Debt crisis: Going from good to bad to ugly

Finance is a key building block of modern economies. Without finance and debt, countries are likely to stay poor. When they borrow, individuals are able to consume in excess of their income. With debt, businesses can invest even when revenue does not allow it. Fiscal authorities can influence the macroeconomy through borrowing. Is it any wonder then that over the last 30 years, the ratio of debt - i.e., household, corporate and government - to GDP in advanced economies has risen from 165% in 1980 to 310% today? But borrowing can create vulnerabilities. As debt accumulates, so does risk, since borrowers' ability to repay becomes progressively more sensitive to drops in income as well as hikes in interest rate. For a given shock, higher debt raises the probability of defaulting. And when lenders stop lending - as happened post the collapse of Lehman Brothers in 2008 - consumption and investment fall. If the downturn is bad enough, default, deficient demand and high unemployment might be the grim result. Hence, instead of high, stable growth with low, stable inflation, economies experience disruptive financial cycles, alternating between credit-fuelled booms and defaultdriven busts. When the busts are deep enough, the financial system collapses, bringing down the real economy too. The key to avoiding crises, therefore, is to determine the point at which the debt level goes from good to bad. A recent paper addresses 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, the paper corroborates what received wisdom has long held: 'Debt is a two-edged sword. Used wisely and in moderation, it clearly improves welfare. But when it is used imprudently and in excess, the result can be disaster. For individual households and firms, overborrowing leads to bankruptcy and financial ruin. For a country, too much debt impairs the government's ability to deliver essential services to citizens.' For government debt, the threshold is in the range of 80-100% 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.' For advanced countries, the challenge is compounded by unfavourable demographics. The ageing of population and the rise in dependency ratios have also the potential to slow growth, making it even more difficult to escape the negative debt dynamics that are now looming. When a crisis strikes, the ability of the government to intervene depends on the amount of debt that it has already accumulated as well as what its creditors perceive to be its fiscal capacity, that is, the capacity to raise tax revenues to service and repay the debt.

Fiscal authorities may become constrained both in their attempt to engage in traditional countercyclical stabilisation policies and in their role as lender of last resort during a financial crisis. That is, high levels of public debt can limit essential government functions.