How to Suffocate Your Economy: Drown it in Massive Private Debt.
By Richard Vague
does the IMF keep badly missing its global growth forecast? And what does that have to do with the 2016 presidential election?
In the years since the 2008 global crisis, when the world’s growth rates tumbled, the IMF has dutifully printed forecast after forecast predicting rebounding growth rates. But in reality, rates have fallen well short of these predictions, as seen in Chart 1.
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One of the key and largely overlooked reasons for this disappointing growth is hiding in plain sight: the increasing global burden of private debt—the combination of business debt and household debt. Even though government debt grabs all the headlines, private debt is larger than government debt and has more impact on economic outcomes. In the United States, total nonfinancial private debt is $27 trillion and public debt is $19 trillion. More telling, since 1950, U.S. private debt has almost tripled from 55 percent of GDP to 150 percent of GDP, and most other major economies have shown a similar trend. [See Chart 2.] Since GDP is largely the sum of all the spending, and thus income, of households and businesses in an economy, if aggregate private debt to GDP has tripled, that means that average businesses and households have three times more debt in relation to their income. Both private debt and government debt matter, and both will be discussed here, but of these two, it is private debt that has the larger and more direct impact on economic outcomes, and addressing the issues associated with private debt is the more productive path to economic revival.
Stagnant incomes, underemployment, and job insecurity are key reasons so many voters in Europe and America are now willing to embrace candidates outside of the mainstream. But the now stultifying level of private debt, and the accompanying impact on growth, is an equally important reason.
Private debt is a beneficial and essential part of any economy. However, as it increases, it can bring two problems. The first is dramatic. Very rapid or “runaway” private debt growth often brings financial crises. Runaway private debt growth brought the 2008 crisis in the United States, the 1991 crisis in Japan, and the 1997 crisis across Asia, to name just three. And just as runaway debt for a country as a whole is predictive of calamity for that country, runaway debt for a subcategory of debt, such as oil and gas or commercial real estate, is predictive of problems within that subcategory.
The second problem it brings is much more subtle and insidious: When too high, private debt becomes a drag on economic growth. It chips away at the margin of growth trends. Though different researchers cite different levels, a growing body of research suggests that when private debt enters the range of 100 to 150 percent of GDP, it impedes economic growth.
When private debt is high, consumers and businesses have to divert an increased portion of their income to paying interest and principal on that debt—and they spend and invest less as a result. That’s a very real part of what’s weighing on economic growth. After private debt reaches these high levels, it suppresses demand.
Because interest rates are low, some economists have dismissed this impact. However, most middle- and lower-income households (which is where the highest rate of debt growth has been), as well as most small- and medium-size businesses, pay interest rates much higher than money market rates. In the case of low-income households and small businesses, the rates for some types of debt can be very high, often an APR of 20 to 30 percent or more. And in addition to interest, all these borrowers have to pay down the principal balance of the loan. High debt makes these borrowers more reluctant to spend or take on more debt. Further, an estimated 6.4 million of the 56 million mortgages held in the United States are still severely underwater. Millions more are less severely underwater or just barely “above.” Many of these mortgages were underwritten at the height of the boom. Since then, the home values, and in many cases the incomes, of these borrowers have fallen. Lower rates may help but do not solve their financial stress. Though their rates may be lower, all of these borrowers are now in a world where increases in income and revenue are harder to come by.
This all takes a bite out of the spending and investing that drives growth.
The unprecedented amount of our global debt glut is underscored by the creeping presence of negative interest rates—a situation where the borrower, unbelievably enough, gets paid for borrowing. An estimated 15 percent of European corporate debt issued now has a negative interest rate. If the massive $150 trillion glut of debt is the culprit that is curbing demand, then perhaps this European Central Bank experiment with negative rates is the inevitable response to this glut. High private debt contributes to lower rates by reducing demand for credit—since highly leveraged borrowers have less ability to borrow more and are often understandably wary of further borrowing. But these negative rates are not generally available to low- and middle-income borrowers.
U.S. private debt growth has disproportionately affected the least well-off Americans. In fact, since 1989 (the year the Fed started a survey of this statistic), the debt level of the 20 percent of U.S. households with the lowest net worth has grown two and a half times faster than all other households. And though consumers have deleveraged since the crisis, and the popular perception is that consumers are in much better shape today, consumers are in fact carrying 13 percent more debt as a percent of GDP than they were in 2000, the moment before the ill-fated private debt boom that led to the 2008 crisis began.
As mentioned, GDP roughly equates to the aggregate spending and income of the businesses and households in a country, and the private debt of a country is the sum of household and business loans. So to speak about the “private debt to GDP ratio” of a country is essentially the same as speaking about the “private loan to income ratio” of that country. You’ll recognize that ratio, because it is the same one that lenders have long used to help make loan decisions for individuals and businesses. Whether you are applying for a loan as an individual or for your business, if your loan-to-income ratio is low, the lender is likely to conclude that you have capacity for more debt, and if it is high, the lender will likely conclude that you will struggle to pay your existing loan, much less qualify to take on additional debt.
It follows directly that if a country’s private debt to GDP ratio is low, let’s say 50 percent, then the households and businesses in that country generally have low loan-to-income ratios and are well positioned to power growth through increased leverage. And if a country’s private debt to GDP ratio is high, let’s say 200 percent, then the households and businesses in that country are generally overleveraged, with, on average, very high debt ratios. They are much less likely to be able to boost growth through more borrowing.
Chart 2 showed that private debt to GDP in major economies has been growing rapidly since World War II. However, it has been growing in size relative to GDP for a lot longer than that. It’s part of a process often described by economists as “financialization” or “financial deepening,” an increase in the size of a country’s debt and equity markets usually explained as simply the maturation of a market. But as we have seen, when it comes to debt, it is much more than that—it is the path from low leverage to overleverage for the participants in that economy. The benefit of increasing leverage from low levels has played a central role in the miraculous gains in incomes over the 200-plus years since the Industrial Revolution. You can see this clearly in Chart 3. I have made a concerted effort to reconstruct more than 200 years of private debt history for the six countries in this chart—China, Japan, Germany, Britain, France, and the United States—because collectively, they have accounted for roughly 50 percent or more of global GDP since the Industrial Revolution. So studying the data of these six countries during this period gives us a fairly solid proxy for the world during the most important era of economic history. (This chart is a work-in-progress which will be augmented and refined in preparation for an upcoming book on this same subject.)