Are we at the end of the debt supercycle?
The pandemic has led central banks and governments around the world to spend record amounts to stimulate their economies, dwarfing what was spent during the global financial crisis. There are now concerns that the pandemic may be the final nail in the coffin for the decades-long growth in government and private debt. Unlike average business cycles which last about 7 to 10 years, debt supercycles typically last between 50 to 75 years. As a supercycle draws to a close there is a necessary process of debt deleveraging so a new cycle of growth can begin again.
The last stages of the debt supercycle?
The concept of the debt supercycle was introduced by BCA Research in the early 1970s. BCA Research is now one of many commentators who are arguing that the pandemic-induced recession marks the final stage of the supercycle, particularly for private debt.
The theory is that since WWII, central banks have managed the economy with countercyclical fiscal and monetary policy. This has made recessions less frequent and severe but has also promoted successive waves of ever-increasing household and corporate borrowing. However, with interest rates at or near to zero, the debt supercycle has now all but “played out”.
Niels Jensen, managing partner and CIO of Absolute Return Partners also sees the debt supercycle as “getting worryingly close to the end”. According to Absolute Return Partners in the early stages of a debt supercycle GDP and debt grow in a 1:1 ratio. That ratio declines as the supercycle “matures” with GDP only growing about $0.25 for each additional dollar of debt — a point which China and the US have already reached.
As more and more debt is added to stimulate economic growth, debt to GDP soars, and increasing amounts of capital are used to service the debt rather than being employed for productive purposes. Because of this productivity and economic growth slows at the end of a debt supercycle.
Drivers of the debt supercycle
Christopher Watling, CEO and Chief Market Strategist at Longview Economics maintains the current debt supercycle has been driven by three things:
- An unanchored monetary system (not backed by a commodity) which allows lots of liquidity creation and can allow massive imbalances to grow
- Financial deregulation post-1980s which has allowed mortgages to be purchased with lower and lower capital
- Targetting of CPI allowing more credit to be created
The result has been a massive growth in global debt and central banks creating increasing levels of liquidity. According to Watling, the answer is to anchor liquidity in some way and to write off all debt in a “debt jubilee” event. The aim would be to return to a model which focuses on productivity growth rather than debt servicing and unproductive investment.
The debt mountain
Global debt rose to a new record high of almost $300 trillion in the second quarter of 2021 according to the Institute of International Finance with total debt levels 10 percent higher than pre-pandemic levels. Debt to GDP declined slightly in the second quarter but the IIF warned in many cases the recovery was not enough to push debt ratios back to pre-pandemic levels.
Household debt also rose almost 3 percent in the first half of 2021 “in line with rising house prices in almost every major economy in the world” according to Emre Tiftik, IIF’s director of sustainability research.
Historically, excessive debt levels have been brought down in four ways:
Austerity — spending cuts or raising tax levels generally prolongs a slowdown and lowers growth. Raising tax levels is unavoidable at the end of debt cycles when large wealth gaps exist due to high asset values
Economic growth — if economic growth exceeds interest rates, the Debt/GDP ratio will decline without the need for austerity measures. However, according to a McKinsey report on debt and deleveraging, since the 1930s growing out of debt has only occurred as a result of a war effort, a “peace dividend” following war, or due to an oil boom.
Inflation — high inflation reduces the real value of debt but it is something central banks tend not tolerate other than in the short term.
Default — default has been used by emerging market economies in the past but is not an option for advanced economies because of the long-term impact on financial stability.
The end of the debt supercycle does not need to be disastrous. Ray Dalio, the founder of Bridgewater Associates argues that if handled well the deleveraging can happen through a mix of cutting spending, reducing debt, transferring wealth and printing money. It may take a decade or more for debt burdens to fall, but once this happens the economy can reset and productivity can begin to grow once again.