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Characteristics of Extremely Over-Indebted Economies

Over the more than two thousand years of economic history , a clear record emerges regarding the relationship between the level of indebtedness of a nation and its resultant pace of economic activity.

The once ourishing and powerful Mesopotamian,

Roman and Bourbon dynasties, as well as the British empire, ultimately lost their great economic vigor due to the inability to prosper under crushing debt levels. In his famous pap er “Of P ublic Fin ance” (1752) David Hume, the man some consi der to have been the intellectual leader of the Enlightenm ent,

wrote about the debt problems of Mesopotamia and

Rome. The contemporary scholar Niall Ferguson of Harvard University also described the over-indebted conditions in all four countries mentioned above. Through the centuries there are also numerous cases of less prominent countries that suffered a similar fate of economic decline resulting from too much debt as a percent of total output. The United States has experienced four bouts of great indebted ness: the 1830-40s , t he 1860- 70s, the 1920-3 0s and the pa st two decade s. Japan has been suffering the consequences of a massive debt over -hang for the past three decad es. In its

rst of three thorough studies of debt, the McKinsey Global Institute (MGI) identied 32 cases of extreme

indebtedness from 1920 to 2010 . Of this group, 24 were advanced economies of their day. The countries identified in the study, as well as those previously cited, exhibited many idiosyncratic differences. Some were mon archies or various forms of dictatorships. Others w ere democracies, both nascent and mature. Some

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First Quarter 2015

countries were on the Gold Standard, while others had paper money . Some had central banks and some did not. In spite of t hese technica l and structu ral differentiations, the effect of high debt levels produced the clear result of diminished economic growth. Indeed, the fact that the debt impact shows through in these diverse circumstances is a clear indication of the powerful deleterious impact of too m uch debt. Six charac teristics seem to be uniform in all circumstances of over-indebtedness in historical studies, and these factors are evident in contemporary times in the U.S., Japanese and European economies.

Six Characteristics

1. Transitory upturns in economic growth, inflation and high-grade bond yields cannot be sustained because debt is too much of a constraint on economic activity . 2. Due to inherently weak aggregate demand, economies are subject to structural downturns without the typical cyclical pressures such as rising interest

rates, ination and exhaustion of pent-up demand.

3. Deterioration in productivity is not inflationary but just another symptom of the

controlling debt inuence. 4. Monetary policy is ineffectual, if not a net

negative.

5. Ination falls dramatically , increasing the risk of deation.

6. Treasury bond yields fall to extremely low levels.