There's a Surplus of Worry About Debt
There continues to be a steady drumbeat of editorials and essays warning about the danger of too much private debt. One of the most articulate and thorough of these was a recent op-ed by Richard Vague in Democracy Journal, arguing that excessive debt levels are putting the world in danger of a big economic crisis.
But this worry is likely overblown. With the important exception of China, private debt levels probably aren’t a big worry right now.
We have a tendency to worry too much about debt. We like to tell ourselves a simple story that I once called the “folk theory” of business cycles -- an economic boom is accompanied by a rise in debt, but that debt then causes a crash, leading to an economic bust. The story resonates with many of our deepest intuitions -- what goes up must come down, profligacy leads to penury and the sins of excess are punished by deprivation.
The problem is that the economy doesn’t have to fit with the general life intuitions we’ve evolved over the centuries. To take a well-known example, private debt has to be paid back at the individual level, but not in aggregate. Debts net out. If I borrow $100 from my friend Jessica, Jessica borrows $100 from Michael, and Michael borrows $100 from me, none of us is going to have to suffer or cut back when all the debts get repaid. This is just one way that personal finance is different from macroeconomics.
This isn't to say, of course, that debt can’t be dangerous. It can. Studies show that financial collapses that follow a big rise in credit levels tend to be more severe than others. Economists have a number of theories for why this might be true, but it does seem clear that debt can interfere with the smooth workings of an economy.
But in terms of telling when a recession is going to come, it’s likely that the quality of debt is more important than the quantity. Economists who forecast recessions have found that indicators of bad debt, like term spreads and the percentage of high-yield debt, do predict recessions, but debt levels themselves don’t yield much additional information.
Outside of academia, what analysts often do is simply to draw graphs showing increases in debt levels. This is what Vague does in his op-ed. He shows long-term graphs of debt-to-gross-domestic-product ratios for selected countries, going back 60 years or more. One of his charts goes back to 1740! Everywhere we see the same trend -- economies with higher debt-to-GDP ratios.
But if a trend can more or less continue for three centuries, we should be a little wary about claiming that it’s going to end soon. How far the world can push that trend is unknown -- maybe there’s a limit, maybe there isn’t one. But it certainly should make us very skeptical of claims that the jig is almost up.
The real question is: How much debt is too much? Is it 200 percent of GDP? How about 300 percent? No one knows. Somehow, most countries have managed to keep their debt numbers growing overall since the dawn of the modern age. What looked like an unthinkably high debt level a century ago looks safely low in 2016. Will current ratios look similarly low to our great-grandchildren?
Many claim that rapid short-term increases in credit, not high levels, are the true danger. But short-term debt trends are little changed or declining for most of the major economies. Here are the recent trends for a number of developed countries, as well as for the world as a whole:
Most of the major developed economies, as well as the world at large, have seen little changed or declining private debt levels since the crisis. In other words, even if a short-term increase in credit levels really does pose a threat, that threat is not now present in most countries.
So while there are a few good reasons to worry about debt, the danger is exaggerated.
The big exception -- which Vague rightly spends a lot of time talking about -- is China. China’s private debt levels, especially corporate debt, have increased extremely rapidly in recent years. More troubling, the quality of the credit seems to have deteriorated. That signals that a downturn may be in China’s near future. The rapid run-up in debt also indicates that a Chinese asset bubble collapse, especially in the property market, would likely be very hard on that country’s economy. It could also spread a good deal of pain to other parts of the world.
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