How Much Debt is Too Much Debt?
There is a lot of confusion as to what « money » really is, how it is created, and how economies end up with high or low inflation rates, and appreciating or depreciating currencies. There is a link between debt and inflation. Read this to finally understand how it is all linked and get a synthetic analysis of many individual countries and their potential for growth going forward.
The process from money to credit to inflation
Money is created in 2 ways: 1) when commercial banks lend money to people and businesses and 2) when the central bank buys financial assets or prints money to finance government spending (which is equivalent to buying government bonds). I will not make the distinction between “base money” and effective money supply to keep things down to earth and simple for all to understand…
The created money “ends up” either in purchases of goods and services or in asset demand (bonds, stock, currencies, etc), which in turn create inflation or asset price bubbles, which is just “inflation” in another form: asset price inflation instead of inflation in goods and services.
We are thus in a credit money system: a bank lends 500k to a person to buy a house and “voilà”, you have 500k of newly created money. Prices of houses, TVs, cars, food, and other stuff remain relatively unchanged for a while, and people have more liquidity to spend due to all this newly created credit, which causes extra demand for goods and services, which pumps up production activity and wages, and adds inflation.
To simplify, suppose we give 1 million dollars today to every adult in the USA. For a short period, people would be “rich”, because prices of goods and services would still not have adjusted. People would start buying more houses (maybe for investment), bigger houses, cars, TVs, Iphones, restaurant meals, stocks, etc. All this would boost demand and producers would face rising costs for labor and other costs, plus they would face strong demand… prices would rise until the “magic of money creation” fades away, and all wages, prices, and transaction amounts would simply have more zeros, without any permanent effect on standards of living, innovation, or jobs.
One detail is missing to complete the picture. Suppose the extra demand created by the newly created money is easily met with huge supply. In other words, the economy produces LOTS of stuff easily. If you produce more stuff, that stuff loses value, which is simple supply and demand: supply increases and prices tend to drop. So extra money creation causes prices to rise and extra production causes prices to drop… the NET EFFECT is that inflation will be approximately the DIFFERENCE between the pace of credit creation and real output growth. So if there is 5% extra credit money created and 3% real GDP growth, you will get roughly 2% inflation.
More credit = more inflation
We now understand that to get rising inflation, you need more debt. Debt can be financed by savings or by credit money, which is essentially created (or influenced) by central bank policies. That debt could be corporate debt, government debt, or household debt… In other words, government debt and private sector debt.
A country with rising total debt that is financed by central bank policy will eventually have rising inflation. A country with flat or falling debt will have low inflation. But a country with rising debt that is caused by high household savings will NOT have significant inflation (China), because it is not created by extra money.
Countries with rising savings will typically NOT display lots of inflation, unless the central bank is “printing like crazy.” When a country has a high savings rate, those savings “land” in the domestic market in the form of 1) land and housing activity and land and house price inflation 2) stock price inflation… or all those savings fuel asset demand in OTHER countries, in which case the entire economy is buying assets in the rest of the world, for example Chinese individuals buying stock or houses and condos in the USA, Australia, Canada.
To get an idea of the inflationary potential of a country, we can thus compare current total debt levels to others and to its own history to know if there is “space for more money (credit) creation.” A country with a low total debt level with potential for credit expansion will have more potential for credit expansion and economic activity, hence more potential for inflation.
How much debt is too much debt?
Suppose a person earns 100k per year and borrows 500k to the bank to buy a house. The debt ratio of this person is 5:1, that is 5$ of debt for each income dollar, which is 500%. This is a bit high, but not abnormal. The ratio of debt to asset value is 1, as the house is worth 500k (suppose), hence covers the debt. If the value of the asset (the house) that covers the debt takes a dive due to a crash, then the debt-to-asset-value ratio could rise to unsustainable levels. This is what happens when a bubble pops, either in housing or any other market.
Another thing to keep in mind is the debt service, which is how much of the annual income currently goes to making debt payments (interest + principal) and what will this ratio be in the FUTURE. If this ratio is low, making payments is no problem, but one also must keep in mind the future, because racking up 500k of debt can be done in one afternoon, but paying 500k in debt can take a LOT of time, especially if the asset you purchased can’t be sold or lost half its value!
This same logic kind of applies to entire economies, including governments, although it is a bit more complex, because governments and “the entire economy” can spread the payment of the debt over a longer time horizon than the individual.
Too much debt is a point where making debt payments drains a large percentage of current or future annual income. If your debt is “productive” such as debt used for human capital, innovation, capital accumulation such as machinery or infrastructure, adding debt increases future income and the extra debt need not be a problem, but if your debt is not productive, extra debt could bring problems down the road. Since a lot of extra debt in the past decade has been related to housing and government deficits, it is not clear to me that the extra debt we are accumulating is “productive.” If it is not, we could end up with eternal stagnation and low-growth economies, with ever-increasing pressure to boost asset prices…
If your debt payments grow more than your total income, you know you have a problem. Take Japan, for example: government debt-to-GDP ratio is 250% as of 2017. The government has NO problem with this for now, because the interest rate is essentially zero, which means the debt service is zero. Now suppose the interest rate rose to only 1% (not likely). That would mean the government debt service alone would represent 2.5% OF GDP PER YEAR, which is significantly more than annual growth for Japan… this would eventually become problematic, because the government would have to tax the economy to death OR print so much that inflation would explode and the currency would crash.
Eternal debt accumulation without extra production means the debt is not used for production and is fueling either inflation or asset demand and asset bubbles.
Who owes what to who?
The last part of the puzzle to put in place is to get some idea of who owes who? Does the government “owe” money to its own central bank? If so, this is really money owed to itself, since the central bank is a government institution. In an extreme case, if there is no inflation, the central bank could even buy all government bonds to finance the government and then tell the government to just “forget it” and eliminate all or a big chunk of the government debt that the government owes to itself through borrowing from the central bank via money creation.
People and businesses borrow from the private sector, domestic and foreign. The government borrows from its own central bank, from the domestic private sector, and from foreign entities (private or public). The more the entire economy “owes to the rest of the world”, the more it is exposed to fluctuations in the demand for its assets, hence to capital flight risk and a currency plunge. Note that this does not apply to the USD, as the usd is the world currency for global market transactions in debt and commodities, which adds extra complexities to the US case.
To the risk of oversimplification, I will say that we can at least get some “general idea” of the net debt position of the entire economy by looking at the “NIIP” (net international investment position) relative to GDP. A positive number means that the rest of the world “owes” the economy more than the economy “owes” to the rest of the world and a negative number means that the entire economy “owes” more to the rest of the world than what it can claim from the ROW. In reality, NIIP is not just standard “loans” — it is made up of all kinds of asset exchanges. For example, if a German buys stock from the US stock market, that German gets a “claim” on future US income, which makes NIIP increase for Germany and decrease for the USA.
When I say “the entire economy”, I mean all private and public institutions, individuals, banks and other financial institutions, corporations, etc. A country that imports more than it exports year after year after year will have a growing net international debt (negative NIIP) and a country that exports more than it imports for long periods of time will have a growing net international claim on future income of other countries (positive NIIP). Note that you can build domestic prosperity by borrowing huge amounts from the rest of the world: you borrow at 2% and the real total economic return in your economy is 3% — this is no problem. However, if the use of borrowed money is not “productive”, you will eventually get problems…
Who has growth and inflation potential?
A country has growth and inflation potential when it has space for credit expansion and basic growth dynamics such as demographics and productivity. If people and businesses do not “borrow” for whatever reason, you will not get credit expansion and you will not get inflation down the road. Sometimes the potential for credit expansion is limited simply because the economy is already saturated with credit, which happens after a period of credit binge.
To get a synthetic picture, I looked at the buildup of private debt-to-GDP and government debt-to-GDP from 2007 to 2017 and I looked at NIIP and the current account. Below are the results. I will comment further below… note that these come from my own simple calculations with data from TradingEconomics.com …
Making sense of the data
Countries with “very high” debt levels are less likely to have EXTRA debt levels in the future, which means the higher the current debt load, the lower the probability of future economic activity and inflation. This can signal that current interest rates will soon rise due to current inflation (hence putting a damper on credit and inflation going forward) OR it can signal a situation where you have lots of debt and nobody wanting to add extra debt (government, households, businesses), even at zero interest rates… a situation where standard central bank policy has weaker impacts on the economy due to the “credit channel” being saturated, which leaves export-driven expansion as the only viable option, which suggests depreciation of the currency. Looking at the data, some countries stand out on both sides of the spectrum…
Germany and Switzerland have low total debt and strongly positive current accounts and NIIP, suggesting pressures on those currencies towards appreciation and low risk of economic catastrophe.
Japan and Portugal have stratospheric debt levels on both private and government sides. Portugal may have a tough time going forward, because it has a saturated debt market AND it shares the Euro with Germany and others. To bring back the macro picture a bit more in balance, the Euro would need to appreciate to decrease the excessive German CA, while Portugal may find things hard if this happens, as the over-indebted domestic economy can’t grow through consumption or government spending with all that debt and an appreciating currency would extra negative pressure via falling exports. Japan will run out of options soon and the only one left will be to print jpy and buy other currencies to depreciate the Yen and get some growth from exports, but that will cause import-push inflation and problems down the road. With its aging demographic outlook and sky-high debt loads on all sides, the only final solution for Japan seems to be for the central bank to buy LOTS of government bonds and then to simply forgive that debt…
The USA still has room for private sector debt expansion, hence room for inflation in the future due to potential extra debt buildup. This economy can grow significantly before hitting a wall.
One country currently has a high total debt load AND exhibited strong credit growth in the past decade: Canada. This country simply can’t continue at this pace for much longer and a slowdown in credit expansion and domestic demand is probably in the cards going forward (which could be counter-balanced by a depreciation and a rise in exports). This is contrary to Germany or even the USA and most others, who had some deleveraging on either the private or public side or only modest overall credit growth.
In the end, inflation is linked to credit expansion. Credit is created by the meeting of credit supply (savings or money indirectly or directly created by the central bank) AND demand for credit from households, businesses, and the government. If the government doesn’t spend more and is keeping a tight control on deficits AND households AND business do not want to borrow, there simply is NO money expansion and hence no inflation and low domestic demand, which could be “counter-balanced” by strong export growth following a depreciation, when that is a possibility. When the central bank “prints” money that does not become credit and inflation, that money ends up in asset bubbles, either in financial markets or housing or as huge supply in the forex market, thus driving down the value of the currency. Either way, you are asking for trouble down the road if it does not follow a balanced path.
For now, Germany and Switzerland seem very solid, while Canada and Portugal seem a bit fragile, and Japan, well… I am not sure what to say about the situation for Japan… Like and share!
Pascal Bedard
pbedard@yourpersonaleconomist.com
