Debt and Demand

LONDON – Former US Treasury Secretary Larry Summers recently caused a stir with his warning of sustained economic stagnation in the advanced economies. But, while many reject his suggestion of a secular trend, the data support him. Yes, economic growth has picked up in the United States and the United Kingdom, while the eurozone economy is no longer contracting and Japan shows some signs of responding to “Abenomics.” But the global recovery remains extremely weak, with most advanced economies still performing at 10-15% below pre-crisis growth trends.

It is not difficult to see why the recovery has been anemic. Excessive private-debt creation before the crisis and subsequent attempts at deleveraging have weakened demand considerably.

While fiscal deficits can help to offset deficient demand, they also result in rising public debt. Leverage has not gone away; it has simply shifted to the public sector – creating a debt overhang that may last for many years, or even decades. Eliminating it will likely require significant debt write-offs or permanent monetization.

But, as Summers noted, the party that preceded this severe post-crisis hangover was not, in terms of actual growth, all that exuberant. Credit volumes and asset prices soared, but labor markets did not overheat, real earnings remained flat in many advanced economies, and inflation rates were remarkably stable. Nominal demand grew at roughly 5% annually, despite annual credit growth of 10% or more.

Today, the same pattern is unfolding in many emerging economies – most notably, China. With credit growth far outpacing nominal GDP growth, leverage is increasing. And it seems that the rising credit intensity of GDP growth (the amount of new credit required to generate a unit of output) is needed to ensure that economic performance remains in line with potential.

This implies a serious dilemma: while rising leverage is apparently essential, it inevitably leads to crisis and recession. Against this background, policymakers must consider whether rapid credit growth is really necessary, and whether there are any alternatives – a question that modern economics has so far largely ignored.

In fact, much credit growth is not critical to economic growth, because it does not play a direct role in financing consumption or investment. Economics textbooks often describe how households deposit money in banks, which lend to businesses to finance capital investment. But, in advanced economies – and increasingly in emerging economies – this story is largely fictional, because such lending accounts for only a small share of the total.

Instead, a large part of bank lending finances the purchase of existing assets, particularly commercial or residential real estate, the prices of which primarily reflect the value of the underlying land. Such existing-asset finance does not directly stimulate investment or consumption. But it does drive up asset prices, causing lenders and borrowers to believe that even more credit growth is both safe and desirable.

Lending to finance existing assets, primarily in real-estate markets, can thus play an asymmetric role in the real economy. While it has little impact on demand, output, and prices during the boom, it results in debt overhang, deleveraging, and depressed demand in the post-crisis period.

In this context, policymakers should distinguish between categories of debt. For example, they could impose higher capital requirements on real-estate lending or introduce direct borrower constraints like limits on loan-to-value or loan-to-income ratios. Such policies would help to reduce the credit intensity of growth, thereby curbing the threat to long-term economic stability.

Nonetheless, the problem of deficient demand might persist. Even though such lending does not stimulate demand for newly produced goods and services directly, it may do so indirectly by generating unsustainable wealth effects (driving people to spend more because they feel richer). Constraining the lending that drives up real-estate prices could lead to lower nominal demand.

Curtailing demand for this category of credit would lower the real (inflation-adjusted) interest rate. But we cannot assume that this would offset the deflationary impact of reduced wealth effects. Even before the crisis, real long-term interest rates were on a clear downward trajectory, with 20-year index-linked yields falling from almost 4% in 1990 to below 2% by 2007. Whether even lower interest rates would have stimulated significant additional investment is unclear.

The fundamental question therefore remains: Is there something about modern economies that makes adequate demand growth impossible without damaging credit growth?

Rising inequality is one driver of this apparent “need for credit.” Wealthier people have a higher marginal propensity to save than poorer people. As the rich get richer, consumption growth may decline, unless the financial system uses their savings to lend to the relatively poor.

But much of this debt may prove unsustainable. As Raghuram Rajan pointed out in his book Fault Lines, the US subprime-mortgage boom and bust owed much to pitiably slow growth in lower-income Americans’ real earnings over the last three decades.

Global imbalances also contribute to rising debt risk. If current-account surpluses are not matched by rising equity claims against the rest of the world – whether through corporate foreign direct investment or household-equity investments in other countries – they inevitably result in debt claims, increasing public or private debt liabilities in deficit countries. Some of those debt claims will likely prove unsustainable, and all of them may contribute to post-crisis debt-overhang effects.

A more stable growth model requires less of the “wrong type of debt” – that is, debt that finances purchases of existing assets, supports consumption without addressing the drivers of inequality, or results from unsustainable global imbalances. Without targeted policies aimed at limiting such debt, the world economy risks secular stagnation or further cycles of instability and crisis.

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