Monthly Report - DossierMarta Noguer
Backpacks, debts and other burdens to calibrate

«Sunday, 5 a.m. Two hours before the ascent. Waterproof, torch, blanket, 2 cans of food and 3 litres of water? 3 cans and 2 litres? 3 and 3? We are stricken with doubt: too heavy a load and we might not be strong enough to reach the summit; too little and we might give up due to lack of supplies. What is the ideal load? How heavy does it have to be to start being a burden?» Replace backpack with debt and ascent with growth and you are asking the same questions as those disturbing the sleep of many academics, politicians and investors since the global financial crisis crossed the Atlantic, mutated into a sovereign debt crisis and completely engulfed the euro area.

You will soon realise that the answer to all these questions is a big «it depends». Just as the ideal weight of a backpack depends on a person's physical strength, the extent of the goal, whether they have support and also the weather, the ideal level of debt or the level of debt a country can sustain without jeopardising its solvency or penalising its long-term economic growth will depend on a long list of conditioning factors. These include its degree of development, growth potential, the quality of the institutions, nature of the debtors (public or private) and of the creditors (national or foreign, official or private), maturities schedule, the debt's currency, whether or not there is a lender of last resort and the use made of the funds provided.

By way of example: Brazil's debt at 70% of GDP does not raise the same doubts if it is used to finance production investment, which is much more likely to have a positive future return in a country with huge economic potential, than when it is used to finance a property bubble or short-lived consumption. Neither does the debt level of 100% of GDP in the USA, the world's leading economic power and with minimal financing costs, cause the same headache as it does in the Sudan. And, of course, a debt ratio of 180% of GDP in Greece, without a lender of last resort and largely in foreign hands, is a lot more worrying than Japan's 240%, with most assets stored in Japanese coffers and watched over by its own central bank.

But why is debt worrying? At the end of the day, and as succinctly put by Alexander Hamilton, first Secretary of the US Treasury, «a national debt, if it is not excessive, will be to us a national blessing». It means that future revenue can be brought into the present and thereby finance projects for investment, innovation or the training of human capital which should ultimately boost long-term economic growth. It can also be a shot in the arm at times of crisis. So what is the problem? Alexander Hamilton himself provides us with the key: the term «excessive». History confirms that, as from certain levels of debt, its positive effect on the path of growth can go awry.

Such a breakdown can have several causes. To begin with, more debt usually results in a higher burden of interest payments. If this debt is public, higher interest payments will require higher taxes, less public spending or a larger deficit. In any case, the outcome is a loss of resources available to invest or consume, with the consequent impact on activity and growth. The problem gets worse if this debt burden forces a hike in taxes, introducing distortions and generating inefficiencies in detriment to growth or if it causes a crowding out effect on private investment that will only be harmless for growth if it ends up financing as many or more productive projects as in the private sphere. Another additional aggravating factor, which applies both to public and private debt, arises when a high proportion of this debt is external; i.e. if it is in the hands of foreign creditors as, in this case, the interest paid exits the domestic economy, apart from the fact that financing costs usually increase with the relative weight of the external debt.

Secondly, the more public debt accumulated by a country, the less room economic authorities have to apply countercyclical policies in a recession or a moderation in the rate of activity without alarm bells ringing. Without such a recourse, there is a greater risk of a recession digging in or an economic boom becoming too volatile, i.e. of a boom-bust, which would exacerbate uncertainty (a severe enemy to investment) and threaten growth in the medium term.

Thirdly, the mother of all divorces between debt and growth occurs when some kind of event destroys confidence and sparks fears of default. If such fears take root, investors will be reticent to refinance debt maturities and debtors may be forced to make an abrupt adjustment to their net borrowing. The ensuing negative impact loop could be as follows: creditors demand a higher risk premium; companies divest, either because it is too expense to finance themselves or because they expect a higher tax burden or expropriation in the future; uncertainty also slows up household consumption; the public sector introduces austerity measures to offset its higher interest burden; investment and consumption end up suffering; growth is damaged; there is a greater likelihood of a write-down, either explicit or via inflation, and this fuels the initial fears even further. These fears become even greater if both the private and public sector start to deleverage at the same time. This vicious loop is difficult to reverse once it starts up, what is known in physics as an unstable system: one which, once it loses equilibrium, requires a powerful external source of energy to avoid catastrophic failure (its antithesis would be a pendulum). Escaping such a debt trap undoubtedly requires powerful levers, such as boosting growth through ambitious reforms that promote gains in competitiveness or external aid through a lender of last resort. Without these, the whirlwind could become a hurricane and cause a liquidity crisis that would truly jeopardise growth by precipitating a massive, sudden adjustment in the imbalances. In the worst case scenario, a self-fulfilling prophesy would come about, with a real write-down.

A crisis of confidence due to fears of default is highly probable when the necessary tax hikes or cutbacks to serve debt exceed the maximum considered to be economically or political achievable.(1) As Paul Krugman warned years ago, when the level of debt is so high the indebted government sees few real possibilities of being able to repay it, the incentives to take measures to continue repaying this debt fade away. This is what is known as «debt overhang» and it is more likely to occur the greater the outstanding debt. When this happens, creditors face a dilemma: if they continue to finance the debtor, the stars may align and they might get all the loan back but they run the risk of the debt overhang pushing the debtor to declare itself insolvent; if, however, they decide to write off part of the debt, they must recognise immediate losses but give the debtor breathing space and increase the likelihood of recovering the rest. Nonetheless, neither the consensus nor empirical evidence has been able to conclusively identify a threshold of debt related to GDP that universally determines the risk of a debt trap.(2)

In any case, as the saying goes, if you can't stand the heat, get out of the kitchen. Taking into account the fact that this kitchen is the equivalent to stagnation, depression, external aid or loss of sovereignty, it is better not to abuse debt and administer national finances following the advice that a mother would give her child just before an excursion: make sure you have not too much nor too little of anything; pace yourself; administer your resources responsibly and prudently; don't leave the group; don't rely on the weather or on your companions helping you out or even that I'm going to rescue you out there; get as far as you can. But, especially, honour my dreams and hard work by not dying in the attempt.

Marta Noguer
International Unit, Research Department, "la Caixa

(1) Most governments have acquired spending commitments that cannot simply be got rid of overnight.

(2) Several studies, particularly the work by Carmen Reinhart and Kenneth Rogoff, identify a negative correlation between debt and growth that, in general, associates an increase of 10 percentage points in the debt to GDP ratio when this exceeds a threshold that, depending on the study in question, would be between 80% and 90% of GDP, to a drop in GDP growth per capita of between 13-17 basis points. However, the opposite relationship has not been ruled out and other authors deem this threshold of 80%-90% to be arbitrary.