Our last two newsletters dealt with public and private debt in the U.S. However, as you know, we have always advocated for a diverse portfolio that includes non-U.S. stocks. So, this month, we thought we should review the debt situation in other advanced economies and in emerging economies.
Before getting into this, maybe we should review just why we’re paying so much attention to debt. Debt is the lubricant that makes a modern economy function. It allows businesses to grow; it allows governments to finance long term infrastructure projects, and it allows people adjust their consumption according to their stage of life (borrowing for education and homes when they are young, paying back and investing as they get older, and collecting on their investments in old age). Up to a point, debt can be a good thing. The problem is that while debt is increasing, the economy sees an extra source of demand. However, if debt increases too rapidly, then the debtors eventually reach the point where they cannot pay the interest that is due, and they stop borrowing. At this point, demand in the economy decreases, an economic downturn may make it harder for people to pay their debts, and a vicious cycle of decline may occur.
The question is, from a societal perspective, how much debt is too much? That’s a very hard question to answer. Modern, more complex societies require more debt. Figure 1 shows how the total debt and the private debt to the non-financial sector, stated as a percentage of gross national product (GDP), has varied over time for the U.S. The total debt includes government debt, household debt, and corporate debt; private debt is the total with government debt removed. Both are much higher now than in 1952. It is interesting that the increase seems to have happened largely in two time periods, the 1980s and the 2000 to 2010 period. Up to a point, the increase really isn’t surprising and shouldn’t be disturbing. A modern economy requires more capital. Modern manufacturers require more complex equipment; farmers need bigger and better tractors and combines; people need more education; and people expect better transportation systems and public facilities. All of this requires more investment capital, which often means greater debt, but it also leads to more efficient production, which should provide the means for paying off the debt. The problem occurs when debt in one or more economic sectors get ahead of productivity, or when inequality grows to the point where those who most need to borrow can’t afford to repay the loans. The point where this happens isn’t obvious to us.
We don’t think it is possible to say that debt is excessive when it reaches some particular percentage of GDP. Nevertheless, history has repeatedly shown that excessive debt can lead to recession or worse. For a long discussion of this, see reference1. Reference 1 also presents data indicating that economic growth is slower after a period when government debt it high.
Figure 1: Total debt to the non-financial sector for the United States. Data is from Federal Reserve Economic Data (FRED).
So, in the last two months, we discussed the situation in the U.S. Now, let’s look at what is happening internationally. In Figure 2, we show the growth of debt in countries with advanced economies, as classified by the Bank for International Settlements (BIS). Unfortunately, the data set only goes back to 1999, so we can’t see the longer-term behavior (note that the horizontal axes in figures 1 and 2 are very different). However, since 1999, there has been a slight uptrend in the total debt as a percent of GDP, and since 2010, the private debt has declined slightly. Based on the most recent values, the advanced economies, taken all together, have higher debt than does the U.S. However, the advanced economy data includes Japan, which is a special case that we will discuss below. The advanced economy data also includes the U.S. To get another view of what’s happening in advanced economies, without the presence of either the U.S. or Japan, we can look at the Euro area, the group of nations that use the Euro as their currency. That data is shown in figure 3. The value of the total debt (as a percent of GDP) is very similar to the value for the U.S., but since 2010, there has been a small decrease in the Euro area. With Japan and the U.S. excluded, debt in the advanced economies is certainly high, it is not increasing and does not have the appearance of a bubble.
Figure 2: Total debt to the non-financial sector for advanced economies. Data is from Federal Reserve Economic Data (FRED).
Figure 3: Total debt to the non-financial sector for the Euro area. Data is from Federal Reserve Economic Data (FRED).
Japan is a unique case. The data on total debt and private debt is shown in figure 4. The total debt is almost 370% of GDP, much higher than in other countries. That figure is mostly due to government debt which is large and increasing. Private debt has been declining since the mid-90s. On the surface, Japan’s debt appears to be so high as to be hopeless. However, much of the Japanese government debt is owned by the Japanese central bank. At the present time, the Japanese government debt in private hands is about 130% of GDP, and the sum of government debt in private hands plus the private debt is about 280% of GDP. The debt in private hands has been coming down as the Japanese central bank buys more bonds. One might suppose that this would cause inflation (the bank creates money to buy the bonds), but that hasn’t occurred yet. So, the Japanese debt is high, but maybe not catastrophic.
Figure 4: Total debt to the non-financial sector for Japan. Data is from Federal Reserve Economic Data (FRED).
Debt in the emerging market countries is generally much lower than in the advanced countries. Data for all emerging market countries (as classified by BIS) is shown in Figure 5. In this case, total debt (as a percent of GDP) is increasing rapidly, but it is clearly driven by private debt. Government debt (the difference between the two curves) seems to be holding about constant. However, this figure is somewhat misleading because it is heavily influenced by China, which is classified as an emerging economy by BIS. Figures 6 and 7 show the picture for China (figure 6) and for the emerging market economies with China removed (figure 7). Debt in China is increasing rapidly, and the total debt is at the same level as in the U.S. In China, the debt is mostly private; public debt is very low. With China removed, debt in the other emerging economies is much lower than in the advanced economies or China. While there has been an increase in the past several years, the total debt is still lower now than it was in the U.S. in 1950.
Figure 5: Total debt to the non-financial sector for emerging market countries. Data is from Federal Reserve Economic Data (FRED).
Figure 6: Total debt to the non-financial sector for China. Data is from Federal Reserve Economic Data (FRED).
Figure 7: Total debt to the non-financial sector for emerging economies with China removed. Data is from Federal Reserve Economic Data (FRED) and from the International Monetary Fund.
When considering all of this data, the country that concerns us the most is China. The Chinese debt is increasing very rapidly. What’s more, we wonder if anyone outside of China really knows what’s happening with the Chinese economy. China acts like a market oriented, capitalist country in many ways, but it is clearly a very different type of capitalism from what is practiced in the U.S. or Europe. The government has very strong control of the economy, and there is a possibility that figures on debt and growth are manipulated. This presents a conundrum to investors. China has been the world’s fastest growing country for many years, but it also presents significant risk. We are happy to have a rather small allocation to China.
The other country that worries us somewhat is the U.S. For several years, total debt in the U.S. had plateaued with growth in government debt being cancelled by decreasing (as a percent of GDP) private debt. Now both seem to be increasing again. The American stock market has been the best place to be for the last 10 years, but we are happy to have a diversified portfolio that includes both foreign and domestic stocks.
Reference 1) Carmen M. Reinhart and Kenneth S. Rogoff, This Time is Different: Eight Centuries of Financial Folly, Princeton University Press, 2010.
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