Is the world economy in a debt trap? - The Economist

An alternative explanation for why real interest rates have fallen since the 1980s is that many countries have become less equal. Richer people save more as a percentage of their income, so as they earn a bigger slice of the economic pie, aggregate savings rise. Atif Mian, Ludwig Straub and Amir Sufi, three economists, say that the American economy suffers from a “savings glut of the rich”, two-thirds of which has been used to finance the debt of the American government or borrowing of other households.

They also propose that rising inequality can cause economies to fall into a “debt trap”. The savings of the rich push down interest rates, encouraging other sectors to borrow and spend more. Over time, the indebtedness of the poor to the rich transfers income upwards, giving the rich even more savings. The cycle starts again, and real interest rates fall further. Policies to stimulate the economy in the short term, such as low interest rates or debt-financed fiscal stimulus, lead to even more debt, meaning lower rates and worse recessions in future.

Today central banks are raising rates to fight inflation. If Mr Mian, Mr Straub and Mr Sufi are right, economies will be more sensitive to higher rates than in the past. Rates will not need to rise much to squeeze indebted households and governments, who will see big chunks of income diverted to the rising costs of servicing mortgages and bonds. But over time the debt trap will assert itself and real interest rates will stay low.

One weakness of the framework for analysing the world economy is that in many rich countries household debt has not risen much as a percentage of gdp since the crisis of 2007-09. Even as rates fell close to zero, households repaired their balance-sheets rather than borrowing more. Governments are running up debts, but their spending is subject to the whims of politics and may not fall as interest rates rise, given the huge pressures on budgets.

There are economies in which households have been on a borrowing binge, however. One is South Korea, where the household-debt-to-gdp ratio rose from 79% in 2010 to 109% at last count. Approximately half of household debt is linked to short-term interest rates, which are rising. In a report on the economy in March, imf staff estimated that the higher level of household debt would be enough to lop an additional 10% off spending in South Korea should rates return to around 5%, their level in 2000.

How might economies escape such a debt trap? Messrs Mian, Straub and Sufi say that only a reduction in inequality can do the trick, whether via redistribution or through structural reforms. But there is another force that might have the same effect: inflation. Unexpected inflation redistributes wealth from creditors to debtors, says Mr Straub, so long as it leads to strong wage growth for debtors, and is not just the result of newly expensive energy. Often economists see inflation as a veil—a “nominal” rather than a ”real” phenomenon. But, should central banks fail to tame price rises, they will redistribute from creditors to debtors, and so might alter the fundamentals of the world economy as well. ■

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Is the world economy in a debt trap? - The Economist
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