The real effects of debt

Discussion in 'Economy' started by itfitzme, Mar 27, 2012.

  1. itfitzme
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    itfitzme VIP Member

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    The real effects of debt

    Stephen G Cecchetti, M S Mohanty and Fabrizio Zampolli*

    September 2011

    Link here →The real effects of debt

    Abstract

    At moderate levels, debt improves welfare and enhances growth. But high levels can be damaging. When does debt go from good to bad? We address this question using a new dataset that includes the level of government, non-financial corporate and household debt in 18 OECD countries from 1980 to 2010. Our results support the view that, beyond a certain level, debt is a drag on growth. For government debt, the threshold is around 85% of GDP. The immediate implication is that countries with high debt must act quickly and decisively to address their fiscal problems. The longer-term lesson is that, to build the fiscal buffer required to address extraordinary events, governments should keep debt well below the estimated thresholds. Our examination of other types of debt yields similar conclusions. When corporate debt goes beyond 90% of GDP, it becomes a drag on growth. And for household debt, we report a threshold around 85% of GDP, although the impact is very imprecisely estimated.

    Conclusions

    While the attention of policymakers following the recent crisis has been on reducing systemic risk stemming from a highly leveraged financial system, the challenges extend beyond that. Our examination of debt and economic activity in industrial countries leads us to conclude that there is a clear linkage: high debt is bad for growth. When public debt is in a range of 85% of GDP, further increases in debt may begin to have a significant impact on growth: specifically, a further 10 percentage point increase reduces trend growth by more than one tenth of 1 percentage point. For corporate debt, the threshold is slightly lower, closer to 90%, and the impact is roughly half as big. Meanwhile for household debt, our best guess is that there is a threshold at something like 85% of GDP, but the estimate of the impact is extremely imprecise.

    A clear implication of these results is that the debt problems facing advanced economies are even worse than we thought. Given the benefits that governments have promised to their populations, ageing will sharply raise public debt to much higher levels in the next few decades. At the same time, ageing may reduce future growth and may also raise interest rates, further undermining debt sustainability. So, as public debt rises and populations age, growth will fall. As growth falls, debt rises even more, reinforcing the downward impact on an already low growth rate. The only possible conclusion is that advanced countries with high debt must act quickly and decisively to address their looming fiscal problems. The longer they wait, the bigger the negative impact will be on growth, and the harder it will be to adjust.

    It is important to note that our finding of a threshold for the effects of public debt on growth does not imply that authorities should aim at stabilising their debt at this level. On the contrary, since governments never know when an extraordinary shock will hit, it is wise to aim at keeping debt at levels well below this threshold.

    As with government debt, we have known for some time that when the private sector becomes highly indebted, the real economy can suffer. But, what should we do about it? Current efforts focus on raising the cost of credit and making funding less readily available to would-be borrowers. Maybe we should go further, reducing both direct government subsidies and the preferential treatment debt receives. In the end, the only way out is to increase saving.
     
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    Last edited: Mar 28, 2012
  2. DSGE
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    "But financial development is not some magic potion. The accumulation of debt involves risk. As debt levels increase, borrowersÂ’ ability to repay becomes progressively more sensitive to drops in income and sales as well as increases in interest rates. For a given shock, the
    higher debt, the higher is the probability of defaulting. Even for a mild shock, highly indebted
    borrowers may suddenly no longer be regarded as creditworthy. And when lenders stop
    lending, consumption and investment fall. If the downturn is bad enough, defaults, deficient
    demand and high unemployment might be the grim result. The higher the level of debt, the
    bigger the drop for a given size of shock to the economy. And the bigger the drop in
    aggregate activity, the higher the probability that borrowers will not be able to make
    payments on their non-state-contingent debt. In other words, higher nominal debt raises real
    volatility, increases financial fragility and reduces average growth.
    "

    Sounds like a pretty strong argument for nominal income level targeting.


    Correlation between debt and per capita GDP volatility is significantly different from zero for private debt. That would be my guess, except I'd have causation going the other way. Expectations of future volatility generate more debt due to consumption and investment smoothing (which the paper mentions earlier). Even then, it says it's economically significant, but I don't know if 2.5 basis points is all that significant.


    "It is important to note that, in order to minimise the potential for the endogeneity bias (and the
    problem of reverse causation), all regressors (with the exception of the population growth
    rate) on the right-hand side of (1) are predetermined with respect to the five-year forward
    average growth rate.
    "

    Sure, but there's still a confounding variable. Expectation of future growth affects both current levels of debt (regressor) and future growth (regressand).


    I'm up to the regression results, but I can't read the table. What's with all of the different columns? I want the marginal impact for each variable, using all the controls, with their p-values. I'm gonna stop reading here for now. Do you know what's going on with Table 5?
     
  3. Widdekind
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    Widdekind Member

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    i.e. "being lent free money is good" ? But, debt saddles future generations, i.e. "inheriting a liability" ?
     
  4. DSGE
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    DSGE VIP Member

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    Huh? [​IMG]
     
  5. editec
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    editec Mr. Forgot-it-All

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    Haircuts.

    That is what is going to happen.
     
  6. sparky
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    sparky VIP Member

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    with all due respect to the economic gurus opining these days, can we dumb this down to owing more than we make?

    or perhaps consuming more than we produce?

    ~S~
     
  7. DSGE
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    DSGE VIP Member

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    Not really. Why would banks lend most people money not expecting to make a profit? They only managed to start doing that toward the end of the housing bubble because they could hide bad loans in crazy securities. But we're wise to their game now. So...
     
  8. Widdekind
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    Widdekind Member

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    banks lend "principal", and take "interest". Ergo, "income" need only offset "interest", merely some fraction of total "principal". But, when debt becomes "large", even the "interest" payments are prohibitive ?
     
  9. DSGE
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    DSGE VIP Member

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    What? Banks need to expect to get the principal back in order to lend. What part do you disagree with? They won't lend money unless they expect to make a profit.
     
  10. eots
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    eots no fly list

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    [ame=http://www.youtube.com/watch?v=ljoFf__x-sQ&feature=g-all-lik&context=G2ea7e5bFAAAAAAAARAA]Ron Paul is the best - YouTube[/ame]
     

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