The debt crisis is only the canary in the mine

ESSAY: Demonising debt distracts us from what caused the public-debt crisis in the first place – the sluggishness of the productive economy.

Since the Western financial crisis struck in 2008, debt has moved to being the No.1 issue in high-income countries. Many argue that state debt in particular is shaping up to be the next big crash. Greece’s insolvency is seen as the future for all Western countries unless they act on reducing debt now. As a result, curbing government budget deficits is said to be the most important issue facing the US, Japan and Europe, Britain included.

High levels of debt are important for the Western world today, but more as a wake-up call than as a problem in themselves. They tell us that economic restructuring cannot be put off much longer. The trend across history is that debt levels move in the opposite direction to economic vitality. Big debts are a symptom of an economy not doing well. They are the canary in the mine rather than the dangerous gas build-up. Trying to deal with debt directly is as foolish and dangerous as trying to revive the canary when you should be dealing with the gas.

Unlike Greece, most Western governments are still able to borrow on the credit markets to fill their budget gaps, though this facility won’t last forever. The time to act on the underlying source of the debt is now, but so far the focus has been too narrowly, futilely and counterproductively on how quickly, and how much, to cut the deficits. For most countries today, including Britain and the US, a focus on debt in its own terms is misplaced because it is looking too much at one economic consequence rather than the cause of the problem: anaemic economic growth.

Of course, consequences, such as debt, can still matter in their own terms: very high debt levels are difficult for individuals, businesses or governments to bear, because even if the debts don’t have to be paid off immediately they do need to be serviced. Even if paying large sums of interest doesn’t cause the economic hardship in the first instance, it adds to pressures on people or institutions with limited resources.

But because something matters, that doesn’t mean it has to be, or even can be, resolved by attacking it directly. The symptoms of pneumonia matter, for example, but treating symptoms is the wrong way of getting rid of them: you deal with the underlying cause, the infection itself.

Trying to deal with the debt symptom directly, rather than through addressing the causes of high debt, is ineffective and can also be counterproductive. This approach ignores the underlying problem – the economic weakness that led in the first place to reliance on borrowing instead of living off currently produced wealth – and, indeed, allows this problem to continue to fester. Worse, by preaching a message of making do with less, the deficit-obsession moves society farther way from the only perspective that can work to reduce debt on a long-lasting basis: the fact that we need to produce more, not less. The only durable solution to debt is to reorganise societies so that they can make more wealth.

A lot of people blame debt for the economic crisis, when things are really the other way round. We need to go deeper to see how the long-term economic slowdown increased dependence on debt in the first place.

Falling GDP growth rates in the major developed economies
(source: McKinsey Global Institute)

Western societies have experienced decay in their productive engines stretching back over the past 40 years to the early 1970s. The part of the economy where goods and services are produced has become more sluggish and this has forced these societies to rely increasingly on debt as a way of compensating for insufficient wealth generation.

The credit explosion

Credit expansion across the economy, and the accumulating debt that ensues, has become a favoured state mechanism to compensate for weakness in the arena of production. Governments have been keen for central banks to keep interest rates low, keen for financial institutions to extend their operations, and keen to encourage people to take out personal debt and mortgage debt because this keeps the economy ticking along. That’s why debt in the 18 core OECD countries doubled from 160 per cent of GDP in 1980 to 321 per cent in 2010. But this process only disguised the underlying weakness of production; it did nothing to solve it.

Thus, debt and the financialisation of the economy have been mistakenly seen as the main problem. True, no society can continue indefinitely to rack up debt by consuming more than it produces, and that applies at the individual and the government level. There is a harsh truth in the notion that ‘no one can live beyond their means forever’. We do need to get away from a debt-dependent way of operating and coping. The bigger question is how.

The problem is not that the big deficit countries – Britain, America, Italy, Greece and the rest – borrowed so heavily. The problem is that this credit fuelled the rise of unproductive consumption to help maintain the semblance of a functioning economy, instead of helping to fund the restructuring of society – in terms of new infrastructure, equipment, methods and education – that would allow an increase in wealth creation.

Borrowing can’t ensure prosperity, as we’ve seen with the financial crisis and the subsequent recessions and return to open depression. But austerity doesn’t bring prosperity either, not just because of the immediate hardship it causes, but also because it fails to address the underlying source of malaise that drove the heavy borrowing in the first place.

The real sequence of events was this: the production economy slowed from the 1970s – that’s the primary development; private debt took off to compensate for this slowdown during the 1980s and 1990s; public debt really only began to accelerate in the 2000s.

Government deficits, and therefore public debts, have accelerated again, especially since 2003, as public expenditures have become more necessary to prop up the economy. This was itself an indication of the limits of credit expansion with the increasingly phantom way that private debt-driven paper prosperity was artificially compensating for the country’s deteriorating economic health. Output growth slowed again in the 2000s, incomes slowed and with that tax revenues. With the onset of the recession around the world, precipitated by the financial crisis, tax revenues fell further and deficits and debts jumped higher.

UK national debt, 1999-2001
(source: Office of National Statistics / Economics Help)

As a result, today the national debt in Britain has reached £1 trillion, or about two-thirds the size of annual output: 64 per cent of GDP. That share is a lot higher, double in fact, the 30 per cent level of 10 years ago, indicating both the deterioration in the underlying real economy and in the government’s finances that are dependent on it.

That said, there is no objective reason to get too excited about a debt-to-GDP ratio of 60-70 per cent in itself. This is far from a British record, and is a much lower ratio than Britain has experienced in the past.

Britain’s national debt was bigger than its GDP - above 100 per cent - for about half the twentieth century, and in fact has been above this rate for more than half the time since 1692 when William III first issued government debt. Over those 300-plus years, spikes in the ratio have been driven mainly by one of two things: major war-driven spending and/or economic slump.

UK government debt since 1692

Debt first exceeded 200 per cent of GDP at the end of the Napoleonic Wars in the early nineteenth century, and hit that level again at the end of the Second World War. On both occasions, the debt-to-GDP ratio subsequently fell away steadily and significantly to below 50 per cent, not because of austerity measures imposed by governments, but mainly because things were going pretty well economically. The economy grew sufficiently strongly for the ratio to fall both during the period of Britain’s industrial heyday in the final two-thirds of the nineteenth century, and again in the postwar boom until the early 1970s.

If there are any magic numbers to do with government debt, it is neither the absolute money level nor the GDP ratio level, but the run-rate of government deficit compared to the annual rate of economic growth. If the level of budget deficit rises more slowly than the normal rate of growth – say a two per cent rise in the deficit, compared to three per cent growth, roughly what happened during the postwar boom - then arithmetically, the debt-to-GDP ratio falls. This relationship started to change with the end of the boom in the 1970s. As a result, the fall in the debt ratio ended and then it fluctuated around the 30 to 40 per cent mark in the 1980s and 1990s, before starting to accelerate after the start of this millennium.

Building the economy

What matters today is less a particular level of debt in relation to the size of the economy, or even the level of deficit this year or in the next couple of years. The question is whether the expected future run-rate of deficit – what economists sometimes call the structural deficit – is likely to be higher or lower than the economic growth rate. Today, it looks very likely that debt will grow faster than the economy, which is what drives the urgency to get to grips with reversing sluggish growth.

Viewing debt as a GDP ratio does highlight that there is a durable alternative to the counterproductive austerity route of seeking to cut the debt part of the ratio. To get the ratio of debt to GDP down, you can attempt to reduce debt directly or you can also increase the size of the economy. It is the latter path that offers the only sure way out of the crisis in the long run.

That’s what happened to Britain after the Napoleonic Wars and the Second World War. More recently, faster growth was the way Sweden and Finland got out of their financial and public-debt crises in the 1990s. It’s the absence of any prospects for genuine and strong economic recovery, and the elite’s fatalistic reluctance to do much about this, that are the big problems we face, not debt levels per se.

What the politicians should be addressing is the need to fix the underlying primary ailment that precipitated the growth of debt in the first place. The best cure for economic malaise, including its expression in high debts, is for stronger economic growth based on industrial expansion. This would put people to work, reduce spending on unemployment benefits, increase tax revenues, shrink the budget deficit, and make possible increases in public spending to support the sort of new industrial policy that would help make growth durable. This requires radical corrective economic surgery, a restructuring not just of debts and the financial system but, more fundamentally, of the productive industries. The longer this is postponed, the more drastic, painful and disruptive it will need to be.   

Barriers to growth

Simply counterposing the need for growth to austerity, or complementing austerity measures with a ‘growth plan’, doesn’t cut the mustard either if it falls short of recognising the ingrained, deep-rooted barriers to growth today. A strategy for growth, just like a strategy for anything, needs to be more than a loose aspiration if it is to be worthy of the name ‘strategy’. It has to be based on a correct diagnosis, and then set out specific actions and tangible steps to reach the stated goal.

An effective growth plan today therefore needs to recognise the long-term deficiency of productive investment across most high-income countries – and also recognise that the market has failed to overcome this spontaneously. The old, decayed capital stock is not up to the job of moving production forward substantially; it needs to be destroyed and replaced - something that there seems great reluctance to bring about.

The state therefore needs to put a stop to its muddle-through approach of bailing out and subsidising the uncompetitive parts of the economy. It needs to adopt a new type of industrial policy that isn’t about saving old decrepit industries but about building and promoting the new. The government needs to find ways to support more start-up businesses, encourage research and development, including funding directly the pure parts of research, and foster technological innovation and productive investment.

Help should not be restricted to any particular sector but given to productive services and goods across the board. Specific targeting rarely works as, at best, it is an expression of the currently fashionable, and at worst a reflection of what used to work. An open approach is much more likely to work.

There will inevitably be pain and hardship for people during this necessary shift from the moribund old to the dynamic new. Unfortunately, there isn’t any painless way to achieve the radical social reorganisation required. The state will therefore also need to fund people’s living standards during any transitional periods of unemployment.

Here’s a crucial point about debt: if society can’t find enough wasteful and fruitless public spending to cut to make way for all this constructive activity then more borrowing is quite legitimate. Debt for productive ends, by government or business, is a good thing because it generates more than enough growth to repay itself. 

Borrowing can aid the inescapable reorganisation of social and economic life to demolish the limits of economic decay. Debt, therefore, shouldn’t be stigmatised in the way it is being today. Focusing on debt as the problem, most politicians today present debt as a symptom of irresponsible behaviour and of moral decay. Debt has become a heavily moralised term.

To be in debt, or more specifically heavily in debt, is seen as the result of feckless, imprudent behaviour. People in debt are often portrayed as living extravagantly, even greedily, beyond their means, and are seen as immorally stealing from their children and grandchildren because the future generations will be liable for this generation’s debts. Similarly, governments in debt are seen to be negligent, or, worse, verging on the corrupt, in bribing their voters with tax cuts or welfare handouts, or bribing special interests with tax allowances or state subsidies. 

All this moralising by politicians mystifies what is really going on: the underlying ailment here is not moral decay but economic decay. Individuals or businesses or governments generally get into bigger and bigger debt not because of irresponsibility, but because of a shortfall in income. Borrowing is simply a way of maintaining customary levels of spending when real wealth production has fallen away, which of course is one of the features of the long slump that began in the 1970s.   

Debt is a good thing - not morally, but economically - if used to expand productive capacity; it is a problem when it is used primarily to finance things like higher property prices and unproductive consumption, as has been increasingly the case over the past quarter of a century. Most of the social progress over the past 250 years has rested on large-scale transformative investments, which could not have happened without debt. Railways and motorways and energy and communications infrastructures could not have been built without debt. In the nineteenth century, for example, America used huge amounts of debt to transform itself from being an undeveloped frontier society into a modern industrial heavyweight. So in economic terms, debt can be good for society.

What matters for any particular level of debt is the economic context, both today and even more importantly in the future. Debt is screaming to us that we need a to create a less debt-dependent society based on durable growth, not artificial and limited credit-based fluff. Austerity, making do with less, is not the answer either; we need a plan to rebuild prosperity based on making more wealth. There is no painless way to reach that goal. Restructuring economies to pave the way for new rounds of productive investment and innovation is destructive and disruptive; we cannot avoid the hardships entailed. But without taking that tough path very soon, we will some day find ourselves in a Greek-type scenario where debt - that consequence of deeper problems - does itself begin to have real consequence for us in pulling society backwards.

Phil Mullan is the author of The Imaginary Time Bomb: Why an Ageing Population Is Not a Social Problem, IB Tauris, 2000. (Buy this book from Amazon (UK) or Amazon (USA).).

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