If Something Can’t Go on Forever, It Won’t

There is an old saying that if you owe the bank ten thousand dollars and can’t pay, you are in trouble, but if you owe the bank ten million dollars and can’t pay, the bank is in trouble.

This is because an individual’s ten million dollar debt is the bank’s ten million dollar asset. If the person becomes unable to service his debt, the bank’s asset disappears. However, so long as he can continue to make his payments, the bank can continue to classify his debt as an asset at full value.

As a large portfolio of assets is what makes a bank appear healthy, the bank has every incentive to do whatever it can to ensure that the borrower continues making regular payments. The easiest thing to do is to lend him more money. An extra million would allow him to continue making the payments on his existing ten million dollar debt for at least the next two years.

And if after a couple of years he is still not able to generate enough income to make his payments, the easiest thing for the bank to do would be to lend him even more money.

The thing is, so long as the individual can continue borrowing, neither he nor the bank need to face the reality of his (and, by extension, the bank’s) true financial situation. The person can avoid bankruptcy and the bank can avoid writing down the value of his debts, which, were they to be reported accurately, might result in the bank itself being declared insolvent.

Now, expand the scale of our example and consider the path that Western banks and governments, who owe hundreds of billions or even trillions of dollars to lenders, are compelled to follow. Just like the individual in the example above, they are insolvent. Just like our individual, they need to borrow ever-greater sums of money in order to make their payments so that they can continue to appear solvent. U.S. government borrowing in 2013 was almost eight and a half trillion dollars. Most of that amount (just over seven and a half trillion dollars) was borrowed in order to pay off maturing debt, but new borrowing still amounted to almost eight hundred billion dollars (which works out to over $2000 for every man, woman and child in the U.S.).

According to David Stockman, who served as Ronald Reagan’s Treasury Secretary back in the 1980s, industrialized countries are now experiencing what he has termed ‘peak debt’, or debt levels that have reached their limit. According to data from the McKinsey Global Institute, over the past fifteen years total national debt in the industrialized West has risen from two and half to over four times national income, a level that is unprecedented in peacetime.

Looking at this crushing burden of debt, the true rationale behind the various measures taken since 2008 to push interest rates to all-time lows (such as ‘Q.E.’, or quantitative easing) becomes obvious. While ultra-low interest rates were ostensibly put in place to encourage households and firms to borrow and spend and thereby support employment and income, the truth is that they were instituted to allow our heavily indebted banks and governments to continue to borrow. With interest rates near zero percent, even the most insolvent can afford to make their regular interest payments, permitting both borrowers and lenders to avoid the pain and loss that would result from bankruptcy.

However, just as it would be madness for a bank to continue lending ever-greater sums of money to an individual with insufficient income, so also is it madness for an economy with stagnant income growth to continue taking on more and more debt.

The truth is that there are limits to how much indebtedness an economy can support. As Stockman suggests, we may be approaching that limit. When that limit is reached, and no new loans are available to help borrowers make the payments on their existing obligations, there will be bankruptcies and defaults. Assets such as bonds which, like so many other financial instruments, are nothing more than someone’s promise to pay their debts will disappear along with those debts. Banks holding such bonds on their balance sheets will find that their assets have evaporated even as their depositors demand their cash. Pension funds holding worthless bonds will find that they are unable to provide the benefits they have promised to their members.

While no one wants to suffer the pain and dislocation that will occur when we reach the limits of peak debt, as Herbert Stein (who, besides being an economic advisor to both Richard Nixon and Gerald Ford, was also the father of Ben Stein, the famous actor and quiz-show host) famously put it, “If something can’t go on forever, it won’t.”