It seems like a meaningless ratio on its own: as he notes, debt nets to zero. A highly financial economy might have a lot of credit outstanding, as individuals choose to obtain mortgages with one hand while investing in corporate debt with the other. A less financial economy may involve individuals paying cash for houses.
But there are likely very important structural changes when debt to GDP increases. It generally coincides with financial deepening. The real economy becomes more responsive to changes in financial conditions, and the financial system becomes more responsive to changes in growth.
Financial Deepening and Stability
Well-developed financial systems are tightly interwoven with the real economy. Some degree of financial service is very beneficial for an economy, helping investment and growth occur. Without intermediation of savings and investment funding, a lot of opportunities would be missed.
But dangerous instability arises when there is too much financial servicing, and as a general consequence, too much debt. The overgrown financial system becomes extremely sensitive to changes in trust, securitization, interest rates, risk preferences, credit availability, and so forth. Because this financial system has also become deeply connected to the real economy, booms and busts become much more likely.
Current levels of debt are apparently associated with severe financial frailty. I don't know where the right level is, but around 130% debt to GDP is a historically stable ratio.
The level may well be different for different economies and different financial systems, giving us leeway to believe we were in a brave new financial world. All the esoterica being traded and the general stability of output and inflation made that transition more credible.
Investment Finance or Consumption Finance?
Banks are not simple intermediaries between saving and investment. Through fractional reserve lending, they can finance many projects on a small base of savings. From a Keynesian perspective, this means the bank is effectively replacing current savings with investment finance. Whether a loan will be issued depends on the anticipated proceeds from the loan and the cost of the lending, not whether there's actually savings to lend from.
This means that a growing debt-to-GDP ratio indicates that the financial system is funding a lot of current consumption and investment, in anticipation of a future increase in production resulting from that consumption and investment.
In essence, the bank is a recursive bridge between the current supply of saving and anticipated future production. If future production fails to reach the levels anticipated, someone has to take damage. Savings act as a cushion for that damage, which is why RRR's and leverage limits are important, even though they're difficult to enforce.
But most investment in modern economies comes from retained earnings. Since corporations saw little better to do with their earnings during the best of times than buy back stock and pay dividends, and most GDP growth was consumption anyway, I'm a little doubtful that there will be much in the way of new production resulting from this accumulation of debt. I strongly suspect it went via HELOC's and other channels towards current consumption.
With these details in hand, the debt-to-GDP ratio looks a little more ominous.
Reducing Debt Levels
To cut debt-to-GDP, either defaults occur, inflation rises, or we wait for that future production to arise, the three options Wolf lays out. He concludes it's best to drag the repayment out long enough that the debtor promises can eventually be repaid.
If the projects that have received the funding can indeed grow production eventually, then lenders will be made mostly whole. Funding available to new projects will be limited for awhile, as resources are dedicated to the old projects.
But implicit in that selection is an assumption that sustaining the projects that were funded will lead to more GDP growth than would the tedious process of bankrupting the old debtors and funding new ones with the newly vacated resources.
I'm skeptical. First, I don't trust zombies. I am fond of creative destruction and controlled default. Second, most of this borrowing probably went towards consumption, with a bit to residential investment. These claims on individual households aren't likely to result in future production unless we have a major outbreak of productivity. I see little reason to spare households from bankruptcy for their own good: bankruptcy is very kind to them. There's a much stronger incentive to prevent bankruptcies for the owners of the claims on the households.
On that point, I've got two more posts coming on how I believe, based on the rise in financial depth and debt-to-GDP, the concentration of wealth in the hands of the few and the tilt towards consumption were inevitable. For now, count me as a Mellonite.