When Debt Gets in the Way of Growth
Posted on Harvard Business Review: September 13, 2011 10:35 AM
This post is part of the HBR Insight Center Growing the Top Line.
Debt is good for growth, but only up to a point. Thanks to a simple and powerful article from three economists at the Bank of International Settlements in Basel, we now know at what point a good thing becomes too much.
Debt is good for growth because it allows people and companies to transfer money over time. By borrowing, you can mobilize your earning capacity to buy a car that you can’t pay for in cash right now. That’s good for the economy because it means that more people can now buy cars, so car companies will employ people to build them and so forth.
But if you start borrowing too much, then you become vulnerable to financial distress. If you lose your job, you will struggle to pay off the car loan, so you will cut your spending, and may even have to sell some other asset to help pay off the loan.
The challenge, of course, is working out just how much debt you can safely take on before it becomes economically counterproductive.
At the national level, this is what Stephen Cecchetti, M.S. Mohanty, and Fabrizio Zampolli decided to find out. They gathered 30 years of data on levels of household, corporate, and government debt for the world’s major developed economies, and they subjected the data to regression analyses against economic growth. What they found was that once government debt amounts to more than 100% of GDP, corporate debt more than 90%, and household debt more than 85%, further indebtedness reduces a country’s ability to grow.
Why is this newsworthy? Well, for a start, the paper points out that in the U.S. public debt already amounts to 97% of GDP, corporate debt 76%, and household debt 95%, so it’s on two of the thresholds already. The picture in Europe is mixed. At 77%, 100%, and 64%, Germany looks reasonably healthy. But at 89%, 126%, and 106%, the UK looks in trouble. The most indebted country on the list is Japan: 213%, 161%, and 82%. These numbers go a long way toward explaining its chronic inability to grow.
The actual thresholds will vary according to a country’s economic characteristics. But it turns out that the most important characteristics are demographic. Countries with an aging workforce are less able to support high debt levels than countries with younger workers because younger workers produce and save while retired people draw on savings and by and large do not generate wealth. This is hopeful news for America — where immigration keeps the workforce numbers up in a variety of ways — but disastrous for Germany and Japan.
Whatever the profile, the scope for governments in developed countries to deliver growth through borrowing and spending is limited; anyone who tries to tell you it isn’t needs their head examined. In fact, from a debt perspective, spending cuts and limits on borrowing are needed. The trouble is that that’s bad for growth as well.
The only thing that seems to be unequivocally good for growth is making it easier for companies to hire and fire younger people. You could argue that it’s a smart way to transfer some of the rosier future growth prospects of developing economies with young populations. But that’s all too often a political no-no, and I suspect harder for politicians to ignore than an economic yes-yes.
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