Economic history is littered with examples of empires and nations that lost their ability to prosper due to heavy debt burdens (Mesopotamia, Rome, France, and England, among many others). In the present age, the U.S. has seen several periods of indebtedness: the 1830s-1840s, the 1860s-70s, the 1920-30s, and the late 1990s to the present year. Japan has struggled with over-indebtedness since the 1980s, and has yet to pull itself out of its unproductive debt trap — in this case unproductive debt defined, by the post-Keynesian economist Hyman Minsky, as debt that does not create an income stream to repay principal plus interest.
The important theme from the McKinsey Global Institute (MGI) studies on over-indebted nations is that regardless of their differences in development, systems of government, currency standards, and economic structures, the nations all suffered from growth constraints due to unproductive debt. A non-linear correlation is also often seen, where increasing levels of unproductive debt in an economy create an even more significant constraint on growth.
At the end of 2015, several major economies had Total Private and Public Debt as a % of GDP well above the typical threshold of 250-300%, including Japan at approximately 650%; the UK and Eurozone, each between 450-475%; the U.S. and Australia, each between 350-375%; Canada at approximately 325%; and China at 350%, which may be much higher due to an overstatement of its GDP — a likelihood that would be consistent with China’s M2 velocity, which is lower than that of Japan.
Some of the effects of over-indebtedness include:
- Transitory spurts in economic growth, inflation, and high-grade bond yields that cannot be sustained due to debt constraints
- Economic downturns due to the constraints of debt repayment. The economic downturn can be triggered by inflation or rising interest rates but these are not required, as the constraints of debt repayment alone can cause downturns.
- Deterioration in productivity growth that isn’t inflationary, as it is the result of a start-stop economy that cannot gain momentum
- Inadequate monetary policy that is only able to restrain growth
- Falling inflation and the potential for deflation
- Falling treasury-bond yields that stay low until unproductive debt constraints are reduced
- Potential for serious social conflict when multiple major economies are over-indebted, as there is no longer a primary engine of growth in the world
However, in an over-indebted environment, fiscal policy may still be able to stimulate growth if it can reduce unproductive debt in the economy, likely without increasing aggregate debt. A combination of productive spending in the form of fiscal policy and multi-year saving plans within the over-indebted areas of the economy may be needed to remove the incorrectly allocated debt.
The Exhaustion of Monetary Policy: Large-Scale Asset Purchases (LSAP), Quantitative Easing (QE), and Negative Interest Rate Policy (NIRP)
The inadequacy of monetary policy, as it relates to the current environment, is becoming clear in empirical data, which has detailed the ineffectual nature of LSAP, QE, and NIRP, and has shown that they are unable to boost the broad economy. One need only look to a plot of U.S. nominal GDP (year-over-year % change, quarterly) to see that three miniscule growth spurts were all reversed during the QE experiments, and that the best growth rate in the current expansion was weaker than the peak levels in all of the post-1948 expansions. The empirical data in Japan and Europe also confirms that LSAP is unable to reach the broader economy.
To understand the mechanism that led to the Fed’s policy error, one needs to look to the disproportionate and narrow distribution of the stimulus throughout the broad economy. The Fed’s attempt to stimulate the broad economy via “the wealth effect” (i.e. higher stock prices) disproportionately benefits publicly traded companies over private companies and holders-of-securities over non-holders. Since the stock market is only a portion of the economy and the majority of the population increases their spending based on increases in income (not based on an increase in portfolio holdings), the broader economy has not been significantly boosted by LSAP. A “trickle down” effect will also disproportionately benefit those who receive the stimulus dollars first, as they have the first bid on purchases of assets, goods, and services. Even if the stimulus is able to work its way thru the economy reaching more individuals and smaller and private businesses, prices for desirable assets, goods, and services will have already been bid up by those that received the stimulus first. The outcome is that LSAP allows for distortions in the flow of capital within the economy and does not significantly boost the broad economy.
Several economists at the Fed’s 2013 Jackson Hole Economic Conference presented research showing that LSAP may have actually pulled growth down. Robert Hall, of Stanford University and Chair of the National Bureau of Economic Research Cycle Dating Committee, said, “An expansion of reserves contracts the economy”. It was decided later that year that the Fed’s LSAP program would be tapered off, to end completely in 2014.
The inadequacy of monetary policy, as it relates to the current environment, can also been seen in the latest central bank experiment: negative interest rate policy — which is also unlikely to boost broad economic growth for several reasons.
When an economy is weighed down by unproductive debt, its growth is not very responsive to small decreases in short-term interest rates, and as those debt levels rise even more significant rate reductions would be needed to generate the same short-term economic boost.
A temporary psychological response from risk-oriented investors is possible (just as it was with QE) due to a misunderstanding of the long-term effects of the policy, but the likely outcome is that money in circulation would increase — cash would be withdrawn from money market and savings accounts to avoid paying interest, which would depress money growth. While restrictions on withdrawals could be implemented to prevent this process, any attempted change would need to overcome a very significant opposition to capital controls. The Fed would likely need to expand their balance sheet even more to counteract depressed money growth, resulting in an outcome similar to that of LSAP, and if the Fed’s balance sheet expansion was viewed as inflationary, a transitory increase in long-term yields could further constrain broad economic growth.
The potential for a miniscule short-term growth boost, based on investor psychology, does not outweigh NIRP’s damaging effects, as was the situation for LSAP. Negative interest rate policy would impair bank earnings; it would also likely reduce the income of the broader population (the majority of households and small businesses) because they tend to hold a larger portion of their assets in bank accounts. Income-oriented groups, such as insurance companies and pension funds would also be strained by NIRP, and corporate spending could be impaired. Employment could even be negatively affected due to a reduction in corporate spending.
Economic Policy — The Proper Tool is Required
The overarching theme of today’s world is that, growth in many developed countries has been restricted due to high levels of unproductive debt, monetary policy in many of these countries has been exhausted, and many of the world’s central banks are desperate to use risky and experimental policies due to a lack of cohesive fiscal policy.
The unintended consequences, of using monetary policy when fiscal policy is the required tool, could be thought of more clearly if one thinks of the unintended consequences of endlessly jabbing at a nail with a screwdriver, instead of using a hammer to finish the job with a few taps. The proper tool is necessary to reach the desired outcome.
- Bureau of Economic Analysis
- Hoisington Investment Management — Van Hoisington & Lacy Hunt: www.hoisingtonmgt.com
- Doubleline Funds — Jeffrey Gundlach: www.doublelinefunds.com
Additional sources for comments on the effects of negative interest rate policies:
- Allianz — Mohamed El-Erian
- Janus Capital — Bill Gross