Leigh Harkness on debt saturation

Advertisement

In a follow up to his previous post please enjoy Leigh Harkness’s latest guest post on “Debt Saturation”.


Many years ago, I tried to identify the relationship between money and inflation. I could not find a general rule for all situations, but for certain countries who adopted “pure” float, I found that inflation was equal to the square root of the growth in bank credit over the growth in real GDP. That simple formula provided a reasonably close explanation of inflation in Australia for domestic products such as services, as shown in Figure 1.

Advertisement

Figure 1. Comparison of Australian Services Price Index and the modelled price changes


The formula also explained most inflation since 1995 for the US economy, as shown in Figure 2.

Figure 2. Comparison of US CPI and modelled prices

The relationship between bank credit, GDP and prices brought me to consider a much more pertinent issue: the relationship between the growth of bank debt and GDP. This relationship can be interpreted as the relationship between domestic debt and our capacity to service that debt. In Australia, the ratio of outstanding bank credit to nominal GDP is 2.7 times the level it was in 1984. Figure 3 compares bank credit, GDP at current prices and the ratio of bank credit to GDP for each quarter since 1980 relative to the level in December 1984.

Figure 3. Australia, bank credit and GDP

Advertisement

Figure 4 presents the same ratios for United States of America since 1985, using 1995 as the base year.

Figure 4. USA, bank credit and GDP

In my earlier blog, I explained how the current account deficit was equal to the growth of bank credit in countries such as the US and Australia. Foreign debt finances a large part of the current account deficit in these countries. Therefore, we can consider that the debt to GDP line also reflects the additional burden of servicing foreign debt. In Figure 4, it would appear that the ratio of bank debt to GDP has hit a ceiling in 2008. It was at that point the US economy experienced a major financial and economic crisis: the GFC.

Advertisement

If there is such a ceiling, it would mean that the growth of bank credit in the US would be constrained in future from increasing any faster than GDP. However, according to the formula for inflation under a pure floating exchange rate system, bank credit can only rise in proportion with GDP if there is no inflation. If bank credit in the US is to rise in proportion with GDP, then it will be rising at a much slower rate than it has in the past. In that case, we may see the US economy perform in a similar manner to the Japanese economy, with slow economic growth, slow growth of bank credit and large fiscal deficits intended to stimulate the economy.

Also, we could see US interest rates remaining low, as in Japan. As the debt burden would be constraining credit growth, it would not be necessary for the Federal Reserve to raise interest rates to constrain credit growth so as to constrain inflation. It is evident from Figure 3 that Australia has not yet reached its debt ceiling. The ratio of debt to GDP continued to grow in Australia, despite the GFC in the USA. Eventually (and possibly soon according to some of the posts on this site) the burden of the growing debt in Australia will reach or exceed the debt servicing capacity of economy. At that point Australia, too, will experience a debt crisis.

The Australian economy may just touch the debt ceiling, and then experience a decline in the rate of growth of bank credit. However, such a decline is likely to reduce the rate of economic growth and could cause a recession. A recession would reduce the capacity of businesses and people to repay their debts, and that could cause a financial crisis similar to that experienced in the US.

Advertisement