A special report on debt
Borrowing has been the answer to all economic troubles in the past 25 years. Now debt itself has become the problem, says Philip Coggan
MAN is born free but is everywhere in debt. In the rich world, getting hold of your first credit card is a rite of passage far more important for your daily life than casting your first vote. Buying your first home normally requires taking on a debt several times the size of your annual income. And even if you shun the temptation of borrowing to indulge yourself, you are still saddled with your portion of the national debt.
Throughout the 1980s and 1990s a rise in debt levels accompanied what economists called the “great moderation”, when growth was steady and unemployment and inflation remained low. No longer did Western banks have to raise rates to halt consumer booms. By the early 2000s a vast international scheme of vendor financing had been created. China and the oil exporters amassed current-account surpluses and then lent the money back to the developed world so it could keep buying their goods.
Those who cautioned against rising debt levels were dismissed as doom-mongers; after all, asset prices were rising even faster, so balance-sheets looked healthy. And with the economy buoyant, debtors could afford to meet their interest payments without defaulting. In short, it paid to borrow and it paid to lend.
Like alcohol, a debt boom tends to induce euphoria. Traders and investors saw the asset-price rises it brought with it as proof of their brilliance; central banks and governments thought that rising markets and higher tax revenues attested to the soundness of their policies.
The answer to all problems seemed to be more debt. Depressed? Use your credit card for a shopping spree “because you’re worth it”. Want to get rich quick? Work for a private-equity or hedge-fund firm, using borrowed money to enhance returns. Looking for faster growth for your company? Borrow money and make an acquisition. And if the economy is in recession, let the government go into deficit to bolster spending. When the European Union countries met in May to deal with the Greek crisis, they proposed a €750 billion ($900 billion) rescue programme largely consisting of even more borrowed money.
Debt increased at every level, from consumers to companies to banks to whole countries. The effect varied from country to country, but a survey by the McKinsey Global Institute found that average total debt (private and public sector combined) in ten mature economies rose from 200% of GDP in 1995 to 300% in 2008 (see chart 1 for a breakdown by country). There were even more startling rises in Iceland and Ireland, where debt-to-GDP ratios reached 1,200% and 700% respectively. The burdens proved too much for those two countries, plunging them into financial crisis. Such turmoil is a sign that debt is not the instant solution it was made out to be. The market cheer that greeted the EU package for Greece lasted just one day before the doubts resurfaced.
From early 2007 onwards there were signs that economies were reaching the limit of their ability to absorb more borrowing. The growth-boosting potential of debt seemed to peter out. According to Leigh Skene of Lombard Street Research, each additional dollar of debt was associated with less and less growth (see chart 2).
The big question is whether this rapid build-up of debt—a phenomenon which Martin Barnes of the Bank Credit Analyst, a research group, has dubbed the “debt supercycle”—has now come to an end. Debt reduction has become a hot political issue. Rioters on the streets of Athens have been protesting against the “junta of the markets” that is imposing austerity on the Greek economy, and tea-party activists in America, angry about trillion-dollar deficits and growing government involvement in the economy, have been upsetting the calculations of both the Democratic and Republican party leaderships.
To understand why debt may have become a burden rather than a boon, it is necessary to go back to first principles. Why do people, companies and countries borrow? One obvious answer is that it is the only way they can maintain their desired level of spending. Another reason is optimism; they believe the return on the borrowed money will be greater than the cost of servicing the debt. Crucially, creditors must believe that debtors’ incomes will rise; otherwise how would they be able to pay the interest and repay the capital?
But in parts of the rich world such optimism may now be misplaced. With ageing populations and shrinking workforces, their economies may grow more slowly than they have done in the past. They may have borrowed from the future, using debt to enjoy a standard of living that is unsustainable. Greece provides a stark example. Standard & Poor’s, a rating agency, estimates that its GDP will not regain its 2008 level until 2017.
Rising government debt is a Ponzi scheme that requires an ever-growing population to assume the burden—unless some deus ex machina, such as a technological breakthrough, can boost growth. As Roland Nash, head of research at Renaissance Capital, an investment bank, puts it: “Can the West, with its regulated industry, uncompetitive labour and large government, afford its borrowing-funded living standards and increasingly expensive public sectors?”
An interactive graphicshows the debt levels for a wide range of countriesSovereign default is far from inconceivable. Many people are forecasting that Greece, despite its bail-out package from the EU and the IMF, will be unable to repay its debts in full and on time. Faced with the choice between punishing their populations with austerity programmes and letting down foreign creditors, countries may find it easier to disappoint the foreigners. Defaults have been common in the past, as Carmen Reinhart and Ken Rogoff showed in their book, “This Time is Different”. Adam Smith, a founding father of economics, noted in “The Wealth of Nations” that “when national debts have once been accumulated to a certain degree, there is scarce, I believe, a single instance of their having being fairly and completely paid.”
Governments now face a tricky period when they have to deal with the debt overhang, decide how quickly to cut their deficits (and risk undermining growth), and try to distribute the pain of doing so as equitably as possible.
Debt is often treated as a moral issue as well as an economic one. Margaret Atwood, in her book of essays, “Payback: Debt and the Shadow Side of Wealth”, notes that the Aramaic words for debt and sin are the same. And some versions of the Lord’s Prayer say “Forgive us our debts” rather than “Forgive us our trespasses”.
The Live 8 campaign in 2005 tried to shame developed nations into forgiving the debts of poor countries, particularly in sub-Saharan Africa. Economists have developed the concept of “odious debt” in which citizens should not be forced to repay money borrowed by tyrannical or kleptocratic rulers. Interest payments on debt are often regarded as an onerous burden placed on the poor; interest is seen as an unjustified reward for capital, a concept that goes back to Aristotle and is implicit in the Christian idea of usury. Islam forbids it altogether. The book of Deuteronomy suggested a debt amnesty every seven years, which survived into later Jewish custom.
But conventional morality has not always been on the side of the borrowers. Some regard debt as the road to ruin and the failure to repay as a breach of trust. In the 18th and 19th century debtors in Britain were often thrown into jail (as in Charles Dickens’s “Little Dorrit”), though Samuel Johnson spotted the flaws of the practice: “We have now imprisoned one generation of debtors after another, but we do not find that their numbers lessen. We have now learned that rashness and imprudence will not be deterred from taking credit; let us try whether fraud and avarice may be more easily restrained from giving it.”
In the past 100 years the moral battle has moved in favour of the debtors. Bankruptcy is no longer stigmatised but simply regarded as bad luck. When consumers borrow beyond their means, the blame is laid on lax lending practices rather than irresponsible borrowing. Governments have encouraged more people to become homeowners and thus to take on debt. And defaulting on one’s debts has become much less cumbersome; in the current housing slump many American homeowners have resorted to “jingle mail”, dropping their keys through the lender’s letterbox and walking away from their property.
In business, a few failed directorships are a sign of entrepreneurship rather than incompetence. America’s Chapter 11 process allows the managers of companies to remain in place and the business to be protected from its creditors. The number of companies with safe AAA credit ratings has collapsed as more have acted on the theory that a debt-laden balance-sheet is more efficient (because interest payments are tax-deductible in most countries).
The recent crisis has also diminished belief in the judgment of the financial markets. The role of banks in the credit crunch and the cost of the financial sector bail-out has undermined the idea that the markets assess risk fairly and rationally. Instead, higher borrowing costs are seen as the result of unscrupulous speculation.
The role of sovereign credit-default swaps (CDS), a way of betting on the likelihood of a country’s failure to repay the money it has borrowed, has proved particularly controversial. Southern European nations, which have been at the heart of the recent market turmoil, have been quick to blame an Anglo-Saxon conspiracy, brewed up by hedge funds, credit-rating agencies and even newspapers like this one, for unfairly pushing up their borrowing costs. The German government moved to ban short-selling of government bonds and some CDS transactions last month. As Charles Stanley, a stockbroking firm, cynically puts it, EU nations are saying: “Please fund our lifestyles, but don’t hold us to any commitments.”
If a husband borrows money from his wife, the family is no worse off. By extension, just as every debt is a liability for the borrower, it is an asset for the creditor. Since Earth is not borrowing money from Mars, does the debt explosion really matter, or is it just an accounting device?
During the credit boom of the early 1990s and 2000s the conventional view was that it did not matter. Not only were asset prices rising even faster than debt but the use of derivatives was spreading risk across the system and, in particular, away from the banks, which had capital ratios well above the regulatory minimum.
The problem with debt, though, is the need to repay it. Not for nothing does the word credit have its roots in the Latin word credere, to believe. If creditors lose faith in their borrowers, they will demand the repayment of existing debt or refuse to renew old loans. If the debt is secured against assets, then the borrower may be forced to sell. A lot of forced sales will cause asset prices to fall and make creditors even less willing to extend loans. If the asset price falls below the value of the loan, then both creditors and borrowers will lose money.
This is particularly troublesome if the economy slips into deflation, as happened globally in the 1930s and in Japan in the 1990s. Debt levels are fixed in nominal terms whereas asset prices can go up or down. So falling prices create a spiral in which assets are sold off to repay debts, triggering further price falls and further sales. Irving Fisher, an economist who worked in the first half of the 20th century, called this the debt deflation trap.
Another reason why debt matters is to do with the role of banks in the economy. By their nature, banks borrow short (from depositors or the wholesale markets) and lend long. The business depends on confidence; no bank can survive if its depositors (or its wholesale lenders) all want their money back at once. If banks struggle to meet their own debts, they have no choice but to reduce their lending. If this happens on a large scale, as it did in the 1930s, the ripple effect for the economy as a whole can be devastating.
Both of these effects were seen in the debt crisis of 2007-08. Falling property prices caused defaults and a liquidity crisis in the banking system so severe that the authorities feared the cash machines would stop working. Hence the unprecedented largesse of the bank bail-out.
Hyman Minsky, an American economist who has become more fashionable since his death in 1996, argued that these debt crises were both inherent in the capitalist system and cyclical. Prosperous times encourage individuals and companies to take on more risk, meaning more debt. Initially such speculation is successful and encourages others to follow suit; eventually credit is extended to those who will be able to repay the debt only if asset prices keep rising (a succinct description of the subprime-lending boom). In the end the pyramid collapses.
In the aftermath of the latest collapse it is clear that the distinction between debt in the private and public sector has become blurred. If the private sector suffers, the public sector may be forced to step in and assume, or guarantee, the debt, as happened in 2008. Otherwise the economy may suffer a deep recession which will cut the tax revenues governments need to service their own debt.
If the Western world faces an era of austerity as debts are paid down, how will that affect day-to-day life? Clearly a society built on consumption will have to pay more attention to saving. The idea that using borrowed money to buy assets is the smart road to riches might lose currency, changing attitudes to home ownership as well as to parts of the finance sector such as private equity.
This special report will argue that, for the developed world, the debt-financed model has reached its limit. Most of the options for dealing with the debt overhang are unpalatable. As has already been seen in Greece and Ireland, each government will have to find its own way of reducing the burden. The battle between borrowers and creditors may be the defining struggle of the next generation.
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