The McKinsey Global Institute’s latest report on debt and deleveraging contains the following diagram, which shows combined public and private debt in the ten largest developed economies over the last 20 years:
In case the image is unclear, the sharply rising dark blue line is the United Kingdom’s total debt. Only Japan keeps us from the top spot. For someone like me who broadly subscribes to the Austrian theory of the business cycle (for a musical explanation, click here) this is a very troubling image.
Simplifying somewhat, unsustainable booms usually have their roots in government or central bank action, which is amplified by the commercial banks, and serves to push market interest rates below their ‘natural’ level.
This distorts the economy: people borrow more and save less, and those sectors of the economy which are fuelled by availability of cheap credit – housing and finance, for instance – grow rapidly. This creates a vicious cycle. As the bubbles grow, more and more resources are sucked towards these sectors rather than others. The boom, though ultimately unsustainable, is self-reinforcing and the economy becomes increasingly unbalanced.
Then comes the credit crunch. Maybe the central bank raises interest rates, or the financial regulator increases capital requirements, or maybe a particular market (think sub-prime mortgages) tanks and sets off a confidence-sapping chain reaction. Whatever the trigger, the bubble bursts. Or as the song I linked to above has it, “the boom turns to bust as the interest rates rise”.
Now, what should happen here – assuming government policy is ‘neutral’ – is the liquidation of bad investments, deleveraging, and the reallocation of resources so that they realign with changed consumer preferences. This may be a painful process, but is also a necessary, remedial one. A return to real, sustainable growth cannot and will not happen until this adjustment and recalculation has taken place.
What the diagram above suggests very clearly is that this adjustment has not happened: on the macro level, no significant deleveraging has taken place. Total debt is, of course, only one metric among many – but the story this picture tells is nevertheless a persuasive one.
So why hasn’t the economy adjusted the way I claim it should have? One word: policy. We bailed out the banks, and we’ve propped up housing and other asset markets with low interest rates and quantitative easing. Indeed, the coalition government’s entire economic strategy is to keep interest rates as low as possible and boost lending. The necessary economic adjustment hasn’t been allowed to happen, and so we’re stuck in a rut.
The silvery-grey line on the McKinsey diagram contains a worrying indication of our economic future: are we going to end up like Japan, and have to endure a decade or two of stagnation? Or will renewed crisis in the Eurozone bring matters to a head? The answer to those questions may become clearer as 2012 progresses.