This phenomenon was not taken seriously by conventional economists — which is why the crisis took them by surprise — and they continue to misunderstand why it matters, even as the crisis that they did not see coming continues. On top of that, the government's own debt-financed spending returned the debt contribution to demand to the average of 1996-2006, when the debt ratio grew at roughly 5% p.a. in early 2008, only to fall to minus 5% in mid-2009. The overwhelming reason for this rapid turnaround was the First Home Owners Boost (which I prefer to call the First Home Vendors Boost). in mid-1973 to minus 3% in mid 1975 was the real caused the mid-1970s recession. The same pattern repeats from late 1988 till early 1993 — from a growth rate of 7% to falling at 3.5% p.a. ); It also has an aggregate private debt level of $1,250 billion which is growing at 20% p.a., so that private debt increases by $250 billion that year; Ignoring for the moment the contribution from government deficit spending, total spending in that economy for that year — on all markets, including assets as well as commodities — is therefore $1,250 billion. The change in private sector debt has gone from boosting aggregate demand by over 20% to reducing it by almost 15%. Canada’s national debt currently sits at about $1.2 trillion CAD ($925 billion USD). 80% of this is financed by incomes (GDP) and 20% is financed by increased debt; One year later, the GDP has grown by 10% to $1,100 billion; Now imagine that debt stabilises at $1,500 billion, so that the change in debt that year is zero; Then total spending in the economy is $1,100 billion, consisting of $1.1 trillion of income-financed spending and no debt-financed spending; This is $150 billion less than the previous year; Stabilisation of debt levels thus causes a 12% fall in nominal aggregate demand. Debt-to-GDP Ratio (%) = (Total Debt of Country / Total GDP of Country) × 100. What about if debt doesn't actually stabilise in the second year, but instead grows at the same rate as GDP? Debt-to-GDP Ratio Formula. The next chart shows the annual change in the private debt to GDP ratio in Australia, and the changes in government in the last 65 years (blue for a conservative Liberal party victory, black for a progressive ALP victory, and green for one election that the ALP won against the odds). in early 1993 — and this gave Australia what its then Prime Minister Paul Keating called "the recession we had to have". What's Behind the Interest Rate Conundrum, 2 Great Bollinger Band Trading Strategies. Canada … So Australia has avoided the GFC by recreating the conditions that led to it. These new buyers levered this higher deposit into a far higher loan, driving up prices which then provided the vendors from whom they purchased with an additional $30-50,000. Some of my non-orthodox economics colleagues argue that a sufficiently large government deficit can return a country to economic prosperity. In economics, the debt-to-GDP ratio is the ratio between a country's government debt (measured in units of currency) and its gross domestic product (GDP) (measured in units of currency per year). Debt is the This dramatic turnaround in mortgage debt more than countered deleveraging by the business sector, so that private debt levels rose. and financed an apparent boom. Please enable Javascript to use our menu! It is argued that high debt-to-GDP ratios cause macroeconomic instability which is not good for growth and hence make debt unsustainable. In response, I have developed a simple numerical example that hopefully illustrates why the debt to GDP ratio matters. These vendors in turn used this windfall as additional deposits in their own levered purchases. Then for a decade the debt ratio only rose, before then falling very sharply. Yet, the debate on debt continues. The debt-to-GDP ratio is a formula that compares a country's total debt to its economic productivity. Some conventional economists have criticized me for focusing on what they call a "crude" private debt to GDP ratio; others allege that I am making a "schoolboy error" by comparing a stock to a flow. Though this is painful, it at least addresses the cause of the crisis — too much private debt — by reducing it rather than increasing it once more. This approach not only explains why the GFC was inevitable, but also gives a very different explanation to preceding crises, and it explains why, to date, Australia has successfully avoided the worst of the GFC while America has suffered from it very badly. We can calculate the ratio using the following formula:. We are potentially avoiding pain now by setting ourselves up for greater pain in the near future. Then we get the following situation: This is the real danger posed by debt: once debt becomes a significant fraction of GDP, and its growth rate substantially exceeds that of GDP, the economy will suffer a recession even if the debt to GDP ratio merely stabilizes. and inflation is 5% p.a. Why the Debt to GDP Ratio matters. Mortgage debt, which was on track to fall 3% as a proportion of GDP prior to The Boost, instead increased by 6% of GDP — a 9% turnaround that was equivalent to an additional $100 billion stimulus to Australia's A$1.25 trillion economy. The growth rate peaked at 11.5% p.a. Since America is even more of a Ponzi-dominated economy than Australia, this reduction in private debt — now that the Ponzi Scheme has collapsed — is the key cause of the USA's current slump. Now to our current crisis, which has been more severe than preceding crises, not because debt was rising more quickly (in fact the rate of growth of debt in the 1970s was much higher than now), but because the debt to GDP ratio is so much higher now. Whether government spending can continue to counter private sector deleveraging is now a moot point. When a country has a manageable debt-to-GDP ratio, investors are more eager to invest, and it doesn't have to offer as high of yields on its bonds. © Copyright 2001 - 2020 Incredible Charts Pty Ltd. All rights reserved. However, a careful scrutiny of the data based on which this claim is made shows that the relationship between debt-to-GDP ratio and macroeconomic instability is weak. A low debt-to-GDP ratio indicates an economy that produces and sells goods and services sufficient to pay back debts without incurring further debt . In the first year, total demand is $1,250 billion, consisting of $1,000 billion in income and $250 billion in increased debt; In the second year, total demand is also $1,250 billion, consisting of $1,100 billion in income and $150 billion in increased debt; Nominal aggregate demand is therefore constant; But after inflation, real aggregate demand will have contracted by 5%. America, on the other hand, is clearly experiencing the worst of the GFC because it is deleveraging — reducing its debt to GDP ratio.