UK: Debt-Driven Growth, Where Is The Limit?

Last Updated: 6 February 2015
Article by Ian Stewart

Most Read Contributor in UK, August 2017

Last Friday I was on a conference panel discussing the role of debt in a modern economy. It was an intriguing event raising profound questions about the desirability of ever-increasing indebtedness. Here are some of our thoughts on this complex, hotly debated issue.

The modern financial system has enabled credit to expand at a faster rate than the growth of underlying economies. As a result overall debt levels – measured as the ratio of private and public sector debt to GDP – have risen over time.

The financial crisis has led households, corporates and financial institutions in a number of industrialised countries to pay down debt, or deleverage. In the UK, for instance, all three sectors have reduced levels of debt relative to GDP.

Yet the long uptrend in global debt levels has continued over recent years. Debt reduction by some Western consumers and corporates has been offset by Western governments borrowing more and a continued uptrend in borrowing by emerging market nations.

According to a recent report from the Centre for Economic Policy Research (CEPR), the ratio of global debt, excluding financial institutions, now stands about 210% of global GDP, up from 175% on the eve of the financial crisis. The CEPR report's title, "Deleveraging? What Deleveraging?" captures its key finding.

The financial crisis was in part a product of excessive borrowing, risk taking and sharply rising asset prices. It might therefore seem ironic that the policy response has involved making credit cheaper and more available - in order to bolster borrowing, risk taking and asset prices.

An alternative policy, advocated by some Austrian School economists, is to "purge" excess from the system through reducing debt levels and asset prices. Much the same policy was urged on President Hoover by his Treasury Secretary, Andrew Mellon, during the Great Depression: "liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate... it will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people."

Understandably, the idea of deep deleveraging and a deep recession laying the foundation for sustained growth finds few adherents in democratic societies.

Debt is often taken on in order to purchase an asset – housing, bonds, equities, for instance. It is no surprise, therefore, that the rise in global indebtedness has coincided with, and reinforced, an uptrend in asset prices.

The relationship between credit and asset prices is an old one. Financial innovation and liberalisation, by making credit more available, tends to fuel asset prices. One of the first recorded asset price bubbles, the Dutch "tulip mania" of 1617, was facilitated by tulip merchants lending buyers the money to purchase exotic tulip bulbs at ever rising prices.

In the run up to the Global Financial Crisis cove-lite loans, negative amortisation mortgages and auction rate securities poured more credit into the economy and fuelled the boom in asset prices. Deep and sophisticated financial markets, such as those that exist in the US and UK are good at creating credit and that can, as we have seen time and again, fuel a bubble.

Yet such markets are also widely seen by economists and policymakers as being crucial to the prosperity of the economy. They facilitate the movement of capital to productive uses, enabling consumers, companies and entrepreneurs to secure major assets which they would otherwise be unable to purchase. Debt financing allows governments to spend during downturns and, in so doing, to mitigate the effect of the economic cycle.

So when does debt become excessive and destabilising? A recent working paper from the Bank for International Settlements estimates that debt levels in excess of 85% of GDP for governments and for households and 90% of GDP for corporates are likely to damage growth.

Such precise estimates based on a particular dataset (in this case debt levels in 18 OECD countries between 1980 and 2010) are not necessarily a perfect guide to future policy. But they do raise the question of whether we can distinguish between good, growth enhancing-debt, and bad, growth-reducing debt.

This is tricky. Some high-risk lending pays off and some low-risk lending fails. Some credit-driven booms – for instance the long rise in UK house prices relative to incomes – prove remarkably durable. It is only long after the event that we perhaps have a chance to assess the success of credit creation.

One can, perhaps, rationalize the performance of the financial system in these terms. It is prone to bubbles and excess but it also provides the capital and opportunity to maximise economic growth over the cycle.

That is the ideal: a dynamic, risk-taking culture which raises opportunity and incomes over time and which, periodically, suffers setbacks.

One of the concerns for economists today is that, eventually, the accumulation of debt could give us the worst of both worlds – high levels of debt, falling asset prices and low growth. 

So, to return to the original question, where is the limit to debt-driven growth? Because credit growth is so closely linked to asset prices, establishing the limits to debt-driven growth is like establishing an equilibrium value for the FTSE100, the gold price or Manhattan apartments – it is speculative. Time and again we only discover the limit of indebtedness once we have exceeded it. 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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