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Apr 01 2015

Circling the Drain

The world today is awash in unprecedented amounts of debt – more than ever before in human history. According to McKinsey, all major economies today have higher Debt/GDP ratios than in 2007, with corporate debt about 1.5 times, and government debt over 1.75 times as large. As a result, global debt has grown to some $200 trillion.

In the aggregate, the two ways these debts can be repaid over time are by generating sufficient real growth to do so; or by inflating away the debts, so that they can be repaid in currency that is worth much less.

As we have pointed out before in the context of “the yo-yo years,” real GDP growth has been stair-stepping down for decades in most advanced economies. More recently we have also noted that export prices – especially for emerging economies – have been exhibiting deflationary patterns for years, and those for advanced economies are also showing deepening deflation (International Cyclical Essentials, January 2015).

The hard reality is that there is no magic bullet to get stronger growth – certainly not QE, which merely attempts to pull demand forward from the future, leaving even less residual demand for later. The other way out of the debt trap – generating inflation – is not really possible through currency devaluation because, in the aggregate, the pressures are on every economy to devalue along with others.

At best, economies can take turns devaluing their currencies, as they are doing now, but without much success in igniting inflation. For instance, Japanese core inflation, adjusted for last year’s tax hike, has now dropped to zero.

The larger point is that, in the fullness of time, all the major economies are likely to face a day of reckoning – and earlier than most expect. Sooner or later, the prospects of default or an equally unpalatable alternative like much higher taxes is likely to loom. But the process may involve a rush to a succession of “safe” assets in the interim, even though all of these economies are effectively circling the drain.

Desperate but ineffectual efforts to attain “escape velocity” or even the inflation target are failing, despite round after round of QE. To quote John Maynard Keynes from eight decades ago, “When the rate of interest has fallen to a very low figure and has remained there sufficiently long to show that there is no further capital construction worth doing even at that low rate, then I should agree that the facts point to the necessity of drastic social changes directed towards increasing consumption. For it would be clear that we already had as great a stock of capital as we could usefully employ.” What drastic social changes the present situation might ultimately require remains to be seen.

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