The Debt Tetralemma

Recently I’ve been asking myself the same question over and over: “Why is everyone freaking out about low economic growth?”

I reasoned that for the developed countries an annual real growth rate of 1.5-2.0% wasn’t the end of the world. After all, such a pace of growth would mean a doubling of living standards every 35 years or so. This would be enough for every new generation to enjoy double what their parents had in real income.

So why all the fuss about sluggish growth and the urgent need for stimulus?

I actually overlooked a crucial piece of the puzzle. Let me clarify it for you.

McKinsey Global Institute published a very comprehensive report in 2011 on the effect of post-crisis leverage levels in the biggest economies and some of what they found is worth mentioning. The report, which analyzes 45 instances of an economy deleveraging since 1930, found that periods of deleveraging last on average for 6 to 7 years. During these periods, the debt-to-GDP ratio of the deleveraging country typically decreases by 25%. As the government is paying off part of its debt, the economy usually experiences an important slowdown caused by a significant reduction in public spending.

So, are we currently in a deleveraging episode? And if so, what’s wrong about it?

Looking at the public debt-to-GDP levels of the G7 countries gives us an interesting clue as to how to answer these questions.

Here’s Canada:













And the United Kingdom:



Quite scary isn’t it? Since the crisis, each of the world’s most important economies have been increasing their debt load to levels that are considered high in some cases and alarmingly high in others (Konnichiwa, Japan!). Only Germany seems to have reversed the trend lately thanks to their natural affinity with fiscal austerity.

The sad thing is that all this debt will need to be paid off at some point (or at least reduced to more manageable levels). This is where deleveraging comes into play. And looking at those charts, deleveraging hasn’t even started yet. If people think economic growth is sluggish, wait until the actual deleverage kicks in.

What’s very interesting about the McKinsey report is that it concludes that there are four ways for an economy to reduce its debt load: fiscal austerity, economic growth, inflation or outright default.

Fiscal austerity is an attractive choice, but it risks decreasing the already low growth rates even more as these governments cut spending to pay down their debt. It wouldn’t take much for some countries to fall into a recession, or even deflation (Konnichiwa again, Japan!)

Economic growth is the preferred alternative, but growth cannot be commanded on will by governments. What they can do is increase their spending in order to stimulate the economy. But if they spend more they have to get the funds somewhere. Raising taxes would cancel out most of their spending efforts, so what’s left is taking on more debt. But at around 100% of GDP, current debt levels don’t allow for much more borrowing. The governments need to keep some leeway in terms of leverage in case another crisis happens. The little borrowing capacity remaining would become very handy to revive the economy in such a circumstances.

Creating inflation has also certainly been considered by those countries’ central banks. The great thing with it is that inflation causes a reduction of the debt in real terms. The less great thing is that it also causes a decrease in purchasing power, meaning the dollars in your wallet end up buying less and less stuff. But I wouldn’t count this option out. The U.S. has actually used inflation to reduce the real value of its debt twice in the last 70 years (after World War II and Vietnam).

Defaulting on the debt is obviously out of the question because of the damage it would cause to a country’s ability to access capital markets in the future. Just ask Greece, Argentina or Russia.

It’s hard to know which path the G7 governments will choose to cure this massive debt hangover. But now at least we know why they are all craving for more growth. It’s actually the best chance they got to reduce their debt-to-GDP to more sustainable levels without causing too much damage. If growth doesn’t accelerate, they’ll have to resort to fiscal austerity or higher inflation, both of which could have painful and unpredictable effects.


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