And yet, without it, much of the prosperity and technological progress we rely upon would not be possible. Finance and the power of compound interest has thrust our economy forward faster than any in history. Yet, compound interest is not a tool you want to be used against you. As New York Times columnist Carl Richards notes, “It’s always been one of the most powerful forces in the financial universe.”
Don’t think it matters? Just consider the result of the downgrade of American credit:
Think about that for a minute. If those worst-case-scenario interest rates came to pass and persisted, we’d be approaching a trillion dollars in interest payments per year. That’s what compound interest looks like when it’s working against you.
If that trillion dollar number doesn’t do it for you (that’s 1,000,000,000,000), consider it on a more personal scale.
On a personal scale, you get a taste of it every month if you get careless with credit cards. Take a look at a bill. For every month you carry a balance, there’s a minimum payment required.
Use carefully, it’s a great tool for growth.
Without financing, countries–and businesses and families–are poor and stay poor. Whether it’s a student loan to get through college and get a job that pays better, a business loan to cover the cash flow gap between invoice and payment, or money to build infrastructure and fund the armed forces, finance is a necessary part of growth and getting out of poverty.
Yes, taking on debt creates vulnerabilities for any of these parties; however, debt managed and controlled brings prosperity.
On the other hand, debt out of control creates financial crises. It stops = growth and harms economies.
When the ratio of debt to income rises to a certain level, a new study shows, financial crises–be it household debt, corporate debt, or a national government’s debt–“become both more likely and more severe.” In other words, too much debt is not a good thing.
The study, entitled blandly but descriptively “The real effects of debt,” was reported by Stephen G. Cecchetti, M.S. Mohanty, and Fabrizio Zampolli, economists at the Bank for International Settlements, at the “Achieving Maximum Long-Run Growth” Symposium in Jackson Hole last week.
I can only imagine that the report’s findings threw a lot of cold water on the “more stimulus/raise the debt ceiling” crowd (aka “New Keynesian orthodoxy” believers, according to the economists), including Fed Chairman Ben Bernanke, fresh back from scolding Republicans for their reticence to raise the debt ceiling.
Why? Because, at least in part, the finding vindicates Republican fears about the malignant effect debt can have, and is having, on the national economy.
From the Introduction:
Our result for public debt has the immediate implication that highly indebted governments should aim not only at stabilising their debt but also at reducing it to sufficiently low levels that do not retard growth. Prudence dictates that governments should also aim to keep their debt well below the estimated thresholds so that even extraordinary events are unlikely to push their debt to levels that become damaging to growth.
Emphasis my own.
Which leads to the question: at what levels does begin to hurt and retard growth? The empirical results of the study, based on review of debt levels in 18 OECD countries from 1980 to 2010, show that:
- Households can handle a threshold of about 85% of debt to income.
- For corporations (non-financial), the number is about 90%.
- Governments can borrow between 80 and 100% of GDP.
But that’s just in the short-term. Looking at advanced economies–in other words, Western Europe and the United States, Japan, and Australia– the problem is
compounded by unfavorable demographics. The ageing of populations and the rise in dependency ratios have also the potential to slow growth, making it more difficult to escape the negative debt dynamics that are now looming.
In other words, in our economy more of our population is getting old and few children are being born, which means that Social Security, Medicare, and Medicaid all have fewer people paying for them and more and more people drawing on them.
If I’ve learned nothing from leaving the bachelor world for the role of a family man, buying too many Happy Meals for the kids may make me feel good, but it’s more expensive than a BBQ at home, and its less healthy, too. And when costs are going up faster than my income, that’s not the time to go out and get more debt.
What is our current federal debt ratio to GDP, then? Check out the chart below, and how it compares over our history. Note that, prior to recent history, the level of debt is only comparable to times when we have been at war.
World wide war.
In the meantime, we’ve become addicted to the Happy Meals as a national economy. While Social Security, Medicaid, and Medicare were all begun with the laudable, and often successful, goal of caring for the poor, sick, and elderly, they have expanded to bloat our national budget to a place where our ability to help those needy groups will someday become questionable.
And I do emphasis will. It is inevitable that if we continue on our current track we will be unable to aid those in need. The time for reform was last year, and the longer we delay, the more difficult it will be. We’re not getting any younger as a nation, and we’re not getting any richer either.
The debt is just too damn high.
- Bank for International Settlement – The real effects of debt (bespacific.com)
- Crushed by debt (thesun.co.uk)
- High Debt Levels Poised to Stunt Growth (blogs.wsj.com)
- Spin it all you like, the US budget deal is a dud (tradingfloor.com)
- The Debt – One More Time (ritholtz.com)