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RBA Assistant Governor Guy Debelle
and I spoke at a conference on Subprimes in Adelaide last month. One
aspect of my analysis that Guy queried was my emphasis upon the Debt to GDP
ratio. He noted that this appeared suspect, because
it was comparing a stock (the outstanding level of debt) to a flow (annual
GDP).
It’s a valid point to make. The
engineer-turned-economist Mickal Kalecki once caustically
observed that “economics is the science of confusing stocks with flows”,
and I’m a stickler myself for not making that mistake. So making a song
and dance about a stock to flow comparison like debt to GDP has to be
justified by a sound argument.
The most accessible argument is an analogy to global
warming. Just as the growing level of C02 in the atmosphere is evidence that
the ecosystem is not coping with the (relatively tiny) additional volume of
carbon dioxide human activity is adding to the biosphere, the accumulation of
debt relative to income is evidence that the economy is not coping with the
(relatively large) volume of debt being generated by the financial system to
finance speculative purchases of assets.
There are at least five strong similarities between
this ecological issue and the economic one of accumulating debt:
- The
environment has an established “carbon cycle”, by which the
emission of carbon dioxide into the atmosphere by animals, etc., is
balanced by its re-absorbtion by plants, etc. This
process is augmented by many
other factors–such as the explusion of
CO2 by volcanoes–and, on a geological time frame, far from stable;
but over the period of human existence, the atmospheric concentration
was below 300 parts per million (ppm) until
industrialisation began.
- The fact
that the concentration has risen from under 300 ppm
to over 380 ppm in the past century shows that
the planet’s natural carbon-processing cycle is not coping with
the extra CO2 added by human industrial and agricultural activity. Global
Warming is the most apparent manifestation of this increased stock of
CO2.
- Even if all
human industrial and agricultural activity stopped today, it would take
decades for the additional CO2 we have added to the atmosphere to
decline to pre-industrial levels. At present, the existing natural
carbon cycle is only means to reduce that accumulation, and it could
take longer to reduce the build up than it took to accumulate it, since
we have damaged many of the natural “carbon sinks” in the
ecosystem.
- Persisting
with present or higher levels of CO2 will cause
the ecosystem to undergo both profound and uncertain change, some
aspects of which can be inferred from past geological data.
- There are feedback
effects that mean any climate-altering effects of raised CO2 levels may
be further amplified. For instance, the rise in temperature has reduced
the area of ice in the North Pole, leading to reduced reflection of
sunlight (since ice reflects most light while water mostly absorbs it),
and further increasing global temperatures.
Similar propositions can be put with respect to
debt:
- The economy
has a natural capacity to process debt. Borrowing by businesses to
finance investment can lead to new products whose sale enables the
businesses to make a profit and repay debt over time (Schumpeter’s
Theory of Economic Development gives perhaps the best explanation of
this “natural debt cycle”);
- The fact
that debt levels are rising with respect to income is a sign that the
economic system is not coping with the level of debt being generated
today;
- Even if all
borrowing stopped today, it would take decades for the additional debt
we have accumulated to be reduced to pre-debt bubble levels. The only
way that debt levels can be reduced is if income is redirected from
either consumption or investment into debt reduction. This is the key
reason that the debt to GDP ratio is important: it tells us how much of
income would be needed to reduce debt, and how long such a reduction
would take. However the process of reducing debt will itself reduce
income to some degree, since money that would otherwise have gone into
investment will now simply be used to pay down debt levels–and
incomes and employment will fall as a result;
- Persisting
with the level of debt we have now will mean a profoundly different and
uncertain economic environment. The proportion of income needed to
service debt will remain at levels that have only ever been experienced
in the past during Depressions.
- Finally,
there are feedback effects in the economy that can mean debt to GDP
ratios fall even when, ultimately, borrowers try to reduce their
exposure to debt. The worst such effects are: direct reductions in
investment as retained earnings are used to pay down debt rather than
invest; indirect falls in investment as falls in consumption reduce cash
flow and depress both earnings and expectations; and falling prices if
deflation sets in, as it did during the Great Depression when prices
fell as much as 10% per year.
There is also an academic economic argument that can
be made about the importance of the debt to GDP ratio, deriving from Minsky’s “Financial Instability
Hypothesis”. In this theory, a rising ratio is both a prediction of the
model, and a force leading to greater financial instability and possible
economic breakdown in a Depression. But I’ll leave a full discussion of
this for a future Debtwatch.
Observations on the Data
The most recent data imply that the turnaround in
debt to GDP may finally be starting. The debt to GDP ratio fell last month,
from 165.25% of GDP to 165.2%. It’s not a lot, and it may still return
to its 44-year long upward trend; but it is the first time in fifteen years
that the ratio has fallen.
The contributor was an “unexpected” fall
in the rate of growth of business borrowing (these things always seem to be
“unexpected”). Though it still increased, it grew at a slower
pace than GDP–as did personal borrowing. The grwoth
in mortgage debt, on the other hand, continued to outstrip GDP (see Tables 1
and 2 below for details).
While in one sense this slowing down in debt growth
is a good thing–in that an unsustainable trend may finally be coming to
an end–it also may presage very tough economic times ahead. One aspect
of my focus on the debt to GDP ratio is the contribution
that change in debt then makes to aggregate spending. Aggregate demand
in the economy, for everything from commodities to net asset transfers, is
the sum of both income (GDP) plus the change in debt.
In a well functioning economy, that shouldn’t
be much relative to GDP itself–and it wasn’t in the 1950s and
1960s. Then, the annual change in debt contributed no more than 4% of total
demand.
But as the debt level rises, the change in debt can
become an extremely large and volatile component of aggregate spending. That
clearly is what happened from 1970 onwards: the annual change in debt began
to contribute substantially more than 4% of total demand.
And it was highly volatile: notice the slump in its
contribution from over 10% to just 4% in 1973-75 that coincided with the
collapse of the Whitlam Government, and the fall from a peak of almost 14% of
aggregate demand to minus 1.5% during “the recession we had to
have”.
Today, the annual change in debt is the source of
over 19% of aggregate demand. Should that turn around–as it must even
to stabilise the debt to ratio at its current historically unprecedented
level–then demand in the economy could “unexpectedly”
evaporate.
Steve
Keen
Steve Keen’s Oz Debtwatch
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