In layman language, debt is something we owe. From ancient times, wise elders have communicated the dangers of debt to every young mind that is eager to learn, and almost everyone at an individual capacity regards Debt as a vice. However, when it comes to larger groups of people like companies and especially governments, this lesson seems to lose importance.
Global debt has reached an all-time high of $184 trillion in nominal terms, equivalent to 225% of GDP (as of 2017), and on average, the world’s per capita debt exceeds $86,000, which is more than 2.5 times the per capita income. This figure is frightening, and it should be because such a staggering level of global debt means that all economies of the world taken together do not have enough money to cover their debt.
The previous line might be a little confusing, and in order to understand the problem thoroughly, we must be familiar with the concept of exponential growth. Since the topic of discussion here is debt, let us understand everything in relation to debt. In case debt grows by a constant amount, say $100, every year, it is called Linear Growth. If we chart linear debt growth against time, we will get an upward sloping straight line, with a constant slope equal to the amount of debt growth every year.
Alternatively, if debt grows by a percentage (constant or otherwise) every year, we call it Exponential Growth. The major difference between the two is that in the former, the base is constant, but in the latter, it is not. If debt grows by 10% every year, and the initial level of debt is $100, then debt grows by $10 in the first year, and by $11 in the second year. Hence, even if the rate of growth of debt is constant, the amount of growth increases over time. The graph of exponential debt growth, charted over a period of thousands of years, looks like a hockey stick.
While Keynesian economists emphasize the importance of government debt as a tool to drive economic growth, the more conservative schools of economics are of the view that excessive debt on the part of the government will reduce its credibility and drive interest rates up, thereby crowding out private investment. With higher interest rates, debt servicing costs also rise, making it more difficult for the government to finance its deficits and compelling the government to incur more debt to finance its existing debt. This is known as a vicious debt trap, which has crippled many European countries in the recent past.
Experts have conflicting opinions on the impact of debt on economic growth. In a paper published by Reinhart and Rogoff titled “Growth in a Time of Debt”, the authors compiled empirical evidence to suggest that debt at 90% of GDP begins to substantially impact future economic growth. Compare this threshold to the actual global level of 225%, and one will realize how grave the situation is.
The rapid increase in debt levels is a recent phenomenon; its origin can be found in the expansionary policy tactics used to post the financial crisis of 2008. Increased government expenditure and lower taxes forced governments to incur extra debt, and printing money to finance this debt only led to a negative feedback loop. And the reason why monetary expansion only leads to higher debt levels can be explained through a fundamental fault in the money multiplier concept.
As part of its expansionary monetary policy, the central bank prints $1000 fresh and gives it to commercial banks. Say commercial banks keep 10% of the money as reserves and lends the remaining $900 to individuals. Individuals spend this money, and it becomes the income of another group of individuals, who then deposit their income into commercial banks. Out of $900 deposits, the bank keeps $90 and lends out $810. The same cycle continues until the total amount of deposits through all cycles amounts to $10,000. This is the concept of the money multiplier, and people very conveniently overlook the fact that the absolute amount of additional money in the economy is still $1000, the extra $9000 is actually debt, it is not created out of thin air. This example clearly demonstrates the fact that printing money does lead to increased prosperity to some extent, at the cost of creating a larger amount of debt.
However, in today’s environment, it does seem that high levels of growth cannot be possible without even higher levels of debt. Excessively indebted countries can avoid a debt crisis by resorting to contractionary monetary and fiscal policies but at the cost of facing decades of economic stagnation. High growth must be spurred by high spending on the part of governments, which must be accompanied by a rise in debt level. But the servicing of debt requires a transfer of resources from one’s nation to other nations (in case of external debt) or from one sector to another less productive sector (in case of domestic debt). These arguments are self-contradictory, which leads us to the question: How much debt is too much debt?
There is no definitive answer to this question. In theory, the Domar condition on sustainable debt states 2 conditions for public debt sustainability: first, the nominal GDP growth rate should be greater than the growth rate of public debt; second, the real rate of interest must be less than the real rate of growth. It has also been claimed in various studies and papers that the time-path of debt is a much more significant factor affecting growth than the absolute level of debt. All pieces of evidence point to only one fact: there is no magic threshold for debt, no theoretical rule is sacrosanct; there are diverse factors driving the debt-growth relation, and the same cannot be stated definitively.
Taking the example of our own country, the debt to GDP ratio is 68.3% in the FY 2018-19, much below the Reinhart-Rogoff threshold of 90%, and very much sustainable following Domar’s disposition. This level is not on the rise, in fact, it fell from 68.9% in the previous FY. Despite this, the growth level is falling, bearing witness to our argument that there is no standard of sustainable debt.
High debt growth levels are a deterrent for growth, but high levels of growth are difficult to attain without higher levels of debt. Having said that, 225% of global debt to GDP ratio is NOT a healthy or sustainable level; it can, and will, have a disastrous impact on the world economy. In fact, it has already made its impact felt through falling growth levels, an inverted yield curve, and an unstable global economic system in general. How bad the impact will be, there is no way of discerning, but unless strict measures are taken to curb the rising debt levels, and economic doom is bound to come, debt is only a ticking time-bomb.