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Private sector debt is a burden, not an economic benefit

By David Kauders - posted Wednesday, 24 February 2021


Those of us who question the wisdom of economic policies, seek to understand whether endless credit creation is always such a good idea. Governments can indeed borrow very cheaply, but private borrowers – businesses and households – usually pay more. Australian private debt is now 200% of GDP (Gross Domestic Product, a measure of the size of the economy), some four times the level of public borrowing. Does this private sector debt affect economic growth?

To answer this, it is necessary to know how much economic output is spent on interest. When I first investigated this some three years ago, I searched the literature in vain. Nobody had considered the economic effect of this expense. Therefore, I tried to build an estimate at a global level. What I found, using pre-pandemic data from 2018, was that world economic output was then around USD 80 trillion. The best figure I could calculate for interest cost was USD 17 trillion. One-fifth of economic output.

Tracing back for about forty years, interest rates paid to depositors have fallen, while real costs incurred by borrowers other than governments have risen. Real interest cost is the rate paid by borrowers minus the inflation rate, which itself is stuck at historically low levels. This cost is positive for the private sector globally, whereas some governments can borrow at less than inflation. Higher real private borrowing costs may be the reason why many economies were sluggish before the pandemic arrived.

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The reasons why private borrowers face such rising costs are not hard to find:

1. Banks have incurred greater loan losses, which must be paid for by all borrowers.

2. Banks have also faced their own financial squeeze from falling deposit rates, because their net margin – the amount they earn on money taken in – has fallen.

3. Society has sought to control its banks by imposing more onerous regulations, causing the cost of compliance to further increase rates charged to borrowers.

This unrecognised private sector debt overhead, which I call the financial system limit, has now become a barrier to economic growth. There are three radical ideas underlying this concept:

a) There is indeed a limit to the growth of debt and hence to credit expansion.

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b) The world is well on the way to reaching this limit.

c) Central banks have created a new, dominant economic cycle that transcends traditional economic cycles.

Every stimulus release causes a new downturn perhaps a decade later, as the costs of borrowing overwhelm the initial benefit of extra money injected into economies.

Now we have a glimpse of the theory, we can ask practical questions:

  • Is it right to continue with Keynesian economics?
  • Does Modern Monetary Theory (a recent economic fashion) affect the private sector debt burden?

When Keynes devised his general theory, private sector debt was trivial. I found some data for the United Kingdom showing that private sector debt was 12% of GDP in 1945. Seventy-five years of Keynesian economics has generated an unrecognised overhead. Yet when I put the concept that debt resulting from stimulus is dragging economies down to a leading Keynesian economist in London, I was told that people who could not afford their own debts should go bust. This was hardly what Keynes wanted as a solution to the 1930s depression. Then I was told that net debt is zero, because debts and credits balance out. This misses the point, that some of those people with debts are struggling to afford a decent living standard because they are paying interest above the rate of inflation. The end result of all the decades of Keynesian stimulus is a serious debt affordability problem, as bad in Australia as it is in the United Kingdom and United States.

Modern Monetary Theory (MMT) seeks to explain the way public borrowing works: governments that control their own currency can create more credit to repay previous borrowing, to meet interest on their debt, and to spend as they like. However, describing how the system works does not legitimise MMT. MMT ignores the cost of the much higher level of private sector debt. To the extent that government credit creation encourages banks to lend more, MMT brings the financial system limit closer, burdening economic performance.

Some economic pundits have indeed recognised that there are flaws in the debt-based economic system and proposals appear occasionally as to how to resolve them. I discuss ten such putative solutions in my book and show that there are three general reasons why every one is inadequate, namely that they:

  • make the problem worse by increasing the cost of interest paid by the private sector;
  • create conflict between different groups in society;
  • have inherent flaws that prevent them succeeding.

The weight of private sector debt is deflationary. All attempts to 'inflate the way out lead back to the financial system limit. Australia's debt problems are not unique, because this is a global policy failure. The separation of debit and credit invented by the early Italian bankers has reached end of life and a new financial construct needs to emerge.

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The Financial System Limit is published by Sparkling Books, ISBN 9781907230783 ($A 20). There is also an e-book 9781907230776. The introduction and first chapter can be read without registration at www.sparklingbooks.com/limit.html.



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About the Author

David Kauders , is an investment manager. He is the author of The Greatest Crash: How contradictory policies are sinking the global economy. and the newly released book, The Financial System Limit ‒The World’s Real Debt Burden, which shows that creating more private sector debt eventually leads to economic decline. www.sparklingbooks.com/limit.html

Creative Commons LicenseThis work is licensed under a Creative Commons License.

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