September 15th, marked ten years since the collapse of Lehman Brothers. This marked the start of a recession that plunged two dozen countries into banking crises, and directly led to the Eurozone Crisis. Whilst banks have now employed many measures to prevent such a situation from ever happening again; many economists now believe that the global economy is now threatened by excessive (and ever increasing) levels of debt.
Global debt currently stands at $247 trillion, which is over 300% of global GDP. As every dollar of debt accrued has to be owned by somebody, this means that every financial liability has an accompanying financial asset. For example, if you were to put a certain amount of money into a bank account, it is likely that the bank will lend this money out so that it can be used by another person to buy something like a house. Essentially your financial asset (your savings) becomes their financial liability (their mortgage). In this way, debt is a form of wealth.
As a result, it can be argued that an increase in global debt is actually positive, because it is indicative of a simultaneous increase in global wealth. In addition to this, debt has an important economic function of allowing economic agents (such as households, firms and governments) to spend more than their income. This can boost a country’s GDP as it stimulates consumption, as well as be used to expand future economic capacity if spent on investment goods, such as capital and infrastructure.
However this is not necessarily always the case, as excessive debt can also have negative effects. Higher levels of debt lead to large scheduled repayments with higher interest levels. This can be difficult to keep up with and can lead to bankruptcy for the borrower and large losses for the lender. Higher levels of debt increase leverage, which makes it riskier in-case any borrowers have to default. Many economists have warned that the huge increase in global debt poses a huge risk to international recovery, as it is the case that many countries are still dealing with the aftermath of the Recession and the Eurozone Crisis.
In addition to this, many countries still have very low interest rates due to their post crisis inflationary policies. If we look at the Bank of England, they have recently decided to maintain their interest rates at 0.75% and the Federal Reserve currently have their rates set at 2%. This is problematic for two reasons. Firstly, it is likely that the central banks of many countries are going to raise their interest rates in the near future, which means that the burden of debts will increase alongside this. With excessive levels of debt, rising interest rates means that it is even more likely that a party will have to default. Larger losses for banks and other lenders are even more likely to plunge the economy into another banking crisis, despite all of the safeguarding measures now put in place. Also, already low interest rates mean that in-case of a recession; central banks will not be able to further lower interest rates in order to stimulate the economy (which proved to be a successful strategy during the Financial Crisis). As a result, this may prolong or even worsen an impending recession.
In order to appropriately respond to this problem, policymakers should try to understand why economic growth has become so debt dependent. One reason could be rising levels of inequality, with poorer people increasing borrowing to compensate for stagnating real wages. To avoid a repeat of 2008, it is important to take all of this into consideration when designing a policy response.
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Hi I’m Tanvi, I’m currently in my second-year of undergraduate study at London School of Economics.