All Debt Is Not Created Equally

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Debt does have its purposes, but they are much more specific than many people think. Borrowing to buy a productive asset (like a factory or an education) that will generate sufficient income to repay the loan is fine. However, using debt to pay for current consumption, to live above your means, is counterproductive and forces a future decline in consumption in order to pay off that debt. In other words, that type of borrowing is simply stealing from the future.

Countries can use debt productively by borrowing to build infrastructure or use it unproductively by borrowing for transfer payments (like welfare, extended unemployment benefits, or healthcare). Companies and individuals face similar choices to use debt wisely or foolishly.

Over the last century, the world has seen a steady, even accelerating, modernization of the financial industry. As financial intermediation has become more globalized and efficient at pairing excess savings with interested borrowers, taking on debt became easier and less expensive. This created an incentive to use debt for less productive uses, which means the average benefit of debt has been steadily declining.

One way to measure the effectiveness and judiciousness of debt incurred is by the ratio of debt to GDP. This is not the oft-discussed ratio of government debt to GDP; the debt here is all debt in a country. In a simple sense, the higher the debt to GDP ratio is, the less productive the debt is.

Using data from the World Bank, I looked at the debt to GDP ratio from 1960 to now for all 220 countries with available data. The basic trend is upward all around the world, and the rise is accelerating.

Worldwide, debt to GDP has roughly tripled since 1960. This is not automatically a bad thing, as the debt might have been incurred in order to build infrastructure capable of delivering long-term gains in productivity and national income. However, if we focus in on the more developed countries, specifically those who are in the OECD, the observed trend is a more meaningful signal of improper debt use as these countries all have well-developed welfare states and have tended to run budget deficits over much of the period studied in order to deliver benefits to some of their citizens rather than to increase their infrastructure.

In 1960 the OECD countries had a debt to GDP ratio of 57.3 percent. Over the next twenty years, the ratio rose to 84.0. Then from 1980 to 2000 it jumped to 145.9. By 2013 debt to GDP stood at 163.9 percent for the OECD countries. In the U.S., the story is similar. Debt to GDP was 74.0 percent in 1960, 94.2 in 1980, 162.0 in 2000, and by 2013 has reached 198.0 percent.

What is clear from these figures is that adding debt is not an efficient way to grow an economy. If more debt was good at creating growth, the debt to GDP ratio would be constant or falling. The fact that we see the ratio rising implies that each additional dollar of debt incurred is producing less economic growth, if any. In other words, much of the debt must be going to finance current consumption rather than being invested in productive assets like infrastructure.

Some countries are doing better than others. Germany, for example, had a debt to GDP ratio of only 95.6 percent in 2013, up from 61.4 in 1970. Thus, while the U.S. and the OECD have both more than doubled their debt to GDP ratio over that period, Germany's only rose by a bit over 50 percent. Yet, the German economy has certainly not suffered as a result.

In fact, since 2005, Germany has actually grown faster than the rest of the European Union while lowering its debt to GDP ratio (from 112.6 in 2005 to its current 95.6). Meanwhile the EU saw its ratio go from 114.4 to 126.5 percent. The rest of Europe is working hard to convince Germany to give up on austerity, but the data show that it is possible to grow your economy without increasing your borrowing.

The success of Germany over the long-haul and in its superior recovery from the recent recession provides some clear evidence that debt-financed growth is not a good policy choice. Countries can grow without constantly increasing debt burdens on their government, corporations, and citizens. Debt has its place, but using it to steal growth from the future in order to finance consumption today is not the right way to employ debt. When countries, businesses, and people use debt incorrectly in such a manner the gains are fleeting and in the long-run they will all be poorer.

 

Jeffrey Dorfman is a professor of economics at the University of Georgia, and the author of the e-book, Ending the Era of the Free Lunch

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