Sunday, January 17, 2016

An economy that relies on debt for growth

An increase in debt leads to an increase in spending, economic activity and, hopefully, growth as well. But an increase in debt makes the existing accumulation of debt bigger. And the existing accumulation must be serviced.

The cost of maintaining debt is a drag on spending and economic activity and growth. The cost reduces growth arising from an increase in debt.

An economy that relies on debt for growth needs increases in debt that are big enough to offset the whole cost of existing debt -- and bigger even than that, to induce growth.

As time goes by, ever-larger increases in debt are required to induce growth. This is why the productivity of debt declines. It explains the decline you see in this "Debt Saturation" chart from Economic Edge:

Source: Christopher Rupe and Nathan Martin via Joe Weisenthal
It also explains why Federal deficits got so big. And it explains why we have so much private sector debt.

1 comment:

Tom Hickey said...

The basic idea is that firms borrow to finance investment at a lover rate than the return on investment. This allows firms to service debt while making profits.

That's the theory. Issues arise when other uses of debt are injected, or firms make poor decisions that are reinforced by imprudent lending, leading to the build up of malinvestment.

Minsky explains this (in part anyway) In his theory of the financial cycle, which some think to be the basis of or ordinary business cycles as well as financial crises.