For many, the answer to the question posed in our title is yes. But is there too much debt? Have we somehow borrowed our way to a bleaker future for our children? We explore some of the history of debt to illustrate that we should be wary of making too exact a link between debt and growth.
Residents of the United States, please read this important information before proceeding
Please read this important information before proceeding.
The emotive nature of debt
Debt is an emotive subject. At a personal level, few will have been fortunate enough to avoid the debilitating stress of trying to cobble together sufficient funds to meet overdue loan repayments at some stage in their lives. As consumers, we can feasibly borrow a finite amount, normally linked to our income or the assets we hold. At some stage, it has all got to be paid back. For the individual, it is easy to see why debt is often characterised as “borrowing from our future” or facilitating “living beyond our means.”
Shouldn’t these same parameters apply at the level of the aggregate national or even global economy? Surely this mountain of debt our generation seems to have irresponsibly amassed is just pushing the problems of today onto future generations. Of greater concern still is the fact that this debt financing seems to be getting progressively less powerful in terms of the growth it purportedly generates. (Figure 1)
Many of the world’s most renowned thinkers have weighed in with their thoughts on this debate. From Reinhart and Rogoff’s now infamous piece1 of scholarship to a more recent work on the absence of deleveraging in the post-crisis period from a group of highly regarded economists, the overwhelming consensus seems to be that there is too much debt.
The world has somehow reached and breached a sustainable level of indebtedness, and the process of paying it back suggests years in the economic wilderness for much of the world economy. If debt has fuelled the last few decades of growth, then surely paying it back will have the reverse effect.
It is hard to argue with such assembled academic might, particularly when the points made seem to carry particular resonance with a developed world clearly chastened by the aftermath of the Great Financial Crisis and the European Debt Crisis.
However, what if the level of indebtedness reached in the run up to 2007 was not such a threshold for indebtedness? Can we possibly know what that threshold is?
A reminder of the basics…
There are a couple of important things to remember about debt.
On its own, debt does not actually raise or reduce aggregate financial wealth. At the global level, there is no net debt. A former colleague used to wryly observe that since we have not yet managed to syndicate debt intergalactically, the planet Earth cannot yet be considered a net debtor.
For every borrower there is a lender, and they don’t have to be different entities. In one way or another, companies, governments and consumers will all be both. For example, a consumer may lend to a particular government via his or her ownership of government bonds. However, this same consumer (depending on tax residency) owns the government through tax payments. The relationship doesn’t have to be so abstract either. Both consumers and companies often have loans from the bank in the form of mortgages, but they may also maintain pension funds and other forms of savings.
The broader point is that debt, at its best (and there will always be examples of greed and idiocy on both sides of the ledger) is an efficient form of redistributing capital. However, financial assets and liabilities do not necessarily produce anything directly – long-term economic growth is both independent from monetary policy and still likely driven by land, labour, capital (intellectual and physical), and the ingenuity we use to organise these factors of production. Debt is part of the organisation, but its direct influence on underlying economic growth is surely overstated, as explored in a bit more detail below.
On its own, debt does not actually raise or reduce aggregate financial wealth
Some historical context
In the UK, national or government debt was born in the wake of the Nine Years’ War in the closing stages of the 17th century and exploded over the course of the 18th century, driven by various wars: It grew by over 7,000% between 1700 and the end of the Napoleonic Wars in 1815, which coincided with the First Industrial Revolution. Because living standards for UK citizens enjoyed a dramatic and sustained increase around that time, it could superficially suggest a link between the two.
However, on closer inspection, this connection starts to fade. Although data on incomes are obviously unreliable for this period, it’s interesting to note that life expectancy in the UK really only started to see dramatic increases in the 1870s, decades after modern-day historians date the end of the First Industrial Revolution.
This broadly chimes with the view of certain economic historians (Harley, 1982, Williamson, 1984) who see the 1820s as a turning point for the UK economy, when growth in per capita income and industrial production began to see sustained and material growth – assuming that such improvements take some time to filter through to life expectancy.
However, if this is accurate, this period of unprecedented increases in living standards and life expectancy in the UK began after public debt levels had peaked (c. 1816) and actually coincided with a period of marked deleveraging by the UK government – as the public net debt to GDP ratio fell from well north of 200% in the early 19th century to a low of just 25% in 1914. (Figure 2)
Further undermining the link, few credibly suggest that this surge in government borrowing had any direct relationship to the Industrial Revolution. Some historians have argued that the wars that sucked in all this debt financing may have had some positive technological benefits associated with greater demand for advanced military hardware.2 However, the UK’s role as the cradle of this leap forward in industrial technology is perhaps more plausibly attributed to its unique price and wage structure at the time.3
Essentially British wages were very high by international standards, in large part due to its success in the international textiles market beginning in the late 16th century. On the other hand, thanks to Britain’s rich coal deposits, energy was cheap, providing fertile ground for the substitution of expensive labour with new, cheaper machines.
At the very least, the history of the UK economy during this period of near-unrivalled government deleveraging suggests we should be far less deterministic concerning the relationship between deleveraging and growth. Myriad other factors influenced the UK’s economic performance over this period, with the rising productivity resulting from the substitution of labour for machines and energy likely central.
Interestingly enough, some suggest4 this dramatic increase in government debt over the 18th century was actually responsible for the delayed takeoff of the UK economy during the decades when the Industrial Revolution is now officially dated, a function of the government crowding out private sector investment.
The Third Industrial Revolution?
The First Industrial Revolution is an interesting case study in the context of today’s global economy. We are now regularly told we are in a period of “secular stagnation,” with high levels of debt and below-par GDP growth. GDP statistics have been suggesting that we’ve somehow ceased to get more productive or inventive, the central pillars of long-term growth. Without growth, how can we hope to pay this debt down?
Can this be true, or can it more simply be that GDP is an outdated way of measuring output, a relic of the “steel and wheat economy”? As Mokyr (2014) points out, “Many of the new goods and services are expensive to design, but once they work, they can be copied at very low or zero costs. That means they tend to contribute very little to measured output even if their impact on consumer welfare is very large.”5
Similarly, as Glaeser (2014) suggests, “The theory of price indices is that an individual should be indifferent between living today and living in the past with the same real income. How many people would really be indifferent between earning $23,000 in 1984 and earning $50,000 in 2014? You could surely buy the same amount of most basic commodities in 1984, but you would forgo the use of thousands of significant innovations, some of which improve life expectancy and others which are just fun.” 6
For all intents and purposes, we may already be in the midst of a Third Industrial Revolution; we just lack the economic statistics to adequately describe it. In terms of future productivity, it feels perverse to suggest that we have somehow exhausted the productivity gains available from the inventions of the last few decades. Trends in productivity obviously do not travel in a straight line. New technology is not always immediately assimilated into the wider economy.
It often takes companies and consumers decades to adopt and work out how to best use it. Around 120 years ago, US factories started switching from steam power to electric power; however, productivity gains were reportedly muted for several decades after the switch.
It took the next generation of factory owners to redesign manufacturing processes around this more flexible power source for the gains in productivity to be more effectively reaped.7 The same is true now. Much of today’s global workforce grew up in a world where computers were a rarity and experts were figures of fun. It seems unnecessarily pessimistic to start betting on a structural decline in innovation as the workforce shifts towards a generation that has been immersed in this general purpose technology from birth.
Those still sceptical of the potential for further progress should consider the advances currently being made in materials science. Historically, progress in materials science has always been the result of gruelling trial and error or just outright luck (linoleum, for example). Now, advances in computing power and software allow us to design new resins, ceramics and entirely new solids by computer simulation, with development occurring at the nano-technological level. This is already leading to previously undreamed-of synthesised materials, with custom-ordered properties in terms of elasticity, resilience and so on.
This not only has massive implications for our level of resource consumption as a planet, but in combination with three-dimensional printing, it has the potential to spawn mass customisation, a truly revolutionary industrial manufacturing concept.8
Robotics, artificial intelligence (AI) and genetic engineering are just some of the other areas where mankind is repeatedly moving into uncharted waters. Not all of it will be net progress. Some of these advances, particularly those in robotics and AI, will raise questions: what kind of education do we need to provide our citizens to prosper in this new world?
How does our social safety net need to be adapted to reflect the more rapidly evolving employment backdrop? For the latter point, bear in mind that most of us now work in jobs that wouldn’t have existed 100 years ago, and the same will likely be true 100 years from now.
It is likely that future increases in productivity, historically the most significant contributor to long-term output growth, could easily coincide with one or more segments of the economy paying down debt. There simply doesn’t have to be a strong relationship between the two.
Debt and growth in the modern day
The surge in private sector borrowing that followed the piecemeal financial deregulation over the ‘60s, ‘70s and ‘80s in the West did not coincide with a dramatic acceleration in economic growth in either the US or the UK, as illustrated by Figures 3 and 4. Much of the credit expansion from the 1980s onwards has been associated with balance sheet transactions – for example, the acquisition of houses already in existence – where the direct economic impact has been surely modest. This could in turn mean that some mild deleveraging may have a similarly mild impact on economic growth.
However, for the US at least, the likely trend right now is for much of the private sector to increase debt, not reduce it. This shouldn’t alarm us, since, viewed in the broader context of the consumer’s total balance sheet, there might not be as much to worry about as some would have us believe. (Figure 5) The US consumer, much like many developed market consumers, enjoys strong positive net worth when factoring in the houses and financial assets they own, alongside the debts they owe.
The increase in net worth in 2013 for the US consumer, as house, stock and bond prices all rose, was roughly the same size of the Chinese economy. The same goes for the non-financial corporate sector in the US. Levels of leverage, when compared to pre-depreciation and amortisation corporate profits, for example, do not look especially high. We see leverage increasing from here, as companies continue to grow in confidence and boost capital expenditure.
There must be limits to borrowing for individuals, sectors and governments, but the likely reality is that such limits should be loosely defined and may well change over time. A population whose living standards and tangible assets are growing steadily may have greater uses for the flexibility facilitated by debt and use disproportionately more of it.
None of this is to say that certain countries, individuals and companies did not borrow recklessly and excessively in the run-up to the Great Financial Crisis, with some of these actors remaining questionable credit risks today (Greece for example). However, the current obsession with a fixed appropriate level of debt for the world as a whole is perhaps misplaced, as is the idea that deleveraging has to go hand-in-hand with slower growth. The prospects for the longer-term drivers of economic growth - the factors of production - are showing signs of health right now, bolstered by ongoing technological advances.
To ignore that may mean missing out on some still attractive investment opportunities within the asset class that best expresses optimism about our future growth prospects – equities. The difficulties inherent in measuring the positive productivity effects arising from the spread of this new technology, combined with these same technologies’ deflationary effects go some way to explaining, if not excusing, the bond market’s continued buoyancy.