Unsustainable Global Debt?

By James Chessen

Debt can be a good thing, but too much of it can be a problem.

The Great Recession is a prime example of borrowing by households well beyond the growth in income. In the seven years before 2007, household debt in the U.S. rose 40 percent (relative to GDP), supported by a 42 percent growth in financial sector debt.

In the seven years that followed the financial crisis, households deleveraged, dropping debt 18 percent relative to GDP. Financial institution debt dropped as well, by 27 percent. Not surprisingly, the government stepped in, filling the deleveraging gap and growing its share of debt to GDP by 60 percent.

That increase continues to this day with the government debt-to-GDP ratio near 100 percent—which is considered the point at which government debt becomes unsustainable, dramatically reducing the country’s potential growth. Given the trends in entitlements and revenues, the Congressional Budget Office projects it to rise to 150 percent of GDP in 30 years.

Debt growth is not just a U.S. phenomenon, but one shared across the globe. In fact, in the seven years before the financial crisis, global debt increased by a whopping $83 trillion, with the U.S. accounting for $23 trillion. In the seven years thereafter, $43 trillion more was added to global debt with the US contributing only $8 trillion. The shift in debt went from households and financial debt to government and corporate debt.

By far, the biggest driver of global debt has been China. Overall, debt more than quadrupled since 2007, with real estate loans counting for half of it. Pictures of empty skyscrapers are a stark reminder of the extensive losses waiting to be recognized. According to the latest Institute of International Finance data, non-financial debt in China is 167 percent of GDP (see chart), far more than double the same ratio in the U.S.

Much of that debt has been financed by China’s shadow banking system. As China shifts toward domestic consumption, household debt also has jumped significantly and now is close to 45 percent of GDP.

What are the takeaways?

The growth in debt worldwide did help drive economic growth at a critical time, but the levels are now so high that large headwinds are forming and likely to be an anchor on future growth. In the U.S., with weak productivity and slow labor force growth—and without a boost from tax reform—it’s hard to see how the economy could grow consistently beyond 2 percent.

The pace of global debt has been slowing, but that’s largely due to improvements in mature markets. Emerging markets are another story and feel like a disaster waiting to happen. Any downturn will expose large numbers of weak borrowers and increases of rates by the central banks will only compound the problems. While China’s government has the capacity to absorb the corporate debt if that sector falters, it will not be without pain that will spread across the globe. If the Great Recession taught us anything, it’s that high leverage can smack down an economy in a hurry, taking years to recover.

About James Chessen

James Chessen
James Chessen is ABA's chief economist.
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