Debt and leveraging has been a key point of discussion after the financial crisis of 2008-09. In the period prior to the crisis, the private and household sector witnessed significant leveraging and the crisis started with the sub-prime loans, before spilling over to the entire financial system.
Eight years down the line, there seems to be little learning from the financial crisis as the global financial system is more leveraged than it was in 2008. While the private sector and the household sector have deleveraged (or moderately leveraged), the government sector has significantly leveraged.
Is leveraging or piling on more debt the answer to sluggish economic growth?
This article discusses the impact of one dollar of debt on GDP growth in the United States from 1960 to 2015. For the purpose of analysis, the total credit market debt is considered and its impact analyzed on GDP growth.
If the impact of debt on GDP is constant over the years or increasing, it makes sense to leverage for growth. However, if the impact of debt of GDP is diminishing, policymakers need to look beyond leveraging as the answer to every problem.
The reason for this discussion will be clear from the chart below that gives the total credit market debt from early 1950s to 3Q15.
From 1980, credit market debt growth has accelerated with a brief pause during the crisis. The total debt as of 3Q15 stands at $62.5 trillion (345% of GDP). While debt growth has accelerated, the impact of debt on GDP growth has continuously declined.
I have considered 20-year periods for this analysis – 1960 to 1980, 1980 to 2000 and 2000 to 2016. For each of these periods, the increase in debt and the increase in GDP are given in the chart below along with the impact of debt on GDP growth.
The Diminishing Impact of Debt on GDP Growth in the United States
For the period 1960-80, every additional dollar of debt had a significant impact of $0.61 on GDP. However, this has slumped to $0.23 in the last 16 years.
If this trend continues, the economy is gradually headed towards zero hour when an increase in debt has no impact on GDP. I am not suggesting that zero-hour is coming immediately, but the trend seems to be in that direction and with consumption driven growth remaining in focus, I see further decline in impact of debt on GDP growth.
While deflation fears still exist, there can potentially be a point when additional debt just contributed to inflation with no impact on real GDP. If this has to reverse, policymakers need to work towards creating a finer balance of production and consumption driven economy. There needs to be more fixed asset investments from incremental debt than consumption growth through leveraging.
However, I am not expecting dramatic changes from policy perspective and debt will continue to mount in the coming decade. In line with this expectation, I expect economic growth to remain sluggish even if there is no recession.
From an investment perspective, I see strong upside for gold in the next decade as debt mounts. In few of my recent articles, I have elaborated on the point that the United States is potentially in an inescapable debt trap. If that argument holds true, there are good times ahead for all hard assets.