3 Debt
Pettis
Most economists have trouble understanding why too much debt may harm an economy, let alone how much debt counts as too much. To make matters worse, the common practice of comparing vastly different countries’ debt-to-GDP levels is not a useful tool for gauging how a particular economy is likely to manage its debt burden.
Debt is conventionally viewed as consisting of transfers of resources from the future to the present, but that isn’t quite right. On the contrary, borrowing consists of a current transfer of resources from the lender to the borrower, followed by a future transfer that closes out the loan. This future transfer is normally expected to reverse the original transaction—as resources are transferred from the borrower back to the lender—but this occurs mainly in cases where increases in demand created by the debt are matched by increases in supply. In other cases, depending on a variety of circumstances, the transfers may end up being to or from other sectors of the economy, as described above, that end up bearing the cost of the debt.
Global debt, according to a recent report by the Institute for International Finance, amounted to nearly $300 trillion in 2021, equal to 356 percent of global GDP. This extraordinarily high debt level represents a 30 percentage-point rise in the global debt-to-GDP ratio in the past five years.
Unfortunately, few economists have a clear understanding of why too much debt is a bad thing, let alone how much debt is too much. That makes it hard to know what to worry about and why. Because economists tend to assume that the extent of a country’s debt burden is measured by its national debt-to GDP ratio, they often fail to distinguish between types of debt, instead treating a rise in one country’s debt-to-GDP ratio as equivalent to the same rise in another country’s ratio, even though the two cases may have very different implications.
So when is debt a burden for the economy and why? Crucially, different kinds of rising debt can have very different effects on an economy. Moreover, even in countries that are seen as having too much debt, the adjustment costs can vary significantly.
There are many ways to resolve ex ante imbalances between demand and supply created by government spending, and all these ways involve the same underlying process: some mechanism, whether intended or not, implicitly or explicitly allocates the adjustment cost onto some sector of the economy. Understanding this is important for understanding some of the ways in which excessive debt can undermine an economy.
Four separate consequences of rising debt can adversely affect the current and subsequent performance of an economy:transfers, financial distress, bezzle (or fictional wealth), and additional spillover adjustment costs termed hysteresis.
Rising debt is not a problem when it causes the supply of goods and services to rise along with the demand it creates. When that happens, the debt is effectively self-liquidating, with debt rising no faster than the real debt-servicing capacity of the economy. The problem is more concerning when debt rises faster than the country’s real debt-servicing capacity.
If the transfers take the form of high levels of inflation or financial repression, they can raise business uncertainty and otherwise distort economic activity. If they take the form of higher taxes, they can undermine what economist John Meynard Keynes called “animal spirits” and reduce investment in risky but productive sectors of the economy. Or if they result in trade deficits, they can force up unemployment or household debt and so on.
A related, and far more important, potential problem is the extent to which these implicit or explicit transfers undermine growth indirectly.
Increasing uncertainty about which sector will be forced to absorb the cost and how, so economic agents are likely to alter their behavior in ways that protect themselves.
As rising debt causes a growing gap between ex ante demand and supply, economic agents understand that this gap will be resolved by some combination of means including inflation, higher taxes, rising unemployment, wage suppression, financial repression, capital controls, and currency depreciation. As this happens, households—especially wealthy ones—shift their wealth into movable assets or into foreign currency (capital flight), consumers cut back on spending, home buyers and equipment buyers delay purchases, manufacturers move operations abroad, farmers hoard production or cut back on land development, and workers, if they are allowed to do so, will unionize and become more militant or, if not, they will work less efficiently. In countries where foreigners might be seen as acceptable political targets, foreign businesses in particular are likely to react to uncertainty over debt repayment by liquidating assets and moving abroad. These actions in turn can cause a host of spillover effects.
To the extent rising debt must lead to some sort of adjustment in which certain economic sectors will lose purchasing power to equilibrate demand and supply, each sector recognizes the risk and changes its behavior to protect itself from being forced to absorb the cost. These behavioral changes cause growth to slow, exacerbating the adjustment costs that must be borne by vulnerable economic agents as financial distress automatically spreads through the economy.
Finance specialists will note that a lot of this resembles corporate-finance discussions about the behavior of stakeholders in a business whose probability of default is rising. In fact, what I describe above is the macroeconomic equivalent of something that is well understood in corporate finance circles. While this behavior is well-documented and well-understood in corporate finance, its macroeconomic counterpart seems to be much less familiar to economists.
Rising debt is that it can encourage and accommodate a rise in fictitious wealth or bezzle. This is often the most damaging consequence of rising debt because this fictitious wealth creates distortions in economic behavior both as it is created and, much more importantly, as it is destroyed.
A November 2021 McKinsey report on global wealth reached broadly similar conclusions. Worryingly, it concluded that measures of global wealth, of which real estate accounts for 68 percent, have risen in the past two decades to levels that are roughly 40–50 percent higher than normal. The report reinforces the idea that there may be a great deal of bezzle in the world’s major economies