Christine Lagarde is attempting to provide a solution for reducing the debt of leading nations, but is the world in too deep?

In the aftermath of the 2008 financial crisis, a global economic recession – possibly the deepest, and most definitely the longest that the world has ever seen – took hold. The billions of taxpayer dollars that had been spent on bailing out the banks, combined with huge amounts of quantitative easing and reducing interest rates to rock-bottom levels, resulted in advanced economies holding the highest public debt-to-GDP ratios that had ever been seen.

To make matters worse, that debt, even now, continues to grow. Currently, global debt has risen to more than $57trn and, according to the management consultancy firm McKinsey & Company, this has subsequently increased the ratio of debt-to-GDP globally by more than 17 percentage points. With global debt at these levels, the compound annual growth rate comes in at 5.3 percent; far exceeding the 3.3 percent global growth predicted by the International Monetary Fund (IMF) in 2015 and the 3.8 percent that the organisation expects the world to achieve by the end of 2016. In short, the world is going to struggle to pay off the interest, let alone make any meaningful dent in the debt itself.

This massive accumulation of debt around the world, combined with the fact that very little has been done to deleverage the global economy both in terms of household or public debt, has led many commentators to contend that the seeds for the next economic crisis have already been sown. Some are even predicting that another global meltdown is imminent. If that is the case, it is important to understand how the world has arrived at this position – and, more importantly, to try and ascertain what will happen when the world eventually buckles under its own debt.

Those who control society are living in a bubble where the belief is that the tiny adjustments that have been made since 2008 are adequate

Rapid reduction

In an attempt to balance their books, various countries have implemented austerity measures, with many states cutting back on spending and raising taxes – however, some have found that such moves come with a number of drawbacks: if governments cut back on spending and stop investing in infrastructure and other vital projects, there is less economic output with which to reduce the deficit.

As such, a number of different fiscal policies have been put forward in the place of these austere economic ideologies. One of the more interesting stemmed from a report constructed by three IMF researchers, which asserts that if a ‘green zone’ exists – a state of high debt and full employment simultaneously, such as in the US – then it is in the public’s best interest to take on more debt. The report, When Should Public Debt Be Reduced?, argues that ‘the boom, not the slump, is the right time for austerity at the Treasury’.

Shortly after the report was released, Managing Director of the IMF, Christine Lagarde, told NPR journalist Renée Montagne, “[The US] needs to have a medium-term fiscal policy that is aiming at reducing the long-term debt… In the immediate short-term, there is no great risk of increase of [increasing] that US debt… In the short-term, some measures can be taken in order to sustain growth, in order to encourage growth by way of infrastructural investment, for instance.”

Lagarde’s position attempts to provide a balanced solution for reducing the debt of those advanced economies that exist in the green zone: when economic growth is minimal, focus should be diverted away from debt reduction and instead placed on public capital projects, which will exceed market returns and generate growth for the economy, allowing debt reduction programmes to take place at a later date.

If this solution sounds simple, that’s because it is: as with most theories, the major problem with this scheme is that it sounds great on paper, but the conditions that it requires do not exist in reality. Focusing on debt reduction during boom periods is good advice, but to this day growth remains stagnant, and many countries are struggling to stay out of recession. Lagarde’s theory is also simplistic in its suggestion that governments will make the right choices, and public investment projects will provide rates of return high enough for debt reduction to begin in the first place.

Reliance on debt

Ultimately, so long as the ratio of debt-to-GDP remains high, the debate over what the best method for reducing public debt is, will rage on. However, a great many economists are beginning to question why so little attention is being paid to the extreme levels of private household debt being accrued in many advanced economies (see Fig.1). If left unchecked, this has the potential to hamper economic growth far more than cutting back on public spending could, especially in consumer-based economies, as during levels of extreme debt people have a tendency to tighten their belts. As in these circumstances, the middle and lower classes often use their disposable income to pay down their debt instead of driving economic growth through consumption, Lagarde’s rose-tinted theories of debt reduction have been essentially rendered ineffective.

In the US – as is the case across many developed countries at the moment – the single largest driver behind increasing private debt levels has been the stagnation of real wages. “You have to remember that the US, as a society, one of its uniquenesses – or what it likes to call its ‘exceptional quality’ – was that it did see a rise in real wage for workers pretty much continuously for the 150 years before the 1970s”, according to Professor of Economics Emeritus at the University of Massachusetts and Producer of the Economic Update podcast, Richard D Wolff. “This gave the US not only an extraordinary level of wealth, but it made [the] working class believe that it had arrived in the best possible place on the planet, because [the US] could promise endless waves of immigrants rising wages over time.”

Not only did the US deliver on that promise, providing many of the people that came to its shores a level of prosperity and a standard of living that was not afforded elsewhere, but it also saw the birth of what was known as the ‘American dream’, with workers’ wages rising to reflect the boom in economic activity. However, over the last 35 years, wages for many Americans have failed to grow – which, according to the Economic Policy Institute, is the primary cause of not only a depreciation in family income over the past generation, but also an increase in income inequality across the country.

This stagnation of real wages in the US resulted in the American working class trying to solve its problems with debt. The American people have sustained a rising standard of living in the only way that is available to them when real wages don’t rise: through borrowing. They did so partially by developing the mass credit card, a phenomenon of the 1970s. During the same period, there was an explosion of another relatively new phenomenon – mortgage debt, which took off in a big way.

“You have a population that is addicted to debt as a way to sustain the so-called American dream”, Wolff told World Finance. “To give the mass of Americans… at least a sustainable illusion that their promised well-being – the promised progress of each generation living at a higher standard of living than the one that preceded it – [is still intact]… To keep all that going, which is absolutely crucial for the self-image of American society, debt has become the answer.”

The Bank for International Settlements (BIS) has seen debt-to-GDP rise to worryingly high levels in a number of countries of late, leading many commentators, including Wolff, to fear that another major banking crisis is on the cards within the next three years. “I certainly think we are heading for one”, said Wolff. “I do not see, in any significant way, that [any] response to date – whether it is the Dodd-Frank bill in the US or the various banking regulations imposed in Europe – are adequate to or proportional to the level of the crisis”.

Wolff isn’t the only person to think that the US has failed to learn many lessons from the last financial crisis: speaking at the IMFs’ annual meeting in 2015, José Viñals, Director of the Monetary and Capital Markets Department at IMF, said that all advanced economies have yet to address the legacies of the 2008 crash – something that he argued is essential if there is any hope of financial stability and growth returning. Considering how much is at stake, it is baffling to many why policy-makers have not done more to fix the broken financial system that was at the heart of the last economic crisis.

Working the system

As Wolff sees it, there is a fundamental and constantly evolving social split in American society between the ‘haves’ and the ‘have-nots’, where ‘haves’ are able to live comfortably, and ‘have-nots’ find themselves frequently worrying about their livelihoods (see Fig. 2). Once that divide is fully understood, he believes that it becomes clear not only why the US has found itself in this precarious position, but why little – despite Lagarde’s assertions – is being done to fix it. However, while the vast majority of people are still suffering as a result of the financial turmoil of 2008 and the on-going economic crisis, a small percentage of the American income pyramid has done spectacularly well: between the 1970s and the present day, this group of high-earners has seen extraordinary levels of growth in both their absolute and relative wealth.

Wolff noted, “Yes, things went bad in 2008, but [this group] had the power then to direct the government to bailing themselves out. So for them, everything is working out fairly well, and has gone that way for almost half a century. Therefore, they are deeply persuaded that this [way of life] can and will persist, and the notion that the mass of people are falling ever further behind… becomes unimportant. They just think that this is the way things are now, and the mass of the working class will need to accommodate itself to the changed world.”

For Wolff, the folks at the top understand that they have become extremely powerful by virtue of this highly concentrated wealth pyramid, and that this puts them in a vulnerable position in a society that offers universal suffrage. In the US, according to Wolff, the elites have taken very concrete steps to immobilise the political system and create a systematic barrier against anything that will change the favourable situation they find themselves in.

“America is now a place where, to be a credible political candidate, you have to satisfy 500 people who sit at the top of the economic ladder of this society. And if you manage to displease any significant portion of them, your political career is either over or capped at a point of incapacity to do anything, no matter what the mass of opinion is in the country.” The political system, therefore, has either grown insensitive to the economic problems that it faces, or it has become systematically stymied to them. It is for these reasons that the shortcomings of the economic system have been allowed to persist for so long – because there is seemingly little to no resistance to it.

According to Wolff, politically speaking, there are only marginal signs of discontent about the way in which the country is structured, with only a few high-profile figures, including US Senator Bernie Sanders, publicly addressing inequality levels. However, the real danger with setting up a society up in this manner is that political explosion becomes the only feasible method for bringing about meaningful change for those who oppose the system. Wolff said, “If I were the bank of international settlements, I would be far less worried about a financial crisis than I would about the social explosion that is bubbling below the surface.

“If you read the financial press, there are widespread predictions that 2016 and 2017 are lining up to be difficult years, with various kinds of adjustments, downturns etc. If they are bad enough, and they set off the kind of cascades of trouble that [they have the potential to] – [which certainly happened] in 2008 – it could be the catalyst to social, political and economic reforms on a massive scale.”

Catalyst for change

Since 2012, the world has been talking about an economic recovery, despite the fact that many people have yet to feel the effects of one in their daily lives: most people’s wages haven’t recovered, and while unemployment rates appear to be shrinking at long last (see Fig. 3), for those willing to look a little more closely at the labour market, they will notice that almost all of the jobs that have been created in the last four or five years offer much lower pay without any of the benefits that many have come to expect. There is also much lower job security overall.

All of this is being imposed on the working class, while the government endlessly talks about recovery. In effect, what this does is make the majority of people feel as though there has been a recovery that they have somehow missed out on. This in turn forces people to turn inward and blame themselves for something that is a larger social issue – however, there is no saying that this anger will stay internal forever.

Wolff noted, “If the situation does get worse and you allow the left to function in the US, which it is now doing on a scale that I’ve never seen in my lifetime… Combined with the fact… that a phenomenon like Sanders – someone that identifies as a democratic socialist – can even run for office in some significant way… All this acts as a sign that, just below the surface, there is a lot of anger and a lot of bitterness waiting to be unleashed.” What will eventually ignite this process is difficult to predict – however, what is clear is that the US is a tinderbox.

Separated from reality

Those who control society are living in a bubble where the belief is that the crisis is manageable, and the tiny adjustments that have been made since 2008 are adequate, meaning that nothing is likely to change anytime soon. Meanwhile, the general public is both aware and slightly afraid of the social cataclysm that they know is coming.

As it stands, the US has neither the leadership at the top or – for the time being, at least – the pertinent formations below that are necessary to bring about change in any meaningful way. It is a difficult time, but Wolff admits that the consciousness of the majority is changing. People are growing more and more discontented and less and less patient with the current state of affairs, and while in the past people would put up with capitalism’s shortcomings because it at least ensured a better standard of living to what was afforded to the generation prior, that is no longer the case.

“The mass awareness of the inequality, and the sense of it being unfair and out of control – I’ve never seen that in the US in all my life”, according to Wolff. “This is socially explosive. I don’t think that it is sustainable long-term. The truth of it is that you now have a system that is desperately trying to figure out how to be successful… for those at the top, without being so disastrous for everyone else that it destroys itself. It gives me a sense that the system is en route to sowing the seeds of its own demise.”

There is a level of instability in the economic system that can be disguised and covered over. We can all become Keynesians who believe that governments’ monetary and fiscal policies can still keep everything going, as Lagarde has assured us – but it’s a concern how much longer this can be sustained before cracks begin to appear, and the debt finally takes its toll.