Exploiting debt to boost economic growth, a favorite theory of certain economists, is dangerous and can lead to frightening consequences, according to a Société Générale note on Tuesday.
The note suggests overall nonfinancial debt, and not just government debt, should be a topic of conversation for the Davos World Economic Forum this week. That includes private debt held by households and corporations, among others.
“The idea of using debt to boost economic growth is predicated on the idea that at least the debt/GDP ratio should fall back in times of economic growth,” wrote SG analyst Kit Juckes. “It didn’t happen in the great moderation of the 1990s, and it isn’t showing any signs of happening now, either.”
Overall U.S. debt to gross domestic product grew quickly from the 1980s onwards, as the charts show. These ratios can have implications for interest rates, one of which is known as the real Fed Funds rate.
But those relationships harbor hidden dangers.
“Low rates encourage debt levels to grow, and then higher debt levels mean that rate hikes cause the economy to correct at a lower and lower real rate,” Juckes wrote.
In other words: Lower interest rates encourage debt-fueled growth but increase debt. The latter translates into interest rate hikes to normalize monetary policy, but the top interest rate reached tends to remain lower than in the previous cycle.
“That we need a lower real rate trough in the next downturn is just scary. Lower than -2 percent [interest rates] in order to stage yet another debt-fueled economic recovery in the 2020s? At some point, this pattern has to end,” said Juckes.
Companies, households and the government all share considerable responsibility for worrisome debt problems, on Juckes’ analysis. U.S. government debt to GDP failed to rise dramatically from 1960 to 2008, but it almost doubled from 2008 to date, just as households took on debt rapidly from 2001 to 2009 and companies quietly increased their leverage.
Juckes ended with a final snipe, pinpointing another sector to blame for excessive debt. “Of course the surge in debt levels in the 2000s had absolutely everything to do with lax regulation of the banking industry, and absolutely nothing to do with interest rates being too low. Obviously.”
U.S. public debt stood at $17.2 trillion, according to the latest Treasury data. That’s up from $7 trillion about 10 years ago, in January 2004. By the fall of 2013, domestic nonfinancial debt stood at $41.4 trillion, according to the Federal Reserve, which grew by 3.5 percent in the quarter.
That was divided between household debt ($13.1 trillion), nonfinancial business debt ($13.4 trillion) and government debt ($15 trillion). Household debt rose 3 percent in the quarter, the latest for which Fed data is available. Outstanding U.S. mortgage debt stood at $13.1 trillion, down from 2009.