In the last eight years US public debt has doubled in dollar terms. In Spain, public debt has roughly increased from 40% to 100% of GDP during the same period while the sum of public and private non-financial debt has climbed to 250% of GDP (versus 155% twenty years ago). Both are nice examples of the epidemic of excessive debt that is dragging Western countries. In fact, what everyone calls The Financial Crisis is in reality the lingering Great Debt Crisis. From the early 50s to 1980, non-financial debt levels in developed countries held quite steady (circa 150% of GDP in the US) despite the huge interest rate volatility during the period. After 1980 everything changed: in the following 30 years, non-financial debt levels in OECD countries would rise from 167% of GDP to 314% of GDP. Roughly speaking, governments, corporations and households contributed evenly to this huge increase. Since 2010, government debt has increased dramatically everywhere, while households and corporations have deleveraged in certain countries and have continued to party in others. All in all, Western indebtedness remains near all-time highs.
But does debt really matter after all? For decades, mainstream economists – most of them embracing the untouchable interventionist orthodoxy du jour – have scoffed debt levels as irrelevant. Stock variables didn’t fit in their beautiful models and, although common sense would dictate that debt is important, they closed the door to debate by stating the truism that the liabilities of all borrowers would always match the assets of all lenders. That’s hardly new. Since Luca Pacioli invented double-entry accounting in the 15th century, we all know that both sides of the balance sheet always coincide. However, that never meant debt levels didn’t matter.
Let’s imagine for a moment Robinson Crusoe lending Friday his fishing boat. The former is worried about the risk and the latter is worried about the responsibility, but both are reassured by the shaman of a neighboring island, who confidently states that there’s nothing to fear because assets and liabilities (the boat) match. Unfortunately, Friday is no seaman: as soon as he reaches the reef, he capsizes and the boat sinks. From an accounting point of view, assets and liabilities continue to match after the write-off: Crusoe no longer has an asset, and Friday has declared himself in bankruptcy so there’s no liability either. However, probably out of their sheer ignorance, both feel something is amiss: what they see, poor bastards, is that there’s no longer a fishing boat in the island, so they suspect their community is now poorer. Instead of keeping building new tools, appliances and that new hut for the winter, they argue, they’ll have to build again a boat they already had. The shaman, who has no experience whatsoever neither fishing nor building, tells them not to worry, because a strange fetish he calls GDP will grow every time they rebuild a sunk boat or a hut destroyed by a hurricane. Crusoe and Friday look puzzled: rebuilding the same thing over and over does not seem to add to their previous wealth. Pitying such mere mortals, the shaman graciously shares with them the secret spell of all shamans: “what you need to do is to start valuing the things you own and the work you perform in seashells’ units. In case of a new boat loss, all you have to do is think in seashells’ terms, go to the beach -where there are plenty-, get more seashells to compensate for the loss and, believe me, nothing will have happened.”
When we focus on real, tangible wealth instead of being distracted by its monetary equivalent, we understand that debt matters and that monetary alchemy is nonsense. Slowly, we come back to our senses, the spell loses its charm and we stop pretending that our assets are our net worth, fantasizing that we own what we owe.
So debt matters, as does what we use the debt for. Debt used prudently to finance a cash-producing asset that is expected to pay for the debt service might be just fine. That’s not the case when debt is used to finance household consumption, expensive corporate stock buybacks or the latest Keynesian wonder of the world (i.e., a three-lane bridge to a desert islet): none of these uses will help get the debt repaid. Nowadays, savings-depleted households hardly invest in yield-producing assets, highly leveraged corporations shun capital expenditures and debt-obese governments, already used to bribe voters with subsidies, prefer useless vote-buying pharaonic investments rather than lower-key, productivity-enhancing infrastructures.
Huge indebtedness is a symptom of underlying illnesses. One such illness affects mainstream economics which, to a certain extent, has lost touch with reality and common sense, as it started envying physics and became narcissistically enamored of its own complex models. Equations substituted reasoning, and important variables were forgotten if they could not be easily measurable. Flow variables like GDP became the rule and stock variables, like debt or true accumulated wealth (the balance sheet) were ignored. As a consequence, digging a ditch and refilling it again meant GDP growth and, as such, was absurdly understood as an increase in wealth.
Up to 2007, debt was also a symptom of living beyond our means within a hedonistic society which placed the key to happiness (an elusive one, for sure) in the compulsive consumption of material things, a society obsessed with ostentation and immediate gratification, oblivious to the fact that it was precisely delayed gratification which provided the foundation of the very capitalism which fruits we now enjoy. Paraphrasing Freddie Mercury, we wanted it all, and we wanted it now. Since then, households have been making sacrifices – the opposite of politicians and bureaucrats, permanent partygoers with their ever increasing budgets. Do we “owe it to ourselves”? No: that’s just a fallacy that denies the fact that lenders and borrowers are never the same people, not even from the same country.
Finally, in many Western countries, debt has also been the symptom of understated inflation rates: people watched their expenses grow due to the true, hidden inflation rate, while their income, linked to the lower (unaudited) official inflation rate, couldn’t keep up. Provided a constant lifestyle, the gap had to be funded by debt.
In the good old days, debt excesses were prevented by two forces: “normal”, painful interest rates, which made us remember that capital was not free, and the serious obligation of repayment, which made us remember that the money was not ours. Nowadays, interest rates have been destroyed by central banks’ shamans and rollovers are the new rule, sweeping under the carpet those annoying bad loans that could bring our banks down. We have lost respect to capital.
Lots of research warns of logical lower growth rates when debt doses exceed some safe threshold we left behind long time ago. Giving our debt-poisoned system more of the same is like giving a drug addict further doses to avoid withdrawal. That’s denial: it doesn’t heal; in fact, it kills. Monetary alchemy is just fantasy, a futile exercise of extend-and-pretend that adds enormous fragility to the system. Let’s be clear: this path leads to a cliff, and the disastrous fall is as unpredictable in its details as it is certain in its inevitability.
The monster will not disappear just because we close our eyes. We must face reality and bite the bullet. That’s what adults – that endangered species – are supposed to do.
Fernando del Pino Calvo-Sotelo