Luigi Buttiglione, Philip R. Lane, Lucrezia Reichlin and Vincent Reinhart write,
Contrary to widely held beliefs, the world has not yet begun to delever and the global debt-to-GDP is still growing, breaking new highs. At the same time, in a poisonous combination, world growth and inflation are also lower than previously expected, also – though not only – as a legacy of the past crisis. Deleveraging and slower nominal growth are in many cases interacting in a vicious loop, with the latter making the deleveraging process harder and the former exacerbating the economic slowdown. Moreover, the global capacity to take on debt has been reduced through the combination of slower expansion in real output and lower inflation.
Much of the debt increase has taken place in emerging markets, notably China. I remain suspicious of aggregate debt-to-GDP numbers as an indicator. Indeed, the paper speaks to many of the issues with this measure that trouble me). However, the authors make a reasonable case to worry about two risks. One is that any adverse economic development will be multiplied by the defaults that result from high leverage. The other is that a “confidence crisis,” in which creditors lose faith in some debt instruments, becomes self-fulfilling. As the authors put it,
we outline the nature of the leverage cycle, a pattern repeated across economies and over time in which a reasonable enthusiasm about economic growth becomes overblown, fostering the belief that there is a greater capacity to take on debt than is actually the case. A financial crisis represents the shock of recognition of this over-borrowing and over-lending, with implications for output very different from a ‘normal’ recession. Second, we explain the theoretical foundations of debt capacity limits. Debt capacity represents the resources available to fund current and future spending and to repay current outstanding debt. Estimates of debt capacity crucially depend on beliefs about future potential output and can be quite sensitive to revisions in these expectations.
This report came out two months ago, and I do not recall it getting much play. I think it deserves your attention. Read the whole thing. For the pointer I thank Jon Mauldin’s email newsletter.
2.5% of our economic activity is tied up covering the interest costs of the US government. That is a restriction on the available combinations of chaos that is available to be sorted out with the PSST model. The US government is debt bound. Any inflation close to 2.5% causes a slowdown, so we are headed toward deflation. Some economists think we have too much loose money, but it is a little different, we have too much money fixed into a circular path of interest payments. Anytime government tries more debt it comes to the debt market with a huge bundle of rollovers so the effect on interests costs are magnified.
One really needs to consider both debt and debt service. Falling debt service will lead to more debt which only leads to issues if rates rise and debt is rolled over, but rising rates generally mean greater investment opportunities as long as there is not a lot of foreign denominated debt. Debt can represent a disparity of expectations between borrowers and lenders who would otherwise choose equity. Rising debt and rising debt service are unsustainable long term though rising debt can mask rising debt service for a while by boosting growth.