It is a truism that economies have become more leveraged because the issuance of debt has increased faster than nominal GDP. As the debt mountain expanded, it became more dangerous. The challenge now is to reduce leverage without choking growth. It’s a challenge that is still largely ignored by monetary policy.
Economists from Deutsche Bank have analysed the problem. They start with the “credit impulse”: the change in the rate of growth of new private credit. For the last two decades, accelerating credit has been closely correlated with the change in GDP – both in the United States and the euro zone. GDP growth tended to speed up shortly after the rate of credit growth increased, and slowed down after credit growth started to decrease.
This correlation implies there is an equilibrium rate of credit growth – the rate that corresponds to the long-term pace of nominal GDP growth. Though the pace of credit growth can vary from year to year, over time private debt and nominal GDP have to expand at the same rate for overall leverage to stay constant. That’s not what happened in the past two decades. Since 1990, Deutsche found a significant gap between credit and GDP growth in the United States and the euro zone.
In both, the neutral rate of credit growth – the rate associated with the economy’s long-term growth rate – was 7 percent. Those long-term nominal GDP growth rates were lower: 4.8 percent in the United States and 4 percent in the euro zone. In a single year, the difference of 2-3 percentage points doesn’t have much effect. Over a generation, though, it leads to a massive increase in the ratio of private debt to GDP.
This leads to financial crisis. In the United States, debts mounted disproportionately in the property and financial sectors, leading to booms followed by busts. In the euro zone, credit expansion allowed several countries to live far beyond their means.
More generally, the expansion of debt makes the financial system more fragile. Increased leverage amounts to imposing a larger financial structure on the same economic foundation. As the ratio of loans to underlying values increases, those values become more dependent on the continued availability of credit. More loans are written without any clear asset as collateral. The chains of borrowing almost inevitably become longer and more entwined. Slight setbacks in growth or minor changes in mood can cause substantial losses. And since debt has to be frequently rolled over, there are many opportunities for self-fulfilling panic.
Before the most recent crisis, central bankers were mostly oblivious to this risk. As the Deutsche economists point out, the monetary authorities’ standard analytic framework included output and inflation, but not the credit-intensity of growth. That’s a serious shortcoming. It’s not clear how much has changed since the crisis. Although most central bankers have endorsed the global campaign for “macro prudential” regulation, which focuses on overall threats to financial stability, little work has been done on the legal, intellectual and practical problems caused by integrating other variables into policy-making.
The crisis itself is probably to blame. For almost four years, policymakers have been simultaneously calling for less leverage in the long term and for more lending now. The mental gymnastics required to keep those two almost contradictory goals balanced must be so exhausting that little energy is left for thinking about how the economy became so dependent on debt, or about how to change this unhealthy financial lifestyle.
Though Deutsche’s analysis is not focused on government borrowing, official debt is intrinsically destabilising. It comes without any supporting collateral. It is usually a sign of a significant political deficit, the inability to keep taxes balanced with spending. It is likely to lead to some sort of default – be it through writedowns or inflation. The Keynesian antidote for inadequate private borrowing – the addition of more government debt – may keep depression at bay. But it also reinforces bad national borrowing habits.
The best thing to do about excessive increases in debt is stop them as fast as possible. That is a problem for the future, and a good justification for much tighter regulation of the financial industry. Now, though, the authorities are trying to reduce leverage without causing more economic damage. It’s not easy when real GDP growth is slow, inflation is low and large debt write-downs are considered bad public policy. At the current pace of deleveraging, the world’s great financial imbalance – of debt to GDP – could linger for a generation.