I hope you enjoyed last week’s discussion on bitcoin. And thanks for the all the questions you sent in. In case you missed the video, here’s what Nigel and our crypto expert Sam Volkering made of them.
This week we turn to one of the reasons people love bitcoin so much in the first place, as Nigel explained in the video. The amount of debt we’re facing in the mainstream financial system is a worry. Even the Financial Times called it a “global debt tsunami”:
Governments and companies took on $15tn more borrowing in first nine months of 2020
The total level of global indebtedness has increased by $15tn this year, leaving it on track to exceed $277tn in 2020, said the IIF, which represents financial institutions. It expects total debt to reach 365 per cent of global gross domestic product by the end of the year, surging from 320 per cent at the end of 2019.
Yikes.
But it’s all for a good cause, right? To help us paper over the pandemic… which is only going to last three… six… nine months….
Well, I’m not so sure we’ve done the maths right. Given the level of debt we were at going into the crisis, it might not be such a good idea to borrow more.
But let’s start with the basics. Not that economists can agree on them, by the way. Here’s my take anyway…
When it comes to money, you have three choices. Spend it, save it or borrow it. But what does it mean to borrow money? What is debt?
One answer is that debt is future consumption brought forward to today.
Which sounds confusing at first. But consider the converse. Just as saving means you don’t consume what you earn today, but save it for future consumption, borrowing is the reverse. It is borrowing consumption from the future, because you have to repay it by saving in the future. And that means consuming less in the future.
This creates an interesting trade-off when you consider whether or not to borrow money. Is your consumption today really more important than in the future?
One way to answer that question is to argue that what you buy with your debt actually increases your future income so much that it is a good idea to borrow and spend. Economists call this “investing” – a little different to how we usually use the term in Fortune & Freedom.
If you invest your borrowed money wisely, it could make sense to borrow and buy. A car that gets you to work. A house that saves you paying rent. A machine that makes a business more productive.
But we’ve missed a little something. Borrowing isn’t free. You have to pay interest. Which means you are charged for bringing consumption forward from the future.
Your debt-financed productivity enhancing purchase must improve your income more than the cost of interest for it to be a true benefit. Tomorrow we explore what this means central banks actually do when they fiddle with interest rates.
But now, let’s take a look at what the nation is borrowing to spend money on…
Borrowing for consumption
In the media right now, there is furore over government foreign aid spending. Does borrowing money to spend it on foreign aid improve our ability to repay our debt in the future?
Does borrowing money to spend on welfare improve future earnings? It certainly can.
The military? Perhaps, to protect ourselves and prevent wars.
What about furloughs and the bounce back loans?
As you’ve noticed, the answer isn’t quite as clear as it might seem at first. But I think it’s clear we’re not borrowing only in ways that enhance future income. We’re also borrowing to finance simple consumption. It’s simple impatience, not investment.
All of this bodes ill for future consumption. Future spending will be lowered by all this borrowing. We’ve stolen from the future. In three ways.
The first one is obvious. We have to repay that debt.
Second, there’s the interest.
But it gets worse…
At some point, the amount of debt drags down growth
All around the world, governments are spending like mad to offset Covid-19 and lockdown impacts. This also means they’re borrowing like mad. But they didn’t all start at the same level of debt…
Bloomberg reports on Germany’s efforts (11 June 2020):
Including the latest top-up and ancillary liquidity measures such as guarantees, Germany’s stimulus package to mitigate the economic hit from Covid-19 totals more than 1.3 trillion euros ($1.47 trillion). That’s by far the largest in Europe and even tops America’s, relative to gross domestic product. Kudos to Chancellor Angela Merkel.
Why was Germany able to spend so big? The Germans would argue that it’s because they’d been so prudent going into the crisis. Their budgets and debt levels have been far better than most comparable nations. If you’re frugal, then when a crisis hits, you can spend big.
This applies at the household level too. One of the big changes Nigel Farage sees coming is frugality at the household level, he told me. Instead of relying on debt to see you through a crisis, people will have rainy day funds again.
But that’s another story. Today, we focus on those nations and governments who weren’t frugal going into the pandemic. Many of them are beyond the danger threshold of 90% of GDP. This means their government debt is around about 90% the size of their economy.
In a 2012 study by Carmen Reinhart, Vincent Reinhart and Kenneth Rogoff, they identified this threshold based on a study of 26 past debt crises. The idea is that, once you borrow too much, your future economic growth starts to struggle. This makes the debt even harder to repay. And a bad spiral begins.
Well, Covid-19 has pushed the EU over that 90% level… and the US too… and the UK…
What exactly happens above this level? GDP growth falls by about a third according to the study. Because there’s only so much you can borrow from the future before the future is looking shaky.
In other words, not only does borrowing steal future consumption, it also reduces economic growth, once you go above a certain level of debt. And much of the world has surpassed it, thanks to Covid-19.
There’s already evidence this loss of growth is occurring. From the same FT article we started with:
The change in debt — without a corresponding change in the pace of output growth — “suggests we are seeing a significant reduction in the GDP-generating capacity of debt”, [Institute of International Finance director of sustainability research] Mr Tiftik said.
Each unit of borrowing is generating less and less GDP.
The future, sick of being robbed for the present, is biting back.
Interest rate fiddling
Before you go, one last thing to ponder. How does fiddling with the interest rate impact all of this?
I’ll give you a hint.
We gave up on almost all price controls last century because we learned the hard way that governments aren’t very good at setting prices.
But, for some strange reason, we kept the price control on money – the interest rate. A quasi-government institution still sets that price.
Tomorrow, I’ll explain how this goes awry. Those of you who remember last century’s price controls will only need reminding…
Nick Hubble
Editor, Fortune & Freedom
