An Insight into the Impact of Debt on Economic Growth

An article on debt posted on ZeroHedge came to our attention: Consumer Debt – Still A Long Way To Go. It has a chart that we have seen much of recently, which we now reproduce from FRED® for the household sector as the blue line of total credit market debt and the red line as the total of outstanding mortgage debt.

Figure 1.Household debt outstanding. Left scale: total credit market debt (blue) and total mortgage debt (red). Right scale: total consumer credit (green) both revolving (violet) and non-revolving (orange).

Although all other forms of consumer debt are rising, mortgage debt and total debt are falling. As the article notes (emphasis ours):

This would be good news as lower debt levels means more personal savings which would lead to productive investment.  It would also mean more consumption that would provide stronger end demand to businesses.  Both of these outcomes are necessary for sustained economic growth.  The chart below has been used repeatedly to argue the deleveraging case for the economy.

This is standard economic doctrine. Apart from the fact that increased savings would not spur economic investment because the economy is swamped with – not starved for – liquidity, the falling mortgage debt levels do not translate into increased spending and the rising levels of other forms of consumer credit imply the opposite. The reason is the asymmetric relationship between total debt and debt servicing costs.

Consider a simple example. First let’s create a concept that we shall call marginal disposable income (MDI). This is your monthly income after taxes and social service premiums (the proper definition of disposable income) plus monthly debt carrying charges (such as personal and student loans and mortgage payments), utilities, food, and other fixed costs and essentials. This is income that is committed to regular economic activity and not economic growth. It is your free money or spending money.Further, suppose it is $1500 per month (in fact our essential costs like food fluctuate but tis is simple example)..

Now you decide to make a major purchase and you borrow $10,000 at 20% for one year repayable in 12 equal installments of $1,000 of balanced principal and interest (technically one can structure such a loan even if such is unlikely). This is new money injected into the economy and represents $1000 of income for the next the next year. You have spent your income forward. For the next year your MDI is reduced to $500.

When we consider total credit market debt, you just caused it to spike by $10,000. We do not factor in the $200 in interest you will pay in addition to the $10,oo0 principal.

Now each month you make the $1000 loan payment you are paying back $833.33 in principal, and total credit market debt falls by this amount. This is what is happening with the total outstanding mortgage debt in Figure 1. The pundits declare that this means there is more money in your pocket as a result so you can spend it boosting the economy. And herein is the fallacy. Your MDI is still $500 and will be until the end of the year. Although your total debt is falling, your MDI is fixed at the reduced level. You have no extra money to spend and as the total credit market debt falls, there is no new economic growth.

Ans this is why debt reduces future economic activity, the condition that Western wconomies find themselves in and what central bankers try desperately to understand.

As a final comment, the measured impact of debt acquisition is immediate whereas the economic impact of debt reduction is delayed until after the term of the debt: an overlooked asymmetry. If we return to Figure 1, because mortgage debt is long term, although the debt is being reduced, the total MDI of the mortgagors is unaffected. At the same time, other forms of debt, mostly of much shorter term, are increasing, further reducing collective MDI. It is not surprising that economic growth is anaemic and will remain so for at least a decade or two as we have noted elsewhere.

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