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Why worries about inflation are missing the point…It’s the debt (and low productivity) stupid… We are in the last days of the post-1945 economic miracle

From a repeat of the Roaring 20s to the Boring 20s to “That ‘70s Show”, describing the decade ahead by diving deep into the past for comparisons has become a bit of a fad. 

It’s certainly a fun thought experiment for those who care about these things.

But there is a serious unspoken truth to it all. 

What economists are really trying to do, apart from highlight the unprecedented state of the global economy today – is to ultimately understand how it will all come crashing down:

Will the high asset prices created by the longest bull market in history that was set off by the low interest rates and central bank bond-buying programme (known as Quantitative Easing or QE for short) in response to the 2008 GFC (Global Financial Crisis) be our undoing as it was in 1929?  Or will the system be taken down by the traditional boom-bust economics that inflicted much of the post-second-world-war period.  Where rising inflation had to be remedied with painful fiscal and monetary policies, such as government spending cuts but most important, certainly for the status quo, an unexpected rise in the rate of interest.

Underlying these concerns is the general unease that the fundamentals just don’t add up any more.  That somehow the system is being manipulated and is broken.  And at the very heart of this malaise is the overall debt burden we all face.  And one that has accelerated wildly in the post-GFC era and is finally bringing us to the point of a reckoning.

Debt doesn’t feature much in mainstream economic theory.  It is fundamentally de-stabilising and theorists are loathed to incorporate it into their balanced models that seek to show a system that in the long-run produces wonderful equilibrium and prosperity for all. 

And make no mistake, debt within reason is a very good thing. 

It is the fuel that ignites growth, as long as economic growth outpaces debt in the long-run.  Think of household debt in the form of a mortgage.  It gets paid down over decades and leaves the borrower with a property that has far more real value (adjusted for inflation) than it did when it was bought.  A country’s trade debt imbalances – in the form of a trade deficit – has traditionally also been seen as a good thing. Certainly that was the consensus in the pre-Trump era.  It signalled that resources were being allocated efficiently on a global scale.   Manufacturing was going to countries that produced goods at the best prices for consumers everywhere.  In recent research globalised trade, especially with China, was singled out as the main reason for three decades of low inflation since the early 90s. 

Debt though can be very de-stabilising when the total amount – crucially both public and private combined – becomes too high.  Many economists agree that when it does reach a certain level it starts to act as a drag on growth and no longer reaps returns and economic growth as it once did. 

A fascinating article in the Autumn of 2016 in “Democracy: A Journal of Ideas” by Richard Vague – a former banker and philanthropist,  reasonably demonstrates that since the second world war, the combined level of private and public debt has risen exponentially and has never really fallen, even during periods of prosperity and economic expansion.  When public debt contracted, this was usually matched by an increase in private debt.  In fact, Vague shows that during the period 1951-1980, when many advanced economies were paying down their war debt, public debt did indeed contract from 73% of GDP to 32% of GDP (the percentage of government debt compared to a country’s entire domestic economy).  But in the same period private debt increased from 54% of GDP to over 100%.  In other words, when we thought we were paying down our overall debt, it was actually simply switching from public to private hands. 

Even during periods known for widespread economic prosperity, when the overall debt theoretically should have started to fall as economic growth overtook debt, it actually increased.  According to Vague, between 1985 and 2002, when U.S GDP grew by US$6.6 trillion, total debt – again public and private combined – increased by US$14.9 trillion, taking the U.S’s total debt ratio from 155 percent to 198 percent.   Since 2008 and of course the onset of the pandemic, the debt problem has only gotten far worse.  The entire global economy is in fact fuelled by cheap money.   The overall debt level now is the highest it has been in history. 

Indeed for all the cheap money around, returns are scant and economic growth – especially in advanced economies – has been sluggish.  Stock market euphoria has not been matched by corresponding increases in GDPs since 2008.  This so-called “productivity puzzle” has attracted a lot of attention among economist.   Seen through the eyes of unmanageable debt levels, it starts to make more sense.  Put simply, debt levels in advanced economies are now simply too high to spur on any real economic growth.

OK – so at this stage it is important to add some context when discussing low productivity, especially in the last decade or so, to make some sense of it all.  It is not just a matter of debt impacting on productivity.    There are many theories put forward as to why productivity is currently so low, and to cut a very long story short, most centre on the relationship between labour and capital.  For much of the modern era and certainly in the golden age of labour during most of the 20th century, two-thirds of the economic pie was generated by labour and a third came from capital in an equilibrium that the celebrated U.K economist John Maynard Keynes himself described as a bit of a miracle. 

This though began to break down in the 80s (90s in emerging markets and developing economies).  Capital increasingly took the lion’s share of returns.  In fact, across a range of economies, productivity for capital rose by 30 percent while it grew by just over half that in terms of wages for labour in the same period since the late 70s.  Not only have wages decreased as a portion of the larger pie but they have also become increasingly unequal, with those at top receiving far more than they did 40 years ago compared to those at the bottom.  This has been blamed on automation and globalisation and is the current source of a lot of unrest in many advanced countries. 

Another problem is that capital has also become increasingly decoupled from labour.  In the past, a sizeable portion of capital went into labour-producing investments.  Say a factory that employed a large number of people and therefore increased the economic pie exponentially through increased income tax returns for government and consumption spending for the private sector by those newly-employed.  But since 1980s, capital has increasingly gone into abstract financial instruments that have no bearing on actual economic activity on Main Street and do little to spark overall GDP growth.  This decoupling is a serious problem that has allowed capital to create artificial bubbles and distort and mask underlying realities in an economy at much greater speed and depth.

The real problem now is that even capital’s productivity has stalled since 2008. 

In the era of cheap money, where the cost of investment is negligible, this becomes a huge problem. 

For all the money and debt that is being accumulated, no real discernible results are being achieved overall.  As money concentrates in the hands of a few financial, banking and insurance institutions, it has become detached from the wider economy and no longer acts as a tool for growth as it should, simply adding to debt loads and acting more as a drag on the economy. 

A deeper breakdown of the current debt loads across advanced economies should be ringing alarm bells.   Most economists though will depict a far less gloomy picture.  And on the face of it, they are not wrong.  Debt today in advanced economies is mainly concentrated in two areas:  Government debt and corporate (non-financial) debt, known as NFC (non-financial credit).  While government debt is indeed high, historically it has been far higher.  In the U.K for example, the public debt to GDP ratio was twice as high following world war one.  And more importantly because interest is so low right now, the U.K debt repayments make up the lowest amount as a percentage of tax receipts that they have in history. 

Not exactly an unmanageable picture. 

Sure, if interest rates were to rise even a bit, the debt repayments will shoot up exponentially, and hence the interest rate rise worries.   According to the Economist, a 1% increase in interest rates would add about £21 billion to the Government’s annual debt servicing costs and increase total spending by a full 2 percent.  Not something to be laughed at but as it stands, still not an overwhelming picture. 

And private debt for households and the banking sector actually appear healthy.  After the GFC, banks were regulated and required to be better capitalised (the amount of liquid capital they needed to hold against their investments and loans), and the retail banking sector was separated from the riskier investment banking operations.  As for household debt, the government injection of money to the public during the pandemic – through unemployment insurance top-ups for example in the U.S and furlough schemes in the U.K, coupled with lockdown, where most were unable to spend their accumulated savings, paints a rosy picture for household debt levels across advanced economies. 

The real problem today lies with corporate debt. 

Again, many economists would argue this should not be of major concern.  Many research papers have linked a build-up of household and banking credit as a sure sign of a forthcoming recession.  But corporate debt should in theory be the least of our concern. After all, corporate debt is the most efficient in terms of fuelling growth compared to its more inefficient public sector and household debt.  It is at the heart of economic expansion.  Or so the theory goes.  There is scant research looking at past links between NFC and recessions but a recent U.S Federal Reserve paper did broach the subject (“Non-Financial Corporate Credit and Recessions.”  Curcuru and Jahan-Parvar March 2021).  They concluded that historically there was no statistically significant link between corporate debt and the onset or severity of any particular recession since 1952. 

So, nothing to worry about then. 

Well, not quite.  Going back to Vague’s argument about overall debt levels and more importantly the efficiency and therefore productivity of that capital, things start to look a bit more worrying.  Between 2014 and 2019 NFC grew from about 84% of GDP to just below 100% today in advanced economies.  Between the first and third quarter, it grew by 11 percentage points alone.   And if you look at the quality of the debt – in terms of its investment grade – then serious problems begin to appear.  In 2010, one-fifth of all corporate debt was non-investment grade, a level that reached 25% in 2019. 

In 2020, half of all corporate bonds issued were BBB rated – that is one grade above junk status. 

NFC is basically accelerating to never-before-seen levels in advanced economies.  And the credit-rating of the companies borrowing or issuing bonds is getting worse. 

And the problem doesn’t end there. 

What NFC is being used for in an era of cheap money is extremely worrying too and may anecdotally explain part of the low productivity problem.  As we saw, capital is becoming detached from the reality on the ground.  Investors are demanding quick and better dividends in an era of low growth where there are not many sizeable returns to be made.  Companies compensate for this by borrowing simply to pay their investors.  This is from an article in the Guardian that pre-dates the pandemic in February 2020:

Many of the companies borrowing funds on the international markets don’t need the cash.  They have enough to invest in new equipment or processes – not that they do enough of that – and they generate enough cash to cover all their day-to-day expenditure.  Instead, they are borrowing to pay ever-higher dividends to their shareholders.

With such dangerous levels of debt floating around the corporate world, you can understand why most economists and central bankers are far more focused on generating growth than with the risk of inflation.  Put simply, they understand that the economy is on extremely shaky grounds.  Injecting more public funds in attempt to kickstart the global economy while money is cheap and pumping liquidity into the system through QE is in many respects the real-life version of doubling down on a bad bet. 

We all ignore overall debt at our peril.  It is no longer possible to write it off as an essential part of economic growth generation when it has become so large in and of itself and more importantly has become detached from real growth too. 

I said earlier that mainstream economists largely paper over debt in theoretical models.  Well, there is one notable exception. 

And that is Hyman Minsky. 

A man way before his time, writing in the late 50s – during the longest period of American economic expansion on record at the time – he claimed that a stable financial system inevitably and inherently breeds instability in what came to be known as the “Financial Instability Hypothesis”.  Following financial trauma (as he called it – such as a stock market crash), regulations are put in place that lead to a period of stability and prosperity.  But people inevitably forget these vague lessons of the past and this breeds over-confidence.  Financial euphoria settles that leads to a relaxing of those regulations that then creates a bubble of speculative borrowing that finally causes new instability and leads to another crash. 

Hyman was able to see the bigger picture when most others could not.  He died in 1996, his theories largely forgotten until of course 2008.  In economist circles, the GFC is actually now known as a “Minsky Moment”. 

In all truth though the real “Minsky moment” was in all liklihood only delayed. 

The worst effects of the GFC and the pandemic were in reality postponed through the massive injections of government spending and liquidity into markets.  Capital that in the corporate bond sector has reached a point where it mostly doesn’t create any discernible growth and its size and quality will almost definitely threaten to spill over into the banking and eventually household sector.

If the 2008 GFC got governments, banking and the financial sector hooked on cheap money and debt, then the pandemic got the rest of the general population hooked on public debt through government assistance and subsidies.  Our expectations have changed drastically and fiscal austerity would be treated with as much of a collective tantrum by the general public as it would be by the financial and corporate world who would also balk at any unexpected tightening of the money supply signalling an end to cheap credit.

The party though has to end somewhere. 

Either with an asset crash or with a rise in interest rate to combat  persistently high inflation.  Inflation that could partially be brought about by the growing government spending and debt that pushes demand beyond an economy’s capacity and that eventually does feed through to wage inflation as for example people demand higher wages to return to work (I mean why go back to a crappy job if you can keep receiving government pay-outs).  Something that might (“might” being the operative word) be happening already:  The New York Federal Reserve recently published a report that showed that people are demanding an average 3% wage increase to return to work at present.  And among lower-paid jobs, that rises fully to 19%.  And there is nothing that sets off inflation more than bouts of wage inflation. 

Either way, at some point the fragility that has punctuated the post-GFC economy since 2008 and underpinned by eye-watering levels of debt and low productivity will be exposed in the most brutal fashion. 

And there will be no historic analogy with which to compare the true disaster that follows. 

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