It's been almost four years since the global financial crisis reached its climax, and the world economy is still unable to reach escape velocity without ongoing life support from central banks and governments. The perennial optimists remain unmoved by the unimpressive economic expansion, and continue to believe that reflation efforts will ultimately prove successful, and that growth will return to its historical trajectory in the not-too-distant future.
However, the level of long-term interest rates offered on government bonds across a number of markets including Canada, Germany, Japan, the Netherlands, the U.K. and the U.S., is at odds with this view. Indeed, sub-two per cent yields in many of the world’s leading economies are simply not consistent with robust future growth.
The economic data reported during the current upturn to date confirms that something is fundamentally different about this cycle. The U.S. economy for example, is currently experiencing the weakest recovery on record with growth running at less than half the pace that is typical for this stage in the cycle. Meanwhile, the euro-zone’s economic performance since the ‘great recession’ struck is even less inspiring, and trails the Japanese experience following the deflation of its twin property and stock market bubbles more than two decades ago.
The hard evidence would appear to suggest that the deleveraging of balance sheets to correct for the excessive build-up of debt throughout the developed world, and across all sectors of the economy, in the years leading up to the financial crisis, will exert a heavy toll on growth for years to come.
The extent of the debt accumulation over a period spanning three decades is simply staggering. The level of non-financial sector debt relative to GDP in the developed world increased from 170 per cent in 1980 to almost 310 per cent by 2010, well above the thresholds that have been shown empirically to retard growth. In other words, the rate of debt increase outpaced economic growth by more than four percentage points a year on average for three decades.
The late American economist, Herbert Stein famously wrote in “What I Think: Essays on Economics, Politics & Life” that “If something cannot go on forever, it will stop.” The unsustainable private sector borrowing spree duly came to an end with the arrival of the ‘great recession’ in 2008, but the upward trend in outstanding debt continued, as declining tax revenues and automatic stabilisers increased the pressure on government finances.
The bottom line is that deleveraging has barely begun, with combined public and private sector debt relative to GDP across the developed world still close to an all-time high. It is important to recognise that never before in modern history has so many of the world’s leading economies been saddled with so much debt.
Indeed, an analysis of the U.S. experience post-1945 reveals that total non-financial sector debt rarely strayed far above 150 per cent of GDP until the 1980s. Simply put, the negative growth impulse arising from balance sheet rightsizing in one sector of the economy was traditionally offset by an increasing debt-to-GDP ratio in another sector.
Academic research by Stephen Cecchetti and others at the Bank for International Settlements reveals that debt begins to hurt growth when it reaches 85 per cent of GDP for the public sector, 90 per cent of GDP for the non-financial corporate sector, and 85 per cent of GDP for the household sector.
In aggregate, each of these levels has been surpassed across the industrialised world or an area that accounts for two-thirds of global economic output. In other words, there is simply no balance sheet slack available to counteract the effect of deleveraging, and as a result, growing out of the problem does not appear to be a feasible option.
Several commentators argue that the debt will ultimately be inflated away. However, as repeated rounds of quantitative easing in the U.S. demonstrate, inflation is not that easy to generate in the presence of persistent economic slack, and when the credit channel of monetary transmission is impaired. Further, high inflation rates relative to the emerging world could potentially harm the labour market, as production shifts overseas to exploit lower costs.
The developed world is drowning in debt, and near-zero interest rates and unconventional monetary policies have failed to ignite an economic recovery that is sufficiently robust to allow for a fall in aggregate debt levels to more sustainable levels. Lacklustre economic growth should be expected for several years to come. Welcome to the ‘new normal.’
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