A theme which frequently pops up in current financial and economic commentary is that of the burgeoning levels of outstanding debt under which all too many nations are said to groan. Typically, reference will be made to the percentage of GDP which this mountain of obligations entails, usually by way of putting it into a context which is deliberately slanted to be alarming. But how valid is this comparison?
No Austrian will, of course, be insensitive to rising indebtedness – especially where the majority of these debts are conjured up by the banking system in the form of what used to be called ‘fictional capital’ or else, having started out benignly enough as the creditors’ ex ante savings, they have since been monetized by said banks and so have contravened their originators’ expressed time preference.
The reader may be aware that the reason we followers of Mises, Hayek, et al, object to this latter practice is that it allows multiple claims to be simultaneously exercised over the one quantum of goods whose original loan would otherwise have denied their use to more than one person at once. After all, it is all very well for me to lend you my bicycle – whether you intend to use it in your job as a mail courier or simply take it for a pleasure ride – but it is no good then furnishing countless others with duplicate keys to the bike lock and telling them they are all free to go ahead and use it wherever they may find it temporarily chained.
However, much of the contemporary treatment of elevated debt levels rests not so much on such a fundamental objection as this as on a series of half-truths and outright fallacies.
For instance, one pundit has recently been tweeting that, with estimates suggesting that the grand total of identifiable debt amounts to 320% of the planet’s annual output, even a modest interest rate of 2% per annum payable thereon would seem to require GDP growth of 6.4% to service and hence – the author effectively concludes – ‘abandon hope all Ye who enter here’.
Without spending too much time discussing either the accuracy or indeed the relevance of such super-aggregations, or addressing the fact that 6.4% NOMINAL (which is what we seem to require) is a very different matter to 6.4% REAL (which seems to be implied), and overlooking entirely that such numbers deal with gross, not net debt (i.e., with only the liability side of the balance sheet), we must demur, however, at his obvious-seeming conclusion.
What’s the Beef?
To try to demonstrate the nature of our objection, suppose I am a corn farmer and you a cattle rancher. In the general course of events, we each consume half the product of our own labours and mutually exchange the other half. In this way, we broaden the range of goods we can enjoy while allowing for the product specialization between us to confer its usual blessings, not least those accruing from what is known as ‘comparative advantage’.
Imagine further that you have heard that if you supplement your herd’s feed with a judicious quantity of exactly that same cereal which I grow, the cows will both breed more prolifically and mature more rapidly, thus putting on a greater poundage of consumable meat pr unit of time. This, you reckon, will add to your overall output and so potentially raise your income
Not being entirely able to acquire enough corn to try this simply by forgoing a part of the regular personal consumption quota for which you exchange your beef (i.e., by self-funding it), you knock on my door to persuade me to join you in giving up a part of mine, i.e., to save and then to invest those savings in the form of a loan to you. As recompense for my sacrifice of immediate enjoyment (and perhaps also as a premium in recognition of the risk I am taking on your mastery of bovine nutrition, as well as on your general diligence and trustworthiness), you promise to return me not just what you have borrowed, but an additional increment of value when the debt falls due, something which we may obviously refer to as ‘interest’.
Sadly, however, it turns out a few months later that either your understanding was awry, your application faulty, or that factors otherwise beyond your control conspired to frustrate your intentions. At the end of the period specified, you have no extra cattle, nor have the carcasses of the beasts you do possess shown any appreciable gain in weight over the norm.
So, with my harvest of corn also unchanged from the previous year – and hence with our joint ‘GDP’ having been unaltered – what is to be done? Must you default? Declare bankruptcy? Be put out of the ranching business as a result of the failure of your speculation? Am I, too, to suffer a loss of wealth for having funded your ill-starred scheme?
Well, no, actually.
All that must happen to avoid all this is that you, the unsuccessful rancher, must deliver an extra quantity of meat above and beyond the 50% you normally exchange with me to the agreed value of the original loan of corn, plus an amount to make up the interest on it. Alternatively, I could take the same amount of meat but offer less corn in its place – or there could be some mutually agreed upon combination of the two.
When this has been done, it should be readily apparent that I have enjoyed a small increment to my income as the reward for my investment and that you have suffered a reduction in yours as the penalty for your failure to make more fruitful use of this, your PRODUCER loan. We can also see that DESPITE THERE BEING NO AGGREGATE GROWTH, the debt has been both serviced and discharged in full.
The same principle would apply even if the only reason you wanted the loan of corn was to put on a lavish spread for the guests at your daughter’s wedding – a decision which would mean you knew from the off that your advance access to extra goods, achieved via this CONSUMER loan, would mean a diminution of the quantum of those goods available to you in future.
So, no, Mr Pundit! A 320% debt ratio, carried at 2% interest does NOT mean we require 6.4% growth to service it, simply that borrowers must regularly surrender 6.4% of their income to their lenders for these latter then to do with as they wish (or, rather, 12.8% of their half of total global income if we assume the unlikely circumstance where equal-income net debtors are matched one for one with net creditors, with no overlap between the two populations).
That may sound a lot to ask, but transfers of much greater magnitude routinely take place – not least those related to the regular exactions of the State – without either systemic economic breakdown or individual ruination being a necessary consequence.
Divide & Conquer
Beyond this issue is the wider one of whether it makes any sense to compare these numbers to GDP in any case? Here we are not alluding to the advisability of measuring a stock in terms of a flow, but rather whether GDP – for all its talismanic status – should not be supplanted by some more comprehensive measure of commercial activity.
To see why we ask this, we need to take a moment to think through the implications of an increasing – and generally enriching – division of labour which may be at work in the world.
If we start by considering some highly vertically-integrated corporation, run by a scaled-up version of Henry Ford, we could imagine that the firm mines and refines its own iron ore and coking coal, pours its own steel, fabricates its own components and so on, all down the line to the car dealerships and vehicle repairshops which it operates in order to sell and service the resulting cars.
In this case, we might be justified in looking at the debt component of the firm’s capital in relation to the (net) monies it receives from the goods it sells and the services it provides.
But look now at what happens when some bright-eyed management consultant comes back with the results of a study saying efficiencies will be enhanced and returns prospectively raised if the various divisions of the company are spun off into stand-alone units, each responsible for running its own business.
Where there was one giant ‘assembly line’ (if we can stretch the term to extend all the way from the mine to the mall), now there are multiplicity of businesses, picking up – and paying for – inputs from other businesses (generally) more remote from the end customer, before transforming them into a successively more finished product and selling them on to the next entity ‘downstream’ of them.
If, as is likely, each of these firms seeks and grants credit from and to those either side of it in the chain, we now have a situation where extra levels of debt necessarily exist even though the quantity of the final product will only be fractionally enhanced by the new arrangements and where, absent any changes in the supply of money, sales receipts may remain entirely unchanged (prices having benignly fallen along the way).
Thus, with each successive degree of specialization of function, the ratio of debt to end product (this little community’s equivalent of GDP) will rise further in a manner which directly reflects – but is super-proportional to – the improvement in the conduct of its operations.
To see this, let us step back into the realm of Crusoe economics and ponder the evolution from a primitive world where the four men marooned on the island all do the same, generalist thing in unison – stand long hours in the shallows, poised with a sharpened stick under a blistering sun for uncertain reward – to a situation where each concentrates on performing just one of the several stages involved in a given process – say, tool-making, tree-felling, boat-building, and what they this hope will be either the more prolific or the less laborious catching of the fish they will eat for their supper.
Whereas each men had previously earned his sustenance in the course of one day’s endeavour, what results now is a state where the tool-maker needs to be fed for the three further days it takes for his work to contribute to actual fish being landed on the beach (from axe to plank to boat to tuna, as it were); the tree-feller for two days (plank to boat to tuna) and the boat-builder for the one remaining from skiff to skipjack.
To prevent them all from starving while this occurred, sufficient savings need to have been accumulated to allow this network to be built, amounting to 3+2+1 equals 6 days’ provisions. Dependant on who does the saving and the form in which it has been invested, the record of who had access to what, and when they did so, all of that saving could contractually take the form of a series fixed debts.
Furthermore, once the chain has been successfully been completed once, it will settle down into repeated operation. If we now follow the chain in reverse order, the fisherman divides his catch into four, keeping one portion to ‘pay’ himself (strictly, taking it as his ‘profit) and passing three to the boat-maker who, in turn deducts one as recompense for his efforts and passes two on to the forester. Likewise, this latter takes one and pays his debts to the toolmaker with the last remaining quarter of the initial haul.
Four fish have been divided, but total revenue comes to 4+3+2+1 = 10 units, six of which represents a flow of what used to be called ‘circulating capital’ – goods in process, we might now say – and so may potentially be identified with the associated debt claim held by each supplier in the sequence on his customer.
Again, note that physical end product will be only modestly enlarged even if this division has worked well, while its dollar value might even lie entirely unaltered if the number of monetary units employed to undertake the exchange transactions involved is not augmented. GDP therefore fails to capture the essence of what is underway and therefore debt-to-GDP – taken in isolation – paints an entirely misleading picture of the merits of what few would argue is likely to be a superior productive arrangement.
‘Neither a borrower nor a lender be,’ Polonius sententiously enjoined his son Laertes in ‘Hamlet’. But what he should have said is: ‘only borrow for productive ends and only lend so that some other specialist may earn his keep before he discharges his debt to you by helping you realize the value of your own efforts. That way, you can both feed and clothe yourselves, as well as service all your loans.’
Not quite as pithy, obviously, hence we should not accuse the Bard of any possible economic naivety. Nonetheless a more sensible rule of thumb to follow since, in such a chain of sequential value-addition, the fact that we have a four-fish income stream (!) and outstanding debts of 3+2+1 = 6 fish – effectively, amounting to 150% of ‘GDP’ – is not intrinsically a cause for worry and may even be seen as a sign of our greater sophistication over our zero-debt, subsistence-hunter, former selves.[Addendum: By way of putting this into a real-world context, if we make our best estimate at the total of money passing into the coffers of all the private business supplying goods and services to a developed economy like that of the US, we find that the total amounts to almost three times that of (ex-imputation) GDP – or, for the latest years for which we have full data, 2013, to just over $40 trillion versus approximately $14 trillion. The ratio of that larger number to total domestic non-financial debt therefore dips to a more modest-sounding 100%.]