By Richard Vague, Managing Partner, Gabriel Investments
Why does the IMF keep badly missing its global growth forecast? And what does that have to do with the 2016 presidential elections?
In the years since the 2008 global crisis when the world’s growth rates tumbled, the IMF has dutifully printed forecast after forecast showing rebounding growth rates, but
One of the key and largely overlooked reasons for this disappointing growth is the increasing global burden of private debt—the combination of business debt and consumer debt. Even though government debt gets all the headlines, private debt is larger than government
Private debt is a beneficial and essential part of any economy, however, as it increases it can bring two problems. The first is dramatic. Very rapid or “runaway” private debt growth often brings financial crises. Runaway private debt growth brought the 2008 crisis in the U.S., the 1991 crisis in Japan, and the 1997 crisis in Asia, to name just three. (And just as runaway debt for a country as
The second problem it brings is much more subtle and insidious: when too high, private debt becomes a drag on economic growth. It chips away
Stagnant incomes, underemployment, and job insecurity are key reasons so many voters in Europe and America are willing to embrace candidates outside of the mainstream. But the now-stultifying level of private debt, and the accompanying impact on
When private debt is high, consumers and businesses have to divert an increased portion of their income to paying interest and principal on that debt—and they spend and invest less as a result. That’s a very real part of what’s weighing on economic growth. After private debt reaches high levels, it suppresses demand.
Some economists have dismissed this impact since interest rates are low. However, most middle and lower income households (which is where the highest rate of debt growth has been), as well as most small and
This all takes a bite out of spending and investing.
A side note on rates. The very fact that businesses and households are highly leveraged has a suppressing effect on rates for two key reasons. First, because they are highly leveraged, they have less ability to borrow more and are often wary of borrowing more. That decreased demand for credit results in downward pressure on rates. Second, when there is more debt, rising rates have a greater braking effect on the economy—if there is twice as much debt in the country, a Fed-engineered rate increase has twice the braking impact.
The unprecedented amount of our global debt glut is underscored by the creeping presence of negative interest rates—a situation where the borrower, unbelievably enough, gets paid for borrowing. An estimated 15 percent of European corporate debt issued now has a negative interest rate. If the massive glut of debt is the culprit that is curbing demand, then perhaps this Central Bank experiment with negative rates is the inevitable response to this $150 trillion glut. But these negative rates are not available to low and
U.S. private debt growth has disproportionately impacted the least well-off Americans. In fact, since 1989 (the year the Fed started a survey of this statistic), the debt level of the 20 percent of U.S. households with the lowest net worth has grown two and a half times faster all other households. And for all the talk of consumer deleveraging after the crisis, household debt to GDP is still 13% above the level in 2000, and 60% above the level in 1980.
As mentioned, GDP roughly equates to the aggregate spending and income of the businesses and households in a country, and the private debt of a country is the sum of household and business loans. So to speak about the “private debt to GDP ratio” of a country is essentially the same as speaking about the “private loan to income ratio” of that country. You’ll recognize that
It follows directly that of a country’s private debt to GDP ratio is low, let’s say 50%, then the households and businesses in that country generally have low loan-to-income ratios and are well-positioned to power growth through increased leverage. And if a country’s private debt to GDP ratio is high, let’s say 200%, then the households and businesses in that country are generally overleveraged —they have on average very high debt ratios and are much less likely to be able to boost growth through more borrowing.
We saw in chart 2 that private debt to GDP in major economies has been growing rapidly since World War II. However, it has been growing in size relative to GDP for a lot longer than that. It’s a process often described by economists as “financialization” or “financial deepening,” and usually explained as simply the maturation of a market. But as we have seen, it is much more than that—it is instead the path from low leverage to overleverage for the participants in that economy. The benefits of increasing leverage from low levels
You can see that all six countries show more moderate levels of private debt in the early years of this period and much higher levels today, punctuated by private debt crescendos at pivotal moments along the way—the French Revolution, the crisis of 1914 that began immediately prior to World War I, the Crash of 1929, Japan’s Crisis, and the Great Recession. These crescendos are often followed by periods of rapid and painful private debt deleveraging, such as during the Great Depression and World War II. Notwithstanding the peaks and valleys along the way—all instructive and worthy of deeper study—the general trend is toward higher levels of debt. And the world has now reached a point where combined global government and private debt to GDP is the highest by far in history.
As mentioned, short bursts of runaway growth in private debt have often led to
Importantly, the role and importance of private debt
Because this private debt burden suppresses spending and investment, growth rates in the U.S., Europe
As we forecast in this journal in early 2015, China is now beginning to suffer the consequences of its recent private debt binge. Since 2008, it has poured on $18 trillion in new private (or non-government) loans. The proverbial chickens are now starting to come home to roost. In the summer of 2015, China's stock market collapsed by 45 percent. Its economy is decelerating. Its skyrocketing private debt ratio has now reached 231%, bringing a level of overcapacity that makes a continued slowdown in its growth inevitable in order for demand to catch up to a now-staggering oversupply of housing and commodities.
As recently as 2011, China’s growth rate was 15%, but is declining and is now reported by Chinese authorities as 6.7%, though many prominent analysts believe it is 4% or less. In its rush to grow, China has simply built far too many buildings, and produced far too much steel, iron, and other commodities—and made far too many bad loans in the process. Its overcapacity is so pronounced that it will be years for true demand to catch up with this oversupply. That’s a central part of the reason the IMF keeps
There is, however, a major complication in all this: in spite of all rhetoric to the contrary from its leaders, China is compounding the problem by fully continuing to overlend and overproduce, albeit with diminishing returns. China’s loans have grown almost a trillion dollars in the most recently reported period alone, and they are still producing 40% more steel than the world needs. In continuing this trend, they are taking a problem whose size and scope is unprecedented and making it all that much bigger
In fact, the IMF recently reported that fully $1.3 trillion of corporate loans in China, or one-seventh of the total, are
Because China is still pouring it on, it continues to boost some growth and provide some support to commodity prices, however, in so doing, its eventual problem will be both worse and longer lived. Remember that Japan’s crisis of the 1990s took eight years to unfold—after very high GDP growth in the 1980s fueled primarily by runaway lending, Japan suffered a stock market crash in 1990, then a real estate collapse in 1991, and finally a bank rescue in 1998. And Japan has posted twenty years of near-zero growth since that rescue.
China’s ultimate problem is two-fold. First, its growth rate will continue to slow to very low levels, perhaps, similar to Japan, for as long as a generation. Second, the oversupply will continue to mean downward long-term pressure on major non-agricultural commodity prices—deflation. Not just for China but for the world.
This slowdown in growth will spill over to the rest of the world— contributing to the continued mixed growth results in the U.S. and Europe. China’s unfolding crisis will not have as big an impact as the 2008
The most immediate impact of China’s slowdown will be a dampening of the economy in other parts of Asia Pacific, such as South Korea, Australia, Thailand, Vietnam, Singapore
Africa and South America will continue to be profoundly impacted
All in all, the world can be characterized like this: The U.S., Europe, Japan, and China—the big four—together constitute almost 65% of world GDP. These four have collectively been the engines that have powered global growth in the post-World War II era. But of these four, only China has shown rapid growth in recent years. China’s growth is now decelerating and will trend much lower in coming years. All four are now overleveraged and as a
Given this high global leverage, it is not unreasonable to think that the world’s combined real growth rate will stay moderate or low for a generation. Welcome to the new era of sub-par growth.
How to Solve the Problem
So how does a country deal with the problem of too much private debt—a task often referred to as deleveraging? This question does not currently appear on any policymaker’s agenda. However, as is easy to see from chart 4, this will be one of the defining questions of the upcoming age.
Although I believe public debt deleveraging is a less pressing issue than private debt deleveraging— after all, governments can always resort to printing money while households and businesses can't—they will both be a very big part of what defines the economic era ahead, so let’s briefly examine them both.
The first thing to understand, however, is that in developed countries over any sustained period (absent a calamity such as the Great Depression or World War II) total debt always grows at a rate roughly commensurate with GDP or at a rate greater than GDP. In fact, private debt alone usually outgrows GDP. And when, during a war or crisis, debt declines in ratio to GDP, that fact is integral to understanding that calamity.
Debt grows as much or more than GDP because it is a necessary and causal factor in GDP growth. It’s one of the axioms that must be understood to understand the modern world. For example, during the period from 1985 to 2002, which is referred to reverentially by some economists as the “Great Moderation,” GDP grew by $6.6 trillion, but total debt grew by $14.9 trillion, taking America’s total debt ratio from 155 percent to 198 percent. Private debt alone grew by $10.7 trillion. Moderation indeed!
In fact, the most benign period of debt growth since the aftermath of World War II was 1958 to 1968, when total debt declined on a percentage basis from 130% of GDP to 126%—a trivial amount of deleveraging. But even then, absolute debt outgrew GDP. But even given these rare moments of slight deleveraging, the path of debt in that overall postwar period has consistently been to dramatically higher levels—doubling from 127% in 1951 to 255% today.
Some economists assert that establishing causality from debt to economic growth is difficult. That may well be so. Nevertheless, in my everyday experience over forty years in business as the CEO of three businesses and then as a private equity investor, the majority of the companies I am familiar with
How to Address the Problem
So if, absent calamity, debt growth is roughly commensurate with or greater than GDP, and in fact powers growth, how does a country deleverage without putting a dent in economic growth?
Politicians, when confronted with the problem of government debt that is too high, often respond by saying that “we will simply grow our way out of the problem.” Unfortunately, it’s not that simple. Let’s look at how deleveraging has actually been accomplished.
Let’s start with public debt
In fact, offsetting private leveraging is usually the thing that enables the ratio of public debt to come down. We examined all cases in a top 50 country since 1950 where the data was available. These countries together constitute 90 percent of world GDP. There were 47 cases where public debt as a percent of GDP declined by 10% or more in a period of 5 years. Of those 47 cases, 29 were made possible by an offsetting increase in private debt—not the most desirable way to achieve that end. The next 14 cases happened because of very high inflation—an even less desirable way. The remaining 4 cases were possible because of a very high net export (or capital account) surplus—which is a good way to achieve this deleveraging. While this may seem to offer encouragement, both the level of surplus and number of years of surplus necessary for meaningful deleveraging rarely happens to any major country and has never happened in the U.S. in its 200+ year history. Most cases occurred in relatively small countries. Further, when it does happen in a larger country, as in China from 2003 to 2007 or Germany more recently, it usually brings problematic global imbalances—the very kind that economist
The story is similar for private debt. Private debt deleveraging has usually only been possible because of offsetting public debt increases. Japan’s private debt ratio reached a whopping 221% in the lead up to its crisis of the 1990s. But luckily for Japan, its public debt ratio at that time was only 86%. In the two decades following its crisis, private debt has deleveraged to from 221% to 170% (which is unfortunately still too high), but that deleveraging was enabled by a massive increase in the public debt ratio from 86% to 246%. Private debt declined by Y260 trillion, but public debt grew by Y810 trillion, and the combined impact of this debt growth was a meager zero growth in nominal GDP.
We looked at all 45 cases where a top 50 country had reduced private debt as a percent of GDP by 10% or more in a period of 5 years. 26 of those cases occurred only when public debt increased at a rate high enough to offset it, 9 cases occurred through very high inflation, and 10 happened because of a sustained and very high net export level. Again, the high net export cases were usually in smaller countries.
How about situations where both public and private debt deleveraging occurred at the same time? We examined these same top 50 countries and found only 8 instances where the public debt and private debt ratios declined simultaneously. Six of these were the result of very high inflation. Two were largely a result of a high trade/capital account surplus.
So for all of the world’s countries of size, the vast majority of occurrences of deleveraging have been either offsetting growth in debt in another
Actually, it should be no surprise that deleveraging only occurs through these three methods. Absent the help of any of these three methods, if the total debt ratio were to be meaningfully reduced, either through an absolute decline in debt
A decline in debt brings a contraction in GDP.
We are not at some ordinary point in history. Instead, we are at an unprecedented, era-defining crossroads. Debt to GDP is the highest it has ever been in history. Politicians will not address this, and we will almost certainly continue down this debt path, increasingly burdened by high levels of private debt, ignoring what is in front of us, and wondering why global growth remains so mixed.
It is unrealistic to expect the U.S. to be able to deleverage unless there is some strategy beyond these three.
By the process of
But it is a solution fraught with controversy.
Take the United States after the 2008 crisis. A rapid rise in mortgage debt was the proximate cause of the crisis—it rose from $5.3 trillion in 2001 to $10.6 trillion in 2007, an avalanche of new mortgage lending in the space of a mere six years. And yet even though we spent billions to bail out most of the lenders pursuant to this crisis (and largely without meaningful consequence to the management of those lending institutions), the amount of help provided to homeowners has been negligible in comparison. In the wake of the crisis, 15 million of 52 million mortgages in the US were seriously underwater, with an LTV above 125%. When coupled with the diminished incomes of many these households, their spending became highly constrained, leaving them far less able to buy new cars, take vacations, and the many other things that power an economy forward.
Here’s an example of a program that could have been employed in the 2008 to 2010 time period to address this issue (and might be employed in the future). It would have been a one-time program whereby if a borrower, because of the collapse brought on by the crisis, had a $400,000 mortgage on a $300,000 house, the lender would be given a regulatory dispensation to write the mortgage down to, say, $250,000 and spread their loss over an extended period, perhaps 30 years. In exchange, the borrower would provide the lender a certificate that gives them half or more of the upside upon the sale of the house — a type of debt for equity swap.
That’s just one example of the type of program that could be deployed, and it
We have now entered a new age of slow growth. Economists and policymakers need to recognize the central role played in this by the world’s now-heavy burden of private debt.
Richard Vague is currently one of the managing partners of Gabriel Investments and the Chairman of The Governor’s Woods Foundation, a non-profit philanthropic organization. He is also the author of The Next Economic Disaster, a book with a new approach for predicting and preventing financial crises, and A Brief History of Doom, which documents the history of private debt crises. Previously, he was co-founder, Chairman, and CEO of Energy Plus, an electricity and natural gas supply company operating in states throughout the U.S. that was sold to NRG Energy in 2011. Vague was also co-founder and CEO of two credit card companies – First USA, which grew to be the largest Visa issuer in the industry and which was sold to Bank One in 1997, and Juniper Financial, the fastest-growing credit card issuer of the past decade, which was sold to Barclays PLC in 2004.
An excerpt from The Next Economic Disaster: Why It's Coming and How to Avoid It.
A World Economic Roundtable report on private debt and the American middle class.
How institutional design and austerity is destroying the European economy