Now that everyone in the western world (households, firms and governments) is desperately trying to reduce his level of debt, it might be useful to ask a couple of fundamental questions. What impact will this process of debt reduction have on things like growth and inflation? Is there a substantive difference between the effects of deleveraging in the short term and in the medium to long term? Finally, how much debt-reduction is really desirable from current levels? Put differently, is it possible to identify optimal debt levels (from a macro-perspective) for different groups like households and sovereign governments?
In a recent working paper published by the Basel-based Bank for International Settlements, titled “The Real Effects of Debt, September 2011, Stephen Cecchetti”, M S Mohanty and Fabrizio Zampolli try to answer the third question. Though some of their more qualitative insights (such as the fact that moderate levels of debt improves welfare, while higher levels of debt are damaging) are hardly earth-shaking, the important thing is that the authors arrive at quantitative thresholds beyond which debt goes from being “good” to “bad”. From a financial markets perspective, this insight is likely to be extremely useful in trying to, for example, rank the vulnerabilities of different economies to a debt crisis and then pricing these into assets like sovereign or corporate debt.
The funny thing about debt is that while its level has increased exponentially over the last three decades (for advanced economies it has gone from 167 per cent of GDP in 1980 to roughly 314 per cent today if the liabilities of households, companies and governments are added up), the academic literature on debt and its consequences has been sparse and typically confined to the periphery of mainstream theory. That is obviously changing now as economists feverishly work to weave the experience of the past five years into a robust theoretical model. However, instead of waiting for an elegant theory to emerge, the authors get into the trenches of empirical work. Using data for 18 OECD countries for the 1980-2006 period they identify thresholds beyond which debt begins to hurt, that is, an increase in debt levels above these limits begins to reduce the trend levels of growth.
Cecchetti and company find that for government debt this threshold is 85 per cent, while for corporate debt it is about 90 per cent. The authors are less sanguine about household debt but arrive at a tentative threshold of 85 per cent. If we compare the actual levels in different economies against these thresholds, we get some predictable results and some that surprise. For instance, we all know that Japan has extremely high levels of corporate and sovereign debt. What is not so well known is the fact that the UK busts the thresholds for all three debt categories and qualifies as one of the most vulnerable economies in the developed world. Again, while we tend to fret over the debt positions of the European periphery, it is alarming to see that economies such as Denmark and the Netherlands are sitting on mountains of domestic and corporate debt that are significantly above thresholds.
This does not, however, mean that we can take our eyes off Europe’s periphery. Portugal, the latest in line for a possible increase in assistance, fares badly not only in terms of its sovereign debt position but also in terms of household and corporate leverage. This is in contrast to Greece whose sovereign debt level is high but household and corporate debt levels are well in check.
One clear implication of the paper is that the debt problems of the western world go much beyond the current crisis. For one thing, as the authors point out, public debt levels are likely to rise as populations age and governments try to deliver on the promises (pensions, health care and so on).
|DEBT THREATS (Debt levels as a % of GDP)|
|Source: Bank for International settlements & Eurostat|
As public debt levels rise beyond the “danger threshold”, they will tend to pull growth down. This, in turn, could make household and corporate debt servicing far more difficult and countries that are already saddled with dangerously high levels could find themselves in the middle of a crisis. Thus, even if there is a solution to the current crisis in Europe, the “debt” problems of the western world are far from over.
What worries us about the spirit of good cheer that has suddenly returned to the markets is that it might lead to temporary appreciation in the euro. This, alas, could bring back the spectre of a crisis in the region and revive fears of a break-up in the currency union. One of the pre-conditions for the survival of the union is an orderly deprecation of the currency towards some sort of “fair value” that we think could lie anywhere between 1.15 and 1.20. This would make the beleaguered countries of the periphery more competitive and reduce their incentives to exit from the union. If the currency starts to appreciate again, things go back to square one and the sustainability of the union is back under a cloud of uncertainty. Financial markets tend to be prescient about these things and it is possible that while other currencies and assets rally against the dollar, the euro could at least stay put.
The authors are with HDFC Bank. These views are personal