How Much is Too Much?

"Perhaps too much of everything is as bad as too little." - Edna Ferber

"I think we consider too much the good luck of the early bird and not enough the bad luck of the early worm." - Franklin D. Roosevelt

When it comes to debt in an economy the question of "too much" is one that is really hard to answer.  According to the Economist global debt has grown steadily since the Second World War.  It was thought that debt on a national level was fine as it netted out to zero (the debtors would receive the collateral from the creditors making it a zero number) but 2007/8 dispelled that theory.  From 2004 to today total global debt has risen from $24.5 trillion to $55.1 trillion, an increase of more than 100% in 10 years.  More interesting is that since 2007 global debt has skyrocketed from $28.1 trillion or almost 100% in just seven years and this includes the massive write-down taken after the financial shock in 2008.  As a percent of global GDP the world debt level now stands at more than 200% of global GDP so it is time to dig into how much is too much as this will have implications for all investments.  It is the largest macroeconomic influence on all of your investments so it needs to be understood.

The initial premise that should the world have to pay off all the debt that it would amount to zero is a fallacy.  This assumption assumes that the collateral will be there with value to support the loan.  As 2008 showed, the world's collateral pool can lose significant value quickly, particularly when there is a loss of faith which is the exact time that the collateral is needed to pay the debt back.  Taking this a step further, if all of the debt outstanding was called in today, there is no way that every asset could be liquidated in such short order so prices would capitulate and the sum total would be zero, that is the debt holders would receive assets worth zero or a total write-off.  Now as we know this is never going to happen but I used it just to illustrate the point that debt at these levels is not a zero sum game.

Debt is manageable as long as there is economic growth or inflation.  These two factors go pretty much hand in hand as one cannot really exist for an extended period without the other showing up.  Growth at some level will result in inflation and inflation is normally driven by growth although it can also come from poor monetary policies and over extension of monetary stimulus (think of Zimbabwe or the Weimar Republic). For this blog and as we are talking global debt I will leave inflation tied to growth.  If you have GDP growth or inflationary growth the percent of debt to the underlying value of the assets falls thereby giving the illusion that the debt level is manageable.  It is an illusion as it only holds as long as asset prices do not fall.  Inflation too makes the debt more palatable as higher wages and tax revenues means that it is easier to service the debt and therefore more controllable.  The worst possible situation for debt is deflation which as I have mentioned in previous blogs makes asset values shrink while the debt remains fixed thereby making the debt level unmanageable and in some cases unserviceable.  With the world edging very close to the deflationary cliff this is a worry as if the world slips into this spiral investment dollars would be non-existent as debtors would be using every available dollar to repay debt rather than investing in business ventures, ideas or infrastructure.

The only way that the debt can remain manageable under this scenario is to keep interest rates low.  Even a small spike in the interest rates would send the world into a debt spiral as once again interest payments would eat up all excess cash crippling investment and cutting government spending.  As an example if interest rates were to rise 2% the annual amount spent on interest payments alone would increase by over $1 trillion a year!  It is not inconceivable that interest rates could jump by 5% knocking $2.5 trillion out of the debtors pockets stunting growth rather severely.  As it is in no-one's interest to let interest rates rise any time soon (at least until global growth shows signs of accelerating in which case as mentioned above debt payments become more manageable) I fully expect interest rates to remain low for a very long period.  Obviously this assumes that governments can keep interest rates down which is also a leap of faith.

As long as consumers, businesses and foreign governments believe that the debt level is manageable then everything is good to go.  If at some point in the future this thought changes, countries and businesses will suddenly see interest rates rise as really it is all based on a simple demand and supply curve.  Right now there is enough demand (faith in repayment is still high) for the debt at low yields but if the demand for the debt falls (lose of confidence in repayment) the only way to encourage buyers to step up is to raise the returns and suddenly you have a situation where the market controls prices rather than the central bankers.  Yields spiral higher and problems expand.  There is an argument that a spike in interest rates would not have an impact as yields are based on long term notes but with $55 trillion of debt with an average maturity of 10 years there is more than $5 trillion maturing each year ($14 billion every day of the year) and that debt would be subject to the higher rates so it would not take long for the increase in rates to be felt.

So while this rising debt level is still not a problem it is important to keep your eyes on it and understand the implications associated with any changes in interest rates and deflation.  Maybe earning 0.0002% interest on your savings forever is better than the alternative!