By Robert Romano — Recent research is shedding new light on just how destructive excessive debt — both public and private — can be to economic growth.
The study comes not from a right-of-center think-tank like Americans for Limited Government or the Cato Institute, but from the Bank for International Settlements (BIS) — the central banks for all central banks.
The bank of who?
Housed in Basel, Switzerland, the BIS has played a significant role in the direction of monetary policy worldwide since 1930.
At first it was set up to manage the post-war reparations regime against Germany, but once World War II broke out, significantly the bank declared neutrality, and continued doing business with the Third Reich, handling their deposits of gold — which were looted from other central banks.
Nowadays, the BIS is responsible for setting standards for lending worldwide. The Basel Capital Accords, now in their third manifestation, fix how much limited capital banks must hold in order to carry on lending. In practice, however, these agreements, to which the U.S. is a primary signatory, allow institutions to lend far more money than they ever hold in capital.
The standards that have been set in Basel are one of the major reasons why the U.S. — and other advanced economies — have such a high debt load. They are also the principal reason why today when there are large defaults, the entire financial system is imperiled with what policy wonks like to call systemic risk.
If banks were not allowed to lend money into existence, we wouldn’t have these types of problems.
In America alone, there is over $54 trillion of credit outstanding, according to data published by the Federal Reserve. That includes all debts public and private, including financial sector debt, and represents about 352 percent of the entire economy. The only reason that is even possible today is because of the regime of capital requirements that was settled on in Basel.
BIS: ‘beyond a certain level, debt is bad for growth’
So, it is with no small irony then that a bank largely responsible for enabling such gargantuan debts to be issued now appears to be having second thoughts. It has ramped up bank capital requirements since the financial crisis began in Aug. 2007. And in its Sep. 2011 study, “The real effects of debt,” it takes the view that high levels of debt can be quite damaging.
Leaving aside the paradox of an institution repudiating its seeming purpose for existing, the working paper, authored in part by economic advisor and head of Monetary and Economic Department Stephen Cecchetti, is actually quite interesting.
It found that “beyond a certain level, debt is bad for growth. For government debt, the number is about 85 percent of Gross Domestic Product [GDP]. For corporate debt, the threshold is closer to 90 percent. And for household debt, we report a threshold of around 85 percent of GDP”.
Interestingly, the paper does not address debts taken on by financial institutions themselves, but leaving that detail aside, these thresholds Cecchetti lays out are simply devastating to the current state of affairs.
Based on the most recent data, the $15.9 trillion national debt is already greater than 100 percent of the domestic economy and growing, far beyond the 85 percent threshold Cecchetti warns against.
Similarly, household debt is already 95 percent of GDP as of 2010, according to the BIS report, while non-financial corporate debt stood at 76 percent.
That makes the U.S. among the worst nations in the developed world on the issue of debt. Overall, the report finds that over the past 30 years, “summing these three sectors together, the ratio of debt to GDP in advanced economies has risen relentlessly from 167 percent in 1980 to 314 percent today”.
That’s about 54 percent beyond the acceptable thresholds — and perhaps as much as 150 percent beyond sustainable levels — which means not just the U.S., but the entire developed world, is in big trouble.
Was Keynes wrong?
Cecchetti warns, “reducing debt to lower levels represents a severe test for the advanced economies,” noting that the demographic challenges of an aging population will “drive government expenditure up and revenue down”.
The BIS paper even takes issue with New York Times columnist and economist Paul Krugman’s analysis showing that during economic downturns, to avoid high unemployment and deflation, governments should borrow to fill the spending gap left by the private sector.
Writes Cecchetti, “[E]ven the capacity of the public sector to borrow is not unlimited. When a crisis strikes, the ability of the government to intervene depends on the amount of debt it has already accumulated as well as what its creditors perceive to be its fiscal capacity — that is, the capacity to raise tax revenues and repay the debt.”
Ouch. If only Barack Obama and his economic team had known that back in 2009 when Congress began its spending and borrowing binge. Oh well. Whoops.
Of course, after nearly a century of the Keynesians dogmatically running the global economy — always insisting on credit expansion as the means to stimulate growth — something was bound to run amuck.
Cecchetti even comments on this historical oversight: “as the mainstream was building and embracing the New Keynesian orthodoxy, there was a nagging concern that something had been missing from the models. On the fringe there were theoretical papers in which debt plays a key role, and empirical papers concluding that the quantity of debt makes a difference. The latest crisis has revealed the deficiencies of the mainstream approach and the value of joining those once seen as inhabiting the margin.”
In other words, as an academic and policy matter, the total level of debt has been largely ignored as a significant factor affecting the economy since Keynes. Again, whoops.
How could this happen?
But how did we get here? Even Cecchetti acknowledges that “from the late 1970s onwards, restrictions on financial market activity and lending had been progressively and systematically removed, increasing opportunities to borrow,” although he is unspecific about which policies were adopted.
The BIS also attributes the roaring 1980s as a contributing factor that helped convince everyone it was okay to go into debt: “Believing the world to be a safer place, borrowers borrowed more, lenders lent more”.
Cecchetti also points to low interest rates since the mid-1990s, but also to tax policies, that have both further incentivized lending and borrowing.
These things are all true, but they somewhat dance around the problem.
Very plainly, after the fall of the gold exchange standard in 1971, banks have been lending money into existence at a far faster pace than at any point in human history. And if they simply were not allowed to do that, nobody would care what interest rates or tax policies were as factors affecting credit binges — because there would not be any credit binges.
Cecchetti does not explicitly acknowledge that creating debt out of thin air is the problem, but hey, we’re making progress here. Still, the paper takes the view that “financial deepening and rising debt go hand in hand with improvements in economic well-being. Without debt, economies cannot grow and macroeconomic volatility would also be greater than desirable.”
That is a controversial claim, but then again, whether economies could or could not grow without debt, nobody is arguing for the abolition of all forms of credit.
So, now what?
We would agree with Cecchetti that lending should be limited, because we agree that “debt can mean disruptive financial cycles in which economies alternate between credit-fueled booms and default-driven busts.”
We also agree that “[t]o prevent further deterioration, [heavily-indebted] countries will need to implement drastic policy changes that reduce current deficits, as well as future contingent and implicit liabilities.”
It is also somewhat gratifying to read a BIS paper that declares “the debt problems facing advanced economies are even worse than we thought,” indicating a sweeping change of doctrine. The study even anticipates its findings being mishandled by politicians, and warns policymakers against using its “finding of a threshold for the effects of public debt on growth” to mean that “authorities should aim at stabilizing their debt at this level.”
Cecchetti continues, “On the contrary, since governments never know when an extraordinary shock will hit, it is wise to aim at keeping debt at levels well below this threshold,” adding, “advanced countries with high debt must act quickly and decisively to address their looming fiscal problems. The longer they wait, the bigger the negative impact will be on growth, and the harder it will be to adjust.”
Finally, the paper concludes, “Current efforts focus on raising the cost of credit and making funding less readily available to would-be borrowers. Maybe we should go further, reducing both direct government subsidies and the preferential treatment debt receives. In the end, the only way out is to increase saving.”
Coming from a central banker, that’s saying something. After a century of telling us savings and fiscal prudence was the enemy, we have come full circle, and now the banking cartel is declaring that all of the debt it has issued may have not been such a good idea after all.
Oh well. Better late than never. But better never late.
Robert Romano is the Senior Editor of Americans for Limited Government.
