Practical analysis for investment professionals
12 November 2015

Has Global Debt Become Unsustainable?

During the global financial crisis, excessive debt was the principal disease. It also turned out to be the principal cure. That a cure could be worse than the disease was well known. But that the cure could be the same as the disease — that seemed to be something new and rather puzzling.

Debt Begets Debt

Whether it was called quantitative easing (QE) or something else, it all meant the same thing: increased debt — both in absolute terms and relative to GDP. A report by McKinsey & Company notes:

“Rather than reducing indebtedness, or deleveraging, all major economies today have higher levels of borrowing relative to GDP than they did in 2007. Global debt in these years [Q4 2008 to Q2 2014] has grown by $57 trillion, raising the ratio of debt to GDP by 17 percentage point.”

Debt has produced some unexpected outcomes in recent years. Unsustainable debt used to be thought of as principally a problem of some of the world’s poorest countries. Not any more. The World Bank noted in International Debt Statistics 2015:

“Countries reporting to the Quarterly External Debt Statistics confirm that external debt levels in high-income countries are, on average, much higher than in developing countries, but they have moderated somewhat in 2015.”

It is also a comical fact of life in the 21st century that instead of retiring their student debt, some Americans are retiring with their student debt. Who saw that coming?

How Much Is Too Much? 

There is an Urdu saying that cautions against excessive consumption: First you eat the food, and then the food eats you. It applies to the debt situation as well. When we asked readers of CFA Institute Financial NewsBrief if global debt has become unsustainable, the majority (66%) of the 681 participants concurred. While there clearly were those who disagreed, interestingly, the smallest proportion of respondents (4%) was composed of those who strongly disagreed.


Has global debt become unsustainable?

Has global debt become unsustainable?


We can keep looking for more data points, but the conclusion remains the same: The world seems to be pushing the limits on debt. How much is too much is an interesting but ultimately academic question — as the survey suggests, whatever the limit is, we are past it.

Don’t get me wrong. Debt is an integral and inevitable part of our financial lives. But it brings with it a number of loaded questions. Is increasing global debt making the world economy more fragile, hindering economic growth, and contributing to inequality? Have you ever wondered why equity isn’t held responsible for such problems? What’s different about debt?

The Problem Is in the Contract: Risk Avoidance  

Debt is a curious contract. The lender must be paid in full regardless of the outcome for the borrower. It is a contract meant for good times. But that’s not life. How can there be a fixed return in a world where uncertainty is the only constant? It can only work if unpaid debts don’t threaten the whole system. But under the current financial structure, we are far from such a scenario. We have too much debt and too many financial institutions that are “too big to fail.” The borrowers must pay the debt or the taxpayer will have to step in, with the increasingly familiar privatization of profit and socialization of losses, if not austerity, protests, and baton charges.

The Solution Is to Change the Contract: Risk Sharing  

Debt is based on the lender contractually avoiding risk. The solution could be sharing the risk, the downside. As Atif Mian and Amir Sufi write in House of Debt:

“If we are going to fix the financial system — if we are to avoid the painful boom-and-bust episodes that are becoming all too frequent — we must address the key problem: the inflexibility of debt contracts. When someone finances the purchase of a home or a college education, the contract they sign must allow for some sharing of the downside risk. The contract must be made contingent on economic outcomes so that the financial system helps us. It must resemble equity more than debt.”

Alas, discussion on this fatal contractual inflexibility is unlikely to be found in textbooks on finance and economics.

What’s Needed: A More Balanced Narrative on Debt   

One reason we have too much debt is that economists have continued to produce theories that favor debt over equity. These theories suggest that unlike equity, debt reduces the problems of adverse selection and moral hazard caused by the information asymmetry between financier and borrower. It requires less monitoring, lowers transaction costs, and has favorable tax implications. More importantly, debt has been entrenched in the global financial system through fractional-reserve banking. It is so entrenched, it has become hard to differentiate between money and debt.

Fortunately, some economists are willing to question the conventional wisdom, providing us with a more nuanced understanding of debt, its costs, its incentives, and why we have so much of it. One of them is Paul Mills. In the wake of the global financial crisis and ever-mounting debt levels, for those who are interested in alternative perspectives on debt, I’d recommend watching this brief video interview with Mills, “Debt: What’s Wrong with It?”



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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

About the Author(s)
Usman Hayat, CFA

Usman Hayat writes about sustainable, responsible, and impact investing and Islamic finance. He is the lead author of "Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals," and the literature review, "Islamic Finance: Ethics, Concepts, Practice." He is interested in online learning and has directed three e-courses for CFA Institute: "ESG-100," "Islamic Finance Quiz," and "Residual Income Equity Valuation." The other topics he writes about are macroeconomics and behavioral finance. Previously, he was a content director at CFA Institute. He is a former executive director at the Securities and Exchange Commission of Pakistan (SECP). He has experience working in securities regulation and as an independent consultant. His qualifications include the CFA charter, the FRM designation, an MBA, and an MA in Development Economics. His personal interests are reading and hiking.

6 thoughts on “Has Global Debt Become Unsustainable?”

  1. Dr Gloom says:

    Damn you all to hell, you have screwed our future generations by your greed and stupidity.

    1. Dr Gloom

      Thanks for visiting Enterprising Investor and sharing your gloomy comment.

      Regards

      Usman

  2. Frasat Ali,CFA says:

    Usman Hayat highlighted the unattended perspective of traditional finance in excellent way by combination of respondent data, historical data and went to root by discussing very basic nature of contract. Excellent work

    1. Frasat Ali, CFA

      That’s a kind assessment, thank you Frasat.

      Regards

      Usman

  3. Terry Riley says:

    Interesting ideas and interview. A good place to start would be to eliminate the tax deduction of mortgage interest, but we have already seen the political impossibility of that. On the other hand, the U.S. is in such desperate need of corporate tax reform, perhaps debt and equity could be put on more equal footing in that context. However, the Congress is going to need more education like this if it is ever going to happen.

    1. Terry Riley

      Yes, there have been some interesting ideas discussed for some time about how to get better debt-equity balance, but we haven’t seen any progress. These things take time and perhaps crises to develop.

      Thanks for visiting our blog and sharing your views.

      Regards

      Usman

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