The limits of debt

Since 2008 debts have been piling up faster than ever. Total world debt has been estimated at $247 trillion, which is more than three times the world’s product and up 11% from last year (1). Central and regional administrations, cities, towns and villages, big and small businesses, households and students have been borrowing as though there were no tomorrows. This is in line with financial and corporate profits, and has inflated the prices of real estate, stocks and bonds. The question being, how far can this borrowing spree go? It seems obvious that at some stage the boom will go bust. But even a slowdown has an effect on sales and profits, and that would be enough to deflate the bubbles and bring down the banking-credit construction.

Buy now and pay later means an increase in spending, followed by small reductions over a period of time. That is interest for debts repayable at term, and interest plus fractions of the loan in other cases. This works quite well when incomes are growing, as the slack in spending caused by the debt’s repayment is compensated by more income. However, when incomes are stagnant, as they have been for most employees in the developed world over the last two or three decades (2), then the slack in spending lasts as long as the debt’s repayment. This means that the boost in spending due to a new debt is cancelled by the slack in spending of previous borrowers. Supposing a debt of $100 at 8% interest is paid back in twelve $9 instalments. In this case, the reduced spending of eleven past borrowers who are paying back ($99), just about cancels the increased spending by a new borrower ($100). At some point the accumulated paying back of past debts and interest equals the value of new debts (3). That is when growth in spending stops.

Governments seldom pay back their debts, as they are systematically renewed. But they are obliged to pay interest. A government, whose debt equals its national GDP, must increase that debt by the same percentage of GDP as the percentage of interest it is paying, without spending a penny more. With world debt at three times world product, just paying interest represents three times the going rate (say 3%) as a percentage of world product (9%). For the past few years, rates of interest have been kept artificially low by central bank interventions on the market, in the US, the EU, Japan and China. This situation seems to be ending, as interest rates are rising again. That means that future debts will be more expensive, but it also means that existing debts will be devalued. Debt bought at 2% interest can only be sold at two thirds of its original value, if interest rises to 3%. When rates rise, the face value of a debt can only be obtained at its term. Pushing down interest rates encouraged borrowing and sustained demand for goods and services. Now that they are rising, demand will slow down, and debt holders will lose money, two sure paths to recession. So central banks will buy up more debt to keep rates low, and there will be more borrowing. Or maybe that cannot work a second time, in which case there is financial disruption ahead.

1. https://www.reuters.com/article/global-debt-iif/global-debt-load-at-a-record-247-trillion-in-q1-iif-idUSL1N1U51A2

2. If more people are employed, even with miserable wages, spending goes up, as do borrowing and profits.

3. In the case of treasury and corporate bonds, it is their renewal at term that requires a lot of new borrowing. These borrowing cycles could explain the periodic ups and downs of business cycles.