How to approach changing debt dynamics across the world.
Asset Allocation & Macroeconomic Research Team
One striking feature of the years since the 2007–2008 financial crisis has been the rise in public and private debt. While the absolute level of debt is not a concern of itself, the fact remains that debt has grown much faster than GDP. Thus, average public debt in advanced economies rose from 70% of GDP in 2001 to 105% in 2019 and is expected to come in at 125% in 2021 as a result of covid-19, according to the OECD.
This divergence between debt (which is rising) and GDP growth (which is falling structurally in most advanced countries) is what we have named ‘The Great Divergence’. It is an important source of both financial market and economic instability. The Great Divergence was behind the ‘dotcom’ bust in 1999–2000, triggered by loss of confidence in a series of new, highly leveraged internet-based companies that failed to generate sufficient revenues or cash flows to justify their valuations. This crisis, triggered by corporate indebtedness, was followed by one caused by household over-indebtedness in 2007–2008, when the US subprime crisis led to a deep global recession. As the subprime crisis started to fade, was replaced by the sovereign debt crisisin the euro area that peaked in 2010–2012, triggered initially by concerns about the over-indebtedness of various governments (starting with Greece).
The topic is likely to remain of prime importance as we emerge from the pandemic. The issue is particularly important as the actual boost to growth provided by increased fiscal spending seems to be weakening. Indeed, studies show that it is taking ever-increasing levels of fiscal spending and giveaways to generate extra point of GDP growth. In the US, for example, a 1% rise in national debt (government, corporate or household debt taken together) generated 2.6 percentage points of real additional growth between 1960 and 1988. This fell to 1.7 percentage points between 1982 and 2001, and has since fallen further. In the past two decades, each percentage point of additional debt has only generated 0.7 percentage points of real growth. In short, greater debt is generating less growth. The high levels of debt, public and private, have been shaping the approach of central banks, whose focus has been moving from inflation-targeting to the need to keep the cost of borrowing as low as possible, meaning nominal rates are kept lower than nominal growth. It could be argued that the growing appeal of yield curve control and Modern Monetary Theory in certain circles stems from the search for a way to avoid a repetition of the crises that have resulted from the Great Divergence.