Albert Einstein said that the greatest force in the universe is the power of compound interest. What we have seen over the past decades in US credit markets is compound, even exponential growth. In the chart below, the blue curve shows a perfect exponential curve, the red curve shows the actual level of US debt (in trillions of dollars).
A similar chart could be drawn for most of the developed world. Indeed, growth of money supply in many developed countries has also been exponential.
Note that from 1970 to 2008, there is an almost perfect match between US debt and an exponential growth curve. During this period, accumulating levels of debt acted like a steroid, powering the economy forward, contributing to rapid economic growth and rises in living standards.
Then in 2008, debt leveled off – see the squiggle at the end of the red line. You might say that the recession we are now feeling is caused by or correlated with cessation of credit growth (e.g. the removal of the steroid). We are experiencing withdrawal symptoms.
The trillion dollar question is: what happens to the squiggle at the end of the red curve? Let me present two scenarios moving forward:
(a) Governments hold debt under control (e.g. the red line might see dramatically reduced growth, level off, or decline). In this case, due to the cessation of credit growth, our economic growth (and hence consumption and standards of living) will stagnate or deteriorate.
(b) Debt returns to its old exponential growth pattern. This might happen if there is too much social resistance to deficit cutting, in which case governments may choose the less visible route of printing money and piling up debt through deficit spending. Steroids might make us temporarily feel better, but then we could be setting ourselves up for hyperinflation, possibly an eventual even bigger crash, as debt levels become even more unsustainable.
Is it possible for the debt binge of the past decades to end with a soft landing? If a narrow path between the two scenarios does exist, it would require consensus at the political level to find and walk that path. But political consensus seems to be giving way to polarization in the most important economies of the developed world.
The tyranny of the exponential curve – when applied to debt – is that as overall levels of indebtedness double every few years – it becomes increasingly difficult to escape the curve. If we do not escape the curve, and debt continues to double every few years, there are two basic scenarios: (a) if loans are denominated in foreign currency there is a default and collapse; (b) if loans are denominated in local currency, governments can print money and inflate themselves out of a debt problem, resulting in hyperinflation.
If we do bring our exponential debt growth under control, the removal of the constant stimulus of debt growth will result in a very different economic environment in the coming decades – certainly compared to the previous steroid-driven credit growth decades. Growth in the developed world would be much more moderate and standards of living would rise much more slowly, if at all – still better than default or hyperinflation.
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