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Debt Growth Exceeds Income
Growth
In Q2 2009, total
debt outstanding in the United States — financial plus nonfinancial
debt — amounted to 373.4% of GDP.[1] At the start of 1952, the
debt-to-GDP ratio stood at only 130%. In fact, in the last decades the rise
in total debt has increasingly outpaced nominal income — a development
which gained momentum after the erosion of the last vestiges of the gold standard
in the early 1970s.
The current upward dynamic of the debt-to-GDP ratio
is economically unsustainable. It cannot go on forever. To see this, let us
assume that the total debt-to-GDP ratio does continue to grow at the average
rate at which it has expanded from Q1 1971 to Q2 2009 (case 1 in the chart
above). The total debt-to-GDP ratio would exceed 600% at the start of 2029
and reach more than 1000% in 2050.
If one assumes that the total debt-to-GDP ratio will
expand at the average growth rate seen from Q1 1995 to Q2 2009 (case 2), a
level of 600% would be reached as early as the middle of 2024, and the ratio
would go up further towards 1300% by the end of 2050.
Interest payments on total debt would rise
substantially as a percentage of GDP. If one assumes that the average
interest rate was 4% in Q2 2009,[2] total interest
payments amounted to 15% of GDP. In case 1, interest payments would double by
the middle of 2038, while in case 2 this level would be reached in the middle
of 2031.
Correction
Scenarios
Admittedly, we do not know how much debt relative to
GDP an economy can shoulder. And, of course, there might even be good reasons
for the ratio to rise over time. For instance, an increase in "financial
intermediation" and a decline in the societal time preference(related, for instance, to rising confidence in the
protection of property rights) might justify a higher level of loaning and
borrowing in the economy.
One thing is clear, though: the level of debt
relative to income cannot rise without limit.[3] This insight is
important, given that there is strong reason to believe that the
extraordinary rise in the debt-to-GDP ratio is a result of the
government-controlled, fiat-money system in which the money supply is
increased through bank lending.
Let us assume, for the sake of argument, that the
current debt-to-GDP ratio has exceeded its sustainable level. What are the
chances that output could start expanding more strongly than debt, thereby
lowering the ratio? This would be a rather favorable scenario, as the debt-to-GDP
ratio would decline, while income and employment would increase.
Unfortunately, however, it is a rather unlikely correction scenario.
Austrian Economics teaches that a circulation-credit-fueled boom can only
be sustained by ever-greater doses of credit and money expansion, provided at
ever-lower interest rates. As soon as the growth rate of credit and the money
supply slows down, the illusionary upswing collapses. Malinvestment is
revealed, firms cut employment, and the economy goes into recession.
Lenders can then be expected to demand higher
interest rates and/or to stop extending loans — as the outlook for the
possibility of borrowers repaying their debt (in real terms) deteriorates. In
other words, market forces start pressing for a change in the hitherto-observed
path of the total-debt-to-GDP ratio.
If commercial banks make their debtors repay their
loans, the money supply declines. A drop in the money supply, in turn, would
represent deflation — and the symptoms would be declining prices for
goods and services of current production, and for existing assets (such as,
for instance, stocks and real estate).
Deflation would lead to credit losses as a growing
number of borrowers would find their incomes greatly diminished and —
most importantly — falling short of expectations. Many borrowers would
default on their debt.
If credit-related losses exceed their equity base,
banks go bankrupt. Savers and investors in bank debentures would have to
accept losses, as banks could not meet their debt service. It doesn't take
much to see that such an outlook could trigger a "flight out of
debt."
Investors would try to dump their bonds, causing
interest rates to go up. Borrowers in need of rolling over their debt would
have to accept higher refinancing rates, which would leave a growing number
of investment projects unprofitable. The mere expectation of rising credit
costs would therefore make possible an anticorrection
scenario.
The
Anticorrection Scenario
In the
anticorrection scenario, central banks — seeing an
unraveling debt pyramid — would decide to prevent banks from defaulting
on their debt by pushing short-term interest rates to record lows and
providing additional base money for bank refinancing — by monetizing
banks' debentures and/or (troubled) assets.
Keeping a circulation-credit boom going requires
— as Austrian economists have explained in great detail —
ever-greater amounts of credit and money, provided at ever-lower interest
rates. However, credit and money cannot be increased indefinitely by the
central bank and commercial banks. In fact, it is money demand that would set
a limit.
If inflation — that is, a rise in the money
supply — does not exceed an unacceptable
level, people may well continue to use money even if it loses its
purchasing power. If, however, inflation exceeds an acceptable level, or
if people start expecting inflation to continue to rise further, the money is
doomed to fail. As Ludwig von Mises noted in 1923,
Once the people generally realize that the inflation
will be continued on and on and that the value of the monetary unit will
decline more and more, then the fate of the money is sealed. Only the belief,
that the inflation will come to a stop, maintains the value of the notes.[4]
The private sector may be able to cope with
deflation (and the ensuing redistribution of property rights). The
institution of government, in its current size and scope, however, cannot.
Inflation — the rise in the money supply — is an indispensable
tool for financing government outlays for which the taxpayer would presumably
not want to pay out of his current income.
Mises noted,
Inflation becomes one of the most important
psychological aids to an economic policy which tries to camouflage its
effects. In this sense, it may be described as a tool of antidemocratic
policy. By deceiving public opinion, it permits a system of government to
continue which would have no hope of receiving the approval of the people if
conditions were frankly explained to them.[5]
The effort to prevent government from defaulting on
its debt — and this goal would most likely be subscribed to by the
ruled class as well as the ruling class, especially under deflation —
is therefore the greatest danger for the value of money. And this is why an
unsustainable debt-expansion path poses such a great danger to the exchange
value of money.
Central banking makes it possible for the government
to expand the money supply by any amount, at any time deemed necessary. And
once (hyper)inflation is publicly seen as being the lesser evil of all
options available for the government meeting its debt service, it cannot be
dismissed out of hand that (hyper)inflation would be the consequence of an
unsustainable debt-to-GDP ratio.
In 1923, Ludwig von Mises (1881–1973)
published his essay, "Stabilization of the Monetary Unit – From
the Viewpoint of Theory."[6] In it, he not only outlined the consequences if the
government continues to increase the money supply, he also outlined a
monetary reform plan. In view of today's challenges regarding worldwide
monetary affairs, Mises's essay is as insightful and instructive today as it was
back then.
Notes
[1] In this article, I focus on total debt outstanding,
which includes the holders and issuers of debt, namely the financial sector.
[2] At the time of writing, the 10-year Treasury yield
was 3.3%, the corporate AAA yield 5.3% and the BAA rate 6.6%, while the
Federal Funds Target Rate is between 0.0 and 0.25%.
[3] It should be noted here that in the free market,
the real interest rate, which is determined by peoples' time-preference rate,
cannot go to zero (let alone become negative).
[4] von Mises, Ludwig, 2006 (1923), "Stabilization
of the Monetary Unit – From the Viewpoint of Theory," in The Causes of the Economic Crisis,
And Other Essays Before and After the Great Depression, ed. P. L. Greaves, Jr., (Auburn, AL: Ludwig
von Mises Institute) pp. 13–14.
[5] von Mises, Ludwig, 2006 (1923), p. 38.
[6] It should be noted that Mises finalized his essay in
January 1923 — that is, before the Reichsmark had collapsed under
hyperinflation, which occurred in November 1923.
Thorsten Polleit
Thorsten Polleit is Honorary Professor at the Frankfurt School of
Finance & Management.
This essay was originally published in www.Mises.org. By authorization.
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