The role of debt in the recovery – part of the problem or part of the solution?

One of the main distinctive features of the current economic recovery in the developed world is its lack of dynamism compared with other revivals after recessionary periods. This phenomenon has naturally led to concern among economic policymakers and lively debate among analysts and academics. At the risk of oversimplifying, the issue can be summed up as an intellectual dispute between two paradigms: secular stagnation and the debt supercycle.

Secular stagnation theory claims that the weakness of the current expansionary phase is due to the structural trend of advanced economies towards a fall in the growth potential of per capita GDP. According to this view, the rate of potential growth shrinks with each new expansionary cycle, fundamentally because of three reasons. The first is the absence of new technological opportunities and particularly widely-used technologies such as electricity, vehicles and computing. The second is the ageing population which reduces both the propensity to consume and the willingness to take on risk. And, thirdly, the decrease in investment in physical capital which is obviously related to the two previous explanations and is a trend that has been particularly prevalent in the last 15 years.

Ultimately those endorsing secular stagnation believe that the developed world saves too much which, together with the lack of attractive investment projects, results in a lack of dynamism in the economy with interest rates that, in spite of being very low in nominal terms, are not low enough once inflation has been discounted. According to this analysis, such a situation requires a bigger boost for demand and expenditure from public spending, if necessary financed by central banks directly buying up public bonds.

The economists attempting to explain current phenomena via recurrent debt cycles (a debt supercycle) stress the decisive role of monetary and credit expansion over the last 30 years in creating today's scenario. This is characterised not only by the weak growth, insufficient demand, low interest rates and minimal inflation highlighted by the secular stagnation theorists but also by an unusual creation of liquidity and financial asset prices at record highs in many markets.

According to this point of view the debt supercycle reflects how, over the years, monetary authorities have been unable to withstand political and social pressure to come to the rescue of markets and the economy when successive bouts of financial exuberance have burst asset bubbles and created the risk of economic recession. The debt supercycle has also resulted from the error committed by monetary policymakers for many years, using inflation as their basic guideline, measured via the CPI, while failing to take sufficiently into account how liquidity creation pushed up the price of financial assets with serious repercussions for financial and economic stability. In short: instead of focusing on creating new productive assets they have provided the economy with more financing aimed at investing in already existing assets and increasing their price, operations which often seek capital gains rather than returns within a context of very low interest rates which force investors to search for yield.

Evidently the economic policies proposed by economists who support the debt supercycle theory are substantially different from those extolled by the followers of secular stagnation. Moreover, these are politically less popular proposals in many countries since they emphasise debt and therefore recommend policies that focus on supply rather than demand as well as fiscal consolidation and the gradual reduction of private debt. Such proposals cannot even pretend to provide a quick fix for the problem of weak economic growth as, by their very nature, they attempt to stabilise conditions for more sustainable growth in the long term.

It will take years before we know which way this interesting debate on the intellectual plane will go, although probably less time to witness the practical consequences given the inevitable developments in events. Meanwhile, and just in case, whether one side is right or the other, it is useful for us to realise the implications of high levels of debt for our economies, and the Dossier in this Monthly Report focuses on this very issue.

Jordi Gual

Chief Economist

30 April 2015