One of the legacies of the 2008-09 financial crisis is a world awash in debt – and this explains much of the confusion and acrimony of today’s debates about the global economy. Almost everyone wants faster economic growth and lower unemployment. But there’s deep division over whether less or more debt is the way to get there.
On the facts, there is little dispute. The world has more debt now than at the height of the financial crisis. In a new report, the McKinsey Global Institute – the research arm of the well-known management consulting firm – estimates that worldwide debt rose an astonishing $57 trillion, or 40 percent, from the end of 2007 to mid-2014. As a share of the global economy, debt was 286 percent of gross domestic product, up from 269 percent of GDP in 2007.
These figures include all types of debt: government, business and household. About one-third of the extra debt came from China; the United States and Europe also contributed sizable amounts. Did all the new debt help or hurt the global economy? Well, it depends.
For starters, it depends on where countries are in the credit cycle – and also how governments respond. The credit cycle is another label for boom and bust. Easy credit initially stimulates lending and economic growth. Then comes the payback. Credit standards become too loose; defaults mount and borrowers devote more of their income to repaying old loans. The economy slows or slumps. Finally, there is recovery after lenders have absorbed losses and borrowers have paid down excessive loans. Government borrowing (aka, deficit spending) can worsen or soften the cycle.
The United States seems to be in the recovery stage of the credit cycle. The popping of the housing bubble imposed a huge drag on the economy that was cushioned by higher government deficit-spending. But since 2007, mortgage defaults and repayments have reduced household debt by 26 percentage points of disposable income. This seems to have set the stage for a faster recovery. McKinsey puts a number of countries (Spain, the United Kingdom, Ireland) in a similar position. As household debt burdens fell, growth prospects improved.
This is good news for the world economy, but unfortunately it’s not typical. According to McKinsey, more countries have household debt burdens that are rising. These nations may still be in the happy stage of the credit cycle – or close to having housing bubbles burst. Among others, Australia, Sweden, Canada and South Korea belong to this group. In 2014, Canada’s household-debt-to-GDP ratio was almost 56 percent higher than America’s.
There are those – most prominently, Nobel-prize winning economist and New York Times columnist Paul Krugman – who argue that the world needs more, not less, debt. When private borrowing and spending weakens, Krugman contends, the public sector must substitute its borrowing and spending or else the economy will stagnate or worse.
This is what’s happened in Europe, he says, with horrific economic and political consequences. Austerity policies have not reduced debt because spending cuts and tax increases alone did not produce budget surpluses. Meanwhile, the pain (lower incomes, higher unemployment) has radicalized middle-class voters. In his Feb. 9 column, Krugman wrote: “Anyone surprised by the left’s victory in Greece, or the surge of anti-establishment forces in Spain, hasn’t been paying attention.”
In practice, choices may not be so clear-cut. China offers a cautionary lesson.
According to McKinsey, China’s debts (governmental and private) total 282 percent of GDP, up from 158 percent in 2007. This exceeds, on a comparable basis, the debt of the United States (269 percent of GDP) and Germany (258 percent of GDP). Almost half of China’s debt, McKinsey says, relates to housing. The lesson: Short-term stimulus plans often distract from long-run issues and simply postpone problems.
The verdict on debt is mixed because its effects have been mixed. But what the world really needs is another brand of economic growth – one less dependent on debt and more effective in increasing jobs and incomes. That’s easier said than done.