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“Neither a borrower nor a lender be”[1] is a line from Shakespeare that has summed up society’s attitudes towards debt for much of our history. A report from consulting firm McKinsey & Co. [2] illustrates how far we’ve moved away from that credo.

Let’s take a look at some numbers highlighted in the report. As of 2014, global debt stood at $200 trillion[3]. Total debt has actually increased $57 Trn since 2007, and the Global Debt:GDP ratio now stands at 282%. In other words, for every $1 in annual income generated globally, the stock of debt stands at $2.82. What is perhaps even more surprising than the raw numbers is the fact that a great deal of debt accumulation has occurred since the Financial Crisis hit global economies in 2007-08, a crisis that was driven primarily by, er, debt.

Concurrently, despite all this build-up in credit, we are in world of puzzlingly low interest rates. In the U.S., with a robust economy and low unemployment [4], the policy (“Fed Funds”) target rate is at 0-0.25%, while 10-year government borrowing is oscillating around 2%. In Europe around one-third of Eurozone government debt is at negative rates (in other words you pay the governments for the privilege of lending to them). Japan continues to see ultra-low rates, as it has for two decades: 10-year Japanese government bonds yield 0.3%. Emerging Market debt is yielding higher, but there are signs of downward pressure.

This raises a number of questions, not all of which I’ll try to answer in this article:

How much debt is ‘too much’? Why are interest rates close to zero? Why isn’t inflation shooting up?

How much of society’s wealth and prosperity is dependent on these high levels of debt?

Can OECD nations really be seen as an aspirational economic model for Less Developed Countries, given the amount of debt overhang in OECD countries?

Who owns all this debt? Does debt really matter?

Firstly, there’s a case to be made that the debt level in and of itself is not a primary concern. For every borrower there’s a lender; for every $1 in debt there is a corresponding $1 in a financial asset. So at a societal or global level, all debt and lending cancels out.

Let’s say I owe my neighbor $1 mio. and they owe me $0.7 mio. (so that my neighbor has a net exposure of $0.3 mio. on me) and that our respective positions are as follows:

So in this micro-economy, the gross debt stands at $1.7 mio., but a simple way of reducing this is to net out our obligations (by “deleveraging”), so that I end up owing $0.3 mio. to my neighbour. Suppose we do this by mutual agreement, in order to cancel out $0.7 mio. of the debt for each of us. The balance sheets now look like this:

Note that in both before and after cases, the “Net Worth” of this economy is still $0.2 mio. My neighbor still has a net exposure of $0.3 mio. on me.

So with a little bit of negotiation we have reduced the Net Debt in the economy by $1.4 mio. or 82%.

Finance theory also offers similar insights. Some of you may remember from introductory Corporate Finance the Modigliani-Miller (M&M) proposition, which states that the value of the firm is independent of the amount of debt used to finance its operations. A higher level of debt (which has lower financing costs than equity) increases the financial risk of the firm, which raises the required return on equity and as a result the weighted average cost of capital remains unchanged.

Both my dual-actor economy and the M&M theorem are, of course, highly simplified representations of the real world. Even Modigliani & Miller came up with a modified proposition (can we call it 3M ?) that incorporates the effect of taxes [5], and later variations incorporated real-life issues including information asymmetry and bankruptcy costs.

Now let’s introduce a third actor into the micro-economy – a bank – that intermediates between my neighbour and I, and that the balance sheets are as follows:

Assuming that the bank is risk-free (a not unreasonable assumption given that governments explicitly or implicitly backstop or guarantee depositor funds), my neighbours have eliminated any financial risk from their balance sheet by investing in a bank deposit, rather than lending to me.

Let’s analyse the situation in the event I default or am unable to service my loan. In the non-bank scenario, it is difficult to imagine my neighbour being able or willing to countenance legal action to recover their funds. I may have a personal relationship with them; and they may not have the access to legal and other resources required to prosecute and take possession of my house. A likely scenario therefore is that we arrive at an arrangement whereby the loan continues until I am able to start servicing it again. In other words, there is a form of risk-sharing, which perhaps my neighbour is not comfortable with.

However in the second scenario the bank is likely to take a more legalistic and hardline approach to recovering their money, given that they have already guaranteed that my neighbour’s funds are ‘safe’. They are likely to have the loan agreement structured in a manner that allows them to repossess the house; and they are likely to have stronger legal resources to facilitate this process.

So let’s assume the bank succeeds in evicting me from my house and taking possession. The bank has little need of a house so they are likely to sell the house, realize the proceeds, and incur a loss of $0.1 mio.[6]. This loss will be backstopped by the bank’s shareholders; or if they are unable to do so, by the government.

On the surface it appears as though the bank-free economy performs better. In their role as a middleman the bank performs an important function in disintermediating credit (and liquidity) risk. In the first instance, my neighbour may not be willing to risk their savings by lending to me (hence preventing me from buying a house), and therefore the bank’s role in disintermediation is crucial in channelling funds from those that have capital (my neighbour) to those that need capital (me).

Let’s look at this further. The act of my defaulting on the bank loan ultimately triggers the sale of my house, which will undoubtedly add to selling pressure in the housing market, which will reduce house prices. And in what conditions am I likely to default? There may be personal issues involved but a likely cause of my default would be a weak economy. So if economic conditions worsen, the chances of my having to default increase, which add to downward pressure on the housing market, which may trigger bank losses, leading to the bank calling in some marginal loans to reduce their risk and exposure … you can see that the structure of credit in a modern economy is highly precarious and there exists what economists call “procyclicality” : negative events are compounded and exacerbated in a downward spiral. The flip side of this is when the good times roll: there is a virtuous circle of rising asset prices, leading to more debt as economic actors try to take advantage of rising prices. A boom-bust cycle is built-in to our economies. 7 years of plenty followed by 7 years of famine, as the Bible predicts [7].

Governments and regulators have been caught in a bind. They need economic growth in order to deliver on promises to their citizens for greater prosperity; and an excellent way of boosting growth is to increase debt levels. However as we have analysed, higher debt levels increase the systemic risk in the economy and increase the likelihood of a slump in the future. So we have muddled along, not quite able to grow out of sluggish growth conditions, while continuing to increase debt levels.

Central Banks have not been passive observers but have been actively promoting growth in the monetary base and hence debt levels. Actions by the U.S. Federal Reserve (Quantitative Easing, or Q/E) has already raised U.S. money supply by over $4 Trillion; the Bank of Japan and now the European Central Bank are in the process of increasing the money supply by similar amounts.

Q/E is similar to printing money. It increases the amount of money in the system without a corresponding pullback in other forms of credit. You would think that with all this extra money sloshing around the system, price levels or the rate of inflation would increase. In fact we’ve seen precisely the opposite happen for the large economies, with deflation a greater concern that inflation. This has actually created a lot more room for the authorities to spur economic growth via debt creation, since they do not have the spectre of inflation hanging over them.

The answer to this conundrum lies partially with the way credit has been used. The hope has been that loosened credit conditions would lead to more productive and employment-generating activity, such as investment in factories, physical infrastructure, startups, etc. Instead, credit has generally flowed to financial assets and housing/real estate. China is a significant case in point; as McKinsey notes, Chinese borrowers have added nearly $21 Trn in debt since 2007; and nearly 45% of Chinese non-financial debt is directly or indirectly related to real estate. So this has helped inflate (or in many cases, prevent deflation in) the prices of such assets. Remember the primary cause of the crash was over-investment in the U.S. property market[8] and so the extra liquidity and price support for the housing market has helped repair household and financial-sector balance sheets. Equity and bond markets are also outsize beneficiaries of Central Bank actions.

The central bankers’ reason for money creation is, however, not to create stock market bubbles but to spur lending to the SME (small and medium enterprise) sector, and so that large companies deploy cheap funding into capital intensive projects, with the ultimate aim of boosting employment. (The World Bank estimates that SMEs provide 2/3rd of all jobs in the Eurozone economy). In meeting this objective the central bank monetary stimuli have – by and large – failed. Capital formation remains at historically low levels, and SMEs are finding it as tough as ever to raise funding[9]. Banks have tightened credit standards as tough capital rules affect lending capacity in another example of procyclicality[10]. While banks in the Eurozone and elsewhere are flush with central-bank created liquidity, much of this is turned around and placed back with the central banks or in government debt rather than lending to the private sector. This, as Keynes observed when commenting on the limitations of monetary policy, can be likened to “pushing on a string”: you end up going nowhere.

McKinsey offers some worthy solutions to coping with the high levels of debt, including altering mortgage contracts in order to encourage more risk-sharing; improvement in debt restructuring processes; and counter-cyclical regulatory measures such as reducing reserve-requirements on banks during an economic slowdown (the phrase-du-jour used by economists is “macro-prudential policies”).

On a macro-level, debt does matter, although what policy-makers now need to focus on is how to improve the means of transmission of credit through the economic system, rather than on increasing the money supply.

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End of Article

Footnotes:

[1] William Shakespeare, Hamlet, Act 1, scene 3

[2] McKinsey Global Institute, “Debt and (not much) deleveraging”, Feb. 2015. Downloadable from http://www.mckinsey.com/insights/economic_studies/debt_and_not_much_deleveraging

[3] The report mentions $199 Trn, but what’s a trillion dollars between friends?

[4] At around 5.5%, this is close to what the Federal Reserve itself views as the non-inflation accelerating level of employment

[5] The fact that interest payments are tax deductible, and dividend payments are not, result in a higher equity value if debt levels increase, up to a certain point

[6] Assuming they are able to sell at market value

[7] The Old Testament, Genesis, 41

[8] The 4 countries most affected by the bursting of the housing bubble were the U.S., U.K., Ireland and Spain

[9] The World Bank estimates that 50% of SMEs in high-income countries, and 20% in Low- and Middle-income countries, have access to a loan or line of credit from the formal financial sector. Please refer to http://datatopics.worldbank.org/g20fidata/topic/sme-credit

[10] At a time of sluggish economic conditions, banks are being forced to tighten lending standards – and hence reduce credit in the economy, which amplifies the downturn