled since 2007 to stand at about 260 per cent of GDP, and this process shows no signs of ending—under the broadest definition of new claims, it is rising three times as fast as GDP. On current trends, it should reach 300 per cent of GDP by 2020, extraordinary for a country with China’s income per head. More worryingly, there is no indication that the government is willing to terminate it. Typically, China’s debt build-up is attributable largely to local and provincial governments, the property sector, and state enterprises. Household debt accumulation in the form of mortgages has been relatively restrained, though it has been more lively in the last year.

The politics of debt is clearly not an issue in China, but it has become a cause célèbre in the Western world. In the US, Germany and the UK, for example, political parties have used public sector debt as a reason for advocating economic inactivity or retrenchment by the state—sometimes simply as cover for political ends.

Change a-coming?

Yet things maybe shaping up for change. The phenomenon of a weak macroeconomic environment as an agent of, rather than as a solution to debt expansion is finally beginning to attract some attention in policy circles. Abenomics in Japan, Justin Trudeau’s Canada, US presidential politics, and the signs from Theresa May’s government suggest that a change may be coming. In other words, governments may now be prepared to use their own balance sheets more actively to support economic activity, if fiscal circumstances permit. This certainly seems to have the IMF’s blessing nowadays, even though it warns that this need not be an option for all countries, such as Greece or Brazil, where the underlying fiscal situation and structure of public finances are flawed or fragile.

Before getting carried away, though, we should note that macroeconomic deleveraging alone—higher growth and inflation—won’t suffice. In addition to macro deleveraging, we also need debtors (governments, companies, households) to persist with balance sheet deleveraging, which is about asset and liability structures. This is about more boring issues than infrastructure, and focuses on repayment, restructuring, regulations and write-offs. Of course, these things are more easily achieved in a positive nominal growth environment, but governments have a role here too in targeting conditionality programmes for loans and subsidies, incentives and interventions and if necessary, providing stronger institutional procedures for insolvency. This last point is of particular significance for Europe, where bank reorganisation, restructuring and recapitalisation needs still exceed anything provided for under so-called banking union rules and regulations.

Given a fair wind, we could acknowledge the challenge of dealing with a $152 trillion debt mountain and still expect it to be gradually lowered over coming years in the context of sustained growth in nominal GDP. Mathematically, if global money GDP growth rose by a steady 5 per cent a year and debt growth halved compared with its rise between 2000-15, the ratio of global debt to GDP could drop back from 225 to 175 per cent by 2025, and so on. The chance of a fair wind in the West, though, when Brexit, Trumpism and other populist storms are blowing, would be fine thing.