Excessive Debt Will Damage the Economy

As was suggested in the previous post, all the advanced economy has been consistently building an increasing level of debt. What is the effect of using huge debt? I'd like to talk about how excessive debt can damage the economy.
First, too much debt may stunt economy growth. According to Reinhart and Rogoff (2010, Growth in Time of Debt), 90% of GDP can be regarded as the ceiling "safe" level of debt. Countries with debt level above this threshold generally have lower GDP growth rates; one percent lower than countries that hold debt account for 30% to 50% of their GDP. This difference rises to two percent when compared to countries whose indebtedness is smaller than 30% of their GDP.
Second, high debt level means that the economy is unstable and vulnerable. The main reason for why so many developed countries are using huge debt is because of the low interest rate. Developing countries are willing to offer their money at a low cost. However, the interest rate can change rapidly and it is very hard to predict the change. Graph below shows how the long-interest rate changed dramatically in the last 12 months. Unfortunately, leverage ratio cannot be decreased in the same speed. So, it's very risky to hold huge debt.

Data source: ECB and European commission

Obviously we are facing a debt crisis now. Is there any relationship between financial crisis and debt crisis? I will talk about this in the next post.

Too Much Debt

  As has discussed before, the main purpose for enforcing austerity policy is to rein deficit by reducing spending or even rising taxation in some cases. It is straight forward to understand that deficit is caused by government spending more money than its revenue. But how can the government get the exceeding money? The main approach is through debt. According to Reinhart and Rogoff (2011), the level of public debt in developed countries has been rising rapidly in recent years and has now reached the highest level since the Second World War. I would like to focus on the situation of Greece to check the amount of debt it used from 1980 to 2010, comparing with its domestic gross product.

data source: IMF world economic outlook database, September 2011

  From the figure above we can find out that Greece has been consistently using more and more debt over the last three decades. Interestingly the leverage ratio has risen sharply since 2007 and reached a peak of 142.757 percent of GDP in 2010. Such a high rate of debt creates huge instability and uncertainty. And this finally triggers the sovereign debt crisis. But why is Greece using so much debt known it is very risky to do this? It is partly due to the fact the interest rate stays at quite a low level in recent years and it is believed that government should benefit from this low cost lending to expand its economy. However, is this true and is it worth to do so? Is there any historical evidence to support this? I will try to figure it out in the next post.

Austerity Ahead

According to incomplete statistics, the most frequently mentioned word in the World Economic Forum ,which is held in Switzerland last month, is "Austerity". What is Austerity? The basic idea of Austerity is that government spend less and sometimes together with raise tax rate to help reduce the deficit. The latest news said that Greece government has agreed a budget cut of 3.3 billion euro to meet the austerity requirement of eurozone to provide a second bail out package. However as soon as the government had announced the statement, protest activities by people full of anger spread all over Greece. Why? Usually the thing come together with austerity measures is a lower level of public welfare, obviously Greek people won't be happy about this. Photo below show how angry they are. Why does the eurozone stay firm to require Greece to take these austerity measures? It is said that austerity measures are like painful medicine, but can this painful medicine cure the disease? I will try to find out the answers in the next few posts.