Puzzle pieces that don't go together: "Using debt" ... "wisely and in moderation"

"Debt is a two-edged sword," says Stephen Cecchetti.¹ "Used wisely and in moderation, it clearly improves welfare. But, when it is used imprudently and in excess, the result can be disaster."

Mm. I've had a lot of people tell me debt was not a problem before the early 1980s. So debt was used wisely I guess, or at least in moderation, in the 1950s and '60s and the '70s and early '80s:

Graph #1: Comparing a Stock to a Flow

From the look of it, debt was used even more moderately from the mid-'60s to the early '80s than before. Let's put some lipstick on this pig:

Graph #2: First Quarter 1952, Fourth Quarter 1964, First Quarter 1984.

Suppose we look at the period that begins Q1 1952 and ends Q4 1964. Debt was low, back then. Welfare was improved, Stephen Cecchetti says. Suppose we look at the trend as defined by those start- and end-dates. Something like this:

Graph #3: The Red Line Shows the Debt-to-GDP Trend based on the Q1 1952 to Q4 1964 Period.

The graph shows that if we continued to use debt at the rate we were using debt in those early years we would have had more debt than we actually had, in all the years after 1964. So maybe that's the problem? Maybe we're not using enough debt?

No, I don't think so.

Hm. Maybe we should look at the second period -- from Q4 1964 to Q1 1984 -- where the line is more flat.

You can see for yourself that the new trend line would be lower than actual, in all the years since 1985. I don't need to show you that line. Instead, let me show you why the trend was more flat.

During the period in question -- almost 20 years -- the debt/GDP ratio increased only about 16%. Debt increased about 550% (meaning it got 5.5 times bigger) and GDP increased about 460%. The two measures of prices each increased about 200%, from 100.0 to about 300.0. Prices, in other words, tripled during those years.

During those years, GDP increased from about $700 billion to about $3900 billion. But prices had tripled. 1984 GDP in 1964 dollars would be about $1300 billion, not $3900 billion. The $2600 billion difference is due entirely to inflation. That's why economists call those years "the Great Inflation".

Now consider how inflation changed debt and the debt-to-GDP ratio. Rather than reducing the 1984 number to its 1964 value as we did above, this time I will increase the 1964 numbers to their 1984 values.

In Q4 1964 the debt we're looking at (total private non-financial debt, copyright (c) BIS) was $591 billion and change. About $600 billion, but call it $500 billion. It's an easier number to work with.

During the years in question, prices tripled. To buy in 1984 the things we could buy in 1964 with $500 billion would have cost $1500 billion. It would have cost us $1000 billion more if we bought that stuff in 1984. Because of inflation.

In Q1 1984 we had $3854.611 billion of private non-financial debt. If the 1964 stuff cost us $1000 billion more, we would have had $4854.611 in Q1 1984. That's 124% of GDP. Instead of having private non-financial debt that was less than GDP in 1984, debt would have been more than GDP.

And that considers only the debt we had in 1964. To be accurate in our numbers, we would have to take the 1965 addition to our 1964 debt and increase it to account for the change in prices between 1965 and now. And we would have to increase the value of our 1966 addition to that debt, and 1967, and all the other years.

We don't. We don't figure debt that way. And that's fine. But you have to realize that the thing that kept the debt-to-GDP ratio low was inflation. It wasn't that between 1964 and 1984 we were such wise and cautious borrowers. It was inflation that kept debt down and the ratio low.

So much for wisdom and moderation.



// Note
1. Stephen G. Cecchetti, M. S. Mohanty and Fabrizio Zampolli, in Achieving Growth Amid Fiscal Imbalances: The Real Effects of Debt.